Royce Investment Partners Podcast: Small-Cap Quality for the Long Run
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This transcript has been edited for clarity.
Francis Gannon: Hello and welcome. This is Francis Gannon, Co-Chief Investment Officer of Royce Investment Partners. Thank you for joining us. Our conversation today is with Steve McBoyle who, along with Lauren Romeo, is one of the Lead Portfolio Managers of the Royce Small-Cap Premier Quality Strategy which we use in Royce Premier Fund. We're going to look back at performance in this volatile period and look forward to the opportunities the team is seeing in the overall market.
I should note that the Premier Quality Strategy is outperforming its benchmark, the Russell 2000 Index, for the year-to-date, 1-, 3-, 5-, 10-, 15-, 20-, and 30-year periods, as well as its since inception (12/31/91) period, through the end of January. The Strategy has a strong history of outperformance in down markets as it has navigated the volatility of the past several years incredibly well. Perhaps that's a great place to start, Steve. The Strategy had strong performance in 2023 and has had a strong start to the year. What are your thoughts about recent performance?
Steven Mcboyle: Thanks, Frankand thanks for having me on. We've been pleased with our performance of late, which reflects positively on the process and the team. We're particularly proud of last year's outperformance given the volatility that you referenced, and the Strategy's performance since the index high on 11/12/21 through the end of last year, when the Strategy provided positive returns while the index was down -14%.
Now having said that, I have to be objective. Our outperformance last year was not without a few challenges, and the fourth quarter was certainly one. In the fourth quarter, low-quality (defined as companies with low or no returns on invested capital) worked and return on invested capital companies with earnings and high-capitalization rates underperformed, and the Fund trailed the index. That said, a 90% upside capture ratio in a strong up quarter is consistent with the Strategy's performance over time. Most importantly, we continue to believe that quality, and Premier specifically, continues to be well positioned for the times.
FG: Let's switch a little bit and talk about the current earnings season. Where are you hearing that's of interest?
SM: We're certainly having a strong earnings season year to date. Several observations come to mind. As they often do, they tend to be sector specific. I'll start with the continuation of what I call the great digestion, as it relates to this pandemic-induced inventory channel dynamic. We're on the back end of normalizing this dynamic, which is to say that lead times are coming in, channel inventories are normalizing, and companies are reducing their safety stock or even double ordering for that matter, as we get back to a supply-demand parity. This resulting digestion has been anything but normal, requiring a lot of analysis to parse what is normal from what is not, particularly as it relates to pricing. Now, certain sectors were more extremethink of all things electrical component in nature, semiconductors, electrical, building materials, etc.
Due to the many macro factors of latecall it the geopolitical rewriting of supply chains, the strategic importance of supply, and fiscal stimulusit seems to us that premier companies are benefiting from pricing in ways that they had not in the past. Parsing the difference between pricing that's secular versus supply-demand driven is increasingly important. And the impermanence of this pricing is beginning to manifest itself in a lot of our companies' earnings. Certainly, long cycle, backlog-led industrialsparticularly those serving U.S. industrial infrastructure Capexare doing very well. The economy is strong, fiscal money is flowing into many of our companies, and backlogs remain robust. Now these Capex comments are specific to the U.S. Our companies serve global markets, but it's the Capex cycle in the U.S. that remains strong.
We are seeing early signs of the benefits of normalizing rateseven though at higher levels amongst select businesseswithin real estate. It is important to point out that the Strategy's holdings in real estate are very intentional in that we do not own the largest portion of the sector, which is real estate investment trusts. Rather, we own real estate service-oriented models, companies like First Service (NASDAQ:FSV) or Colliers (NASDAQ:CIGI). In both cases, these are companies that possess higher recurring revenue and profit streams as they provide servicesthink of property management, restoration, outsourcing, and advisory leasing sorts of services.
Let's take Colliers. The company does have a small capital markets brokerage line of business where activity levels last year declined at rates not seen since the Great Financial Crisis which, as we well know, were driven by uncertainty and rates, significant bid-ask spreads, and the lack of credit at the time. Today, real estate activity is returning as rates stabilize. Uncertainty is increasingly in the rearview mirror. There are indications of buyer and seller expectations returning closer to parity, and this buyer freeze is beginning to thaw as rates stabilize.
It's hard not to make a comment about consumers, who remain healthy, though there are definite signs of large ticket, nondiscretionary items being deferred. However, this is less of an issue for our Strategy as we have relatively little exposure to nondiscretionary B2C (business to consumer) models.
FG: You mentioned infrastructure, which is front and center on many investors' minds these days. How is the Premier Strategy positioned for that theme?
SM: Yeah, great question. The Premier process seeks differentiated, durable, time-tested models that control their destiny. Simply put, they have pricing power. Over a long period of time, we have always found Industrials to be a target rich sector for finding these unique premier businesses. Many of our industrial holdings are benefiting nicely from infrastructure demands. Just to name a few, take Arcosa (NYSE:ACA), an aggregate model selling sand, gravel, and stone to the infrastructure and construction markets, predominantly in the Southeast. Aggregate models are local monopolies given the radius limitations, while the reserves have high barriers to entry due to the steep permitting requirements.
