This podcast was recorded on 9/15/22. It has been slightly edited for clarity.

Francis Gannon: Welcome everyone. This is Francis Gannon, Co-Chief Investment Officer at Royce Investment Partners. Thank you for joining us. I’m thrilled to have a conversation with Lead Portfolio Manager, Chuck Royce and Portfolio Manager Andrew Palen of Royce Pennsylvania Mutual Fund. We’re going to look back at performance in this volatile period and look forward to see what opportunities that volatility is creating for the Pennsylvania Mutual Fund. The Royce Pennsylvania Mutual Fund, is outperforming its benchmark, the Russell 2000, at the end of August on a year-to-date, one-year, three-year, and five- year basis. Chuck, how are you thinking about performance and the positioning of Penn in this unique environment?

Chuck Royce: I think it’s doing what it’s supposed to do. I think of Penn as having a lower risk profile in general, which should deliver less volatility and yet deliver strong returns over the longer periods of time. We have mitigated some of the volatility and I am impressed with how it’s performed in the long term. The small-cap world is a very large market with a variety of ways to address it. Penn addresses it, I think, in the ideal way.

FG: As the lead portfolio manager of this multi-discipline approach, how do you think about the structure of Pennsylvania Mutual Fund?

CR: We have divided into two approximate categories: value and quality. In the value world, we do use a quality bias, but value there, its lower price to book in general—lower P/Es, lower growth rates. In our quality [segment], we’re using higher corporate attributes, higher returns on capital is probably the primary factor. So, we have divided the world into those two zones. I’m privileged to be here today with Andrew Palen, who is part of our quality zone. And I’m very, very pleased with how they operate separately and yet give you the good, strong lower-risk returns that they have.

FG: Andrew, I’ll switch to you here. Could you spend a second—Chuck alluded to your quality side of the portfolio—perhaps you could spend a few more minutes on exactly how you’re looking at emerging quality within Pennsylvania Mutual Fund.

Andrew Palen: Thank you. Sure. I’d start out with how we approach quality investing with the Premier strategy, which is focusing on returns generated to the enterprise with a focus on a consistent history of execution, sustainable competitive advantages, and robust capital allocation frameworks. In terms of emerging quality, I narrow the aperture and focus on businesses with ample reinvestment opportunities of attractive returns. So the incremental returns on capital are higher than the average returns. That type of investing is a matter of looking at the life cycles of the investment cycle, whether it’s by product, company or an industry.

What I find with emerging quality businesses are situations where there are misperceptions going to those investment cycles. So they aren’t necessarily showing the headline returns on invested capital or margins, or asset efficiency ratios that you would find with Premier quality businesses. My approach is finding those businesses with some resilience and optionality, with a dynamic the market doesn’t appreciate.

FG: Why do you think the market is not appreciating that dynamic today?

AP: Like I said upfront, a lot of these quantitative factors are things like ROIC margins or outputs, and we’re very much focused on the inputs. We’re focused on things like switching costs, the search costs for business, the customer-centricity. Or in a lot of cases, with these businesses earlier in their life cycle, they’re actually making investments in their business both in the CapEx line, but through the income statement that depress quantitative measures. And so that’s a portion of why these businesses are overlooked.

FG: Perhaps you could give us an example of some of these opportunities you’re finding in the market today.

AP: Yes. I’d highlight a business in the category of unfair fights. This is a business called Murphy USA. They were spun out from the Murphy Oil business in 2013. This is the fuel retailer side of the business. And what is notable about this business and is underappreciated is that it’s a low-cost operator, which has improved its position because of structural increases to operating costs. You have a dynamic where they’re a low-cost operator and subscale competitors can’t lower their pricing to Murphy’s level. And so this pricing umbrella actually enables top decile fuel margins for this business. And the reason I like it is they have a big runway for reinvestment. They have a national brand and scaled relationships that will serve the business well. I see an opportunity for them to double their locations, and sustain improving profitability levels as they roll out things like their new C-Store convenience store brand banner and test out new store models and footprints in newer markets that are showing good early returns.

I’d also highlight a business that’s actually benefited quite greatly from the changing work patterns following the pandemic, a business called Calix. And what I call it upfront is a founder-led business that’s actually in its second act, which is a theme that I often find with emerging quality businesses. So they had a legacy business, providing hardware to telecommunications providers basically enabling things like internet and telephony to get to your house. But in the last 10, 15 years, they’ve invested over a billion dollars transitioning the business into software-led solutions that enable their primarily rural communication customers, which now represent over 80% of their business versus 20% over 10 years ago, to improve the service quality to their customers.

This is another kind of business I look for. It’s a mission-critical partner. It’s a business that’s growing double digits at incremental margins over 20%, and it’s actually not showing up in the financials yet. So you had a business that wouldn’t have qualified for our quality investing strategy. It had negative returns on investing capital, and it’s now turning a point where it’s positive and has underappreciated momentum.

FG: And Chuck, how about you? Where have you have been investing lately within Penn?