Reliance Steel & Aluminum (NYSE:RS) has a powerful scaled steel service center model, serving all the local machine shops and most steel manufacturers in the U.S. Another would be ESAB (NYSE:ESAB), an equipment and consumable provider for welding applications in the U.S., with a dominant share in fast growing geographies, including the Middle East and India. So, the demands for infrastructure are real. It's interestingthe Contractors Association recent recently published that there would be a need for over a half a million additional workers for constructionconstruction that is in place todayfurther estimating the need for another 450,000 workers in 2025, even with the slowing year over year expectation in construction spending.
Simpson Manufacturing (NYSE:SSD) is the gold standard for connectors to the residential housing market, and yet they're making strong inroads into providing commercial structural steel connectors, substituting welded connections given the massive welder shortage that we have in the U.S. We are indeed positioned to benefit from infrastructure and non-residential construction demands in the U.S., which we continue to think is a multi-year tailwind of demand.
FG: There was considerable amount of volatility in 2023. How did you adjust the Premier portfolio during that time period?
SM: To say 2023 was interesting from a volatility perspective would be quite an understatement. Overall, the Strategy's sector allocation saw little change from the start of the year to the end of the year. Perhaps not unexpectedly, we were most active in the third quarter of last year. We added three new names: two in Industrials and one in Consumer Discretionary. As an example, the name added in 2023 that is most axiomatic, I suppose, of the volatility opportunity would be Installed Building Products (NYSE:IBP) (IBP), an installer of insulation where 70% of their end market is residential new construction. At one point last year, IBP was down over 30% on fears of rates remaining higher for longer and residential affordability. But we certainly saw that as an opportunity.
FG: Tell us a bit more about that new purchase.
SM: IBP passes the science and the art tests in the Premier process. For one, the market structure is a duopoly with only one other scaled player, with the competitor and IBP accounting for close to 60% of the market. The business model is a nationally scaled, local density branch service model, which we like because scaled economies are shared down to the local branch network, allowing for pricing advantages relative to local mom and pop competitors.
Unlike the typical building products value chain, where there are multiple margin stocksthink of a product flowing from a manufacturer to a distributor to a wholesaler contractor, and ultimately to the builderin IBP's case, it's a direct value chain. The installation ships from the manufacturer to the builder's site by way of IBP. Installation is a mission critical service, as a permit is needed before a house can be built. As you can imagine, the last thing national builders want is underutilized labor due to a lack of permits. There are also increasing regulations being considered around installation that could be quite beneficial. We like the fact that this is a 100% variable cost modelthink materials and laborso there's very little capital intensity. And then to round it out, IBP is founder led, with high insider ownership and a proven M&A framework, with a good remaining percentage of the industry that is ripe for consolidation.
FG: You referenced the science and art as it relates to the Strategy's investment process. Can you explain further what you mean by that statement?
SM: SM It relates to how we define and interpret quality. We think we have a distinct definition and method of building conviction. The reference to science and art is to differentiate the quantitative from the qualitative analysis we do around quality. The critical part of the Premier process is indeed the artdetermining the duration and durability around a business's return on capital. You could say we're in the business of destination analysis, as abstract as that may sound. Simply put, the science is the here and now. We have a business that screens for quality today, defined as one with high returns on invested capital, low leverage (which we define as net debt to EBITDA), high free cash flow conversion (which measures a company's ability to convert operating profits into free cash flow), and preferably a high reinvestment rate of capital into the business.
More importantly, the art is about determining what a business model will look like three, five, or ten years from now. Better yet, when the team can build conviction around a company's destinationin other words, the persistence of those initial quality metricsand our view is not shared by others, all that much the better.
FG: Steve, how do you identify those durable markers three- to five years down the road?
SM: It really relates to all of the premier attributes that we're looking for. Upfront, we want to identify business models that have certain characteristics. For example, they're a global number one or global number two in terms of their share position. They tend to be asset light business models and tend to have products and services that are mission critical in nature, which is to say they have a high value proposition to the ultimate end customer. They also tend to serve operating budgets versus capital budgets, which is important because it invariably leads to a very sticky customer relationship where you're not beholden to the cyclicality of capital budgets. As it relates to those markers, certainly upfront in terms of the process, we want to see those attributes. It's through the full enterprise quality assessment process, where we try to delve into all of those points in far greater depth, with the primary objective of trying to identify durable persistent quality metrics over long-term time, that we try to capture compounding.
FG: One last question before we let you go: Why is quality and specifically the Premier Strategy timely today?
SM: Well, we think investing in Premier specifically is both a timely and a timeless strategy. Timely, given the backdrop of the historic valuation spread between small and large-cap stockswhile within small-cap, quality companies also have a relative valuation benefit. Further, as we sit here today faced with many macroeconomic uncertainties, our premier businesses are currently exhibiting strong operational fundamentals.
Over full market cycles, quality tends to outperform on a risk-adjusted basis with less volatility. Our premier businesses exhibit pricing power and strong cash generation, all while supported by strong balance sheets. For those reasons, we think the moment is timeless and timely for the Premier Strategy.
FG: Thank you, Steve, for what is always an interesting conversation. And thank you all for joining us.
Mr. McBoyle's and Mr. Gannon's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
This article first appeared on GuruFocus.