CR: My role—I have the wonderful advantage of having different managers in the quality segment where recently I’ve used probably slightly more emphasis on value, but I’m really looking for the specific stock opportunity no matter where it falls. In the overall Fund, we’re using more Dorman [Products] and more IAA. IAA is an interesting financial company, very unusual. They specialized in the auction world of used cars. A very particular vertical that only has two players. IAA is the second player, but they have very reasonable market share and they’re on the way up, and we think there is a very strong price opportunity here for IAA. In that particular world, used cars are more valuable, therefore the parts are more valuable. This is a, believe it or not, a global market. When cars come for auction, they’re taken apart, and the parts are sent all over the world.

Dorman is a fascinating company that is in the asset light world of providing products also for longer-aged cars. They have set up a unique distribution system around the country, using their manufacturing relationships to provide the most knowledge about parts that are under high wear and tear, and how do you put those parts so they’re available? They have set up a unique setting for doing this, and their world also is doing well and about to do better.

FG: Why have you been focusing more on value in this environment?

CR: Well, the quick and dirty and cliché reason, of course, is rates are going up. And rates have a way of constricting multiples. So yes, but it’s a cliche. Within growth, I’m always looking for great long-term growth. So we’re not ruling out growth at all, we're just being more careful.

FG: You mentioned that you like value here. Are there any specific names you’ve been adding to on the value side of Pennsylvania Mutual Fund?

CR: Sure. Element Solutions is a wonderful company that provides the chemical requirements for the manufacturer of electronic often semiconductors, they have a leading market share. They are not a fast-growing company, they’re a modest-growing company. And the market tends to be skeptical that they can continue to grow at all. So we have taken a bet, and the value group has supported that with extensive work, that this is a excellent price opportunity.

FG: Pennsylvania Mutual Fund picked up nicely in the decline. The market peaked in November, and bottomed most recently in June of this year. The market was down about 32%. Pennsylvania Mutual Fund was down about 26%. How do you think about positioning the portfolio for recovery, both from an economic perspective and perhaps from a portfolio perspective?

CR: I think we very much should take advantage of this steep decline, that a decline took us down to the mid-June number, so we picked up 500, 600 basis points on that, that’s sort of what we would like to do. We are absolutely looking ahead to the next three years or so, and I would say we are still bending the portfolio with a value orientation and we are at the moment avoiding the growthier names.

FG: So much is being made of this particular time being similar to the ‘70s. What benefits do you think you have having invested through the ‘70s, given its similarity to today’s environment?

CR: The similarities are twofold. We are in an inflationary environment that’s came out of the COVID excess period of putting money into the system. There’s no doubt that inflation is real. It’s substantial. And we had a similar period in the late ‘70s right through early ‘80s. We have a similar period in that the country is divided.

FG: Andrew, I didn’t ask you, but I’d love your answer to the same question I asked Chuck, in terms of how are you positioning for a recovery in this environment?

AP: Yes. So in a nutshell, I find that in these situations, I’m buying insurance on agency costs. And so what does that mean? I’m looking at businesses, stocks that go from, you can’t own them to you can’t not own them. And what does that boil down to? It boils down to over-extrapolation, which we saw for a period of time during the pandemic, in terms of revenue and margins in a lot of businesses, that’s now transitioned to cost over-extrapolation. And so an area where I found opportunities is in semiconductor capital equipment. I’ve found a business in FormFactor that operates in advanced packaging where you have, with the economic worries and slowing growth in this environment, semiconductors have de-rated and earnings revisions have started. But you actually have a business here that through the next cycle will have greatly improved earnings power.

And in this case, it’s going to a theme that we see in the number of holdings called advanced packaging. And so this is addressing the end of the road for Moore’s Law, which was a constant shrinking of transistor sizes for decades that has now run out. And so you have successive generations of semiconductor devices are being built in three dimensions. FormFactor adds value here, because when you’re integrating that many chips together, if one of them is inoperable, you have to throw out the whole device. And so the importance of their solution has improved. Then with dynamics like on-shoring and the national security importance of the semiconductor supply chain, you have a business that cycle over cycle, will be gaining market share. The market will be growing, and they will be improving their margins with the structural changes that are ongoing in this perceived cyclical market.

FG: Chuck, later this year, we’ll be celebrating the 50th anniversary of our management of Royce Pennsylvania Mutual Fund. What lessons have you learned along the way?

CR: I think one of the things I would probably want to emphasize today, although back then we were emphasizing that there were unique opportunity in the small-cap space, that it actually was a separate universe of stocks. That was not acknowledged ‘til the mid-80s when Russell decided to call it an asset class, and named it as such. But then, we were early in describing small-caps as being a distinct asset class. Today we are clearly running Penn on a broader spectrum. We’re using all of the appropriate styles that are available in the small-cap world. We think we have the very best people doing it. And here again, its uniqueness in that it is a highly diversified fund using broad, specific portfolio types within the small cap space. So I think it has continued to be a unique setting.

FG: Great. I think it’s interesting that the Fund remained overweight at the end of the second quarter. The largest three sectors were Industrials, Information Technology, and Financials, and a lot of those names are represented here today in our conversation. I think you’ve given us all a great sense of this multi-disciplined approach, and a good sense of the different segments of the overall portfolio. As I mentioned, later this year, we’ll be celebrating the 50th anniversary of our management of the Pennsylvania Mutual Fund, and the 50th anniversary of Royce. Thank you Chuck, and thank you Andrew.

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