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 Portfolio Manager Mark Fischer, who along with Assistant Portfolio Manager Mark Rayner and Senior Analysts Yutetsu Ametani and Evan Choi, the Royce International Small-Cap Premier Quality Strategy which we use in Royce International Premier Fund.

It has been a difficult few years for international small-cap investing, particularly for those with a quality bent. Mark, perhaps that's a great place to start. Why is international small-cap a structurally attractive asset class?

Mark Fischer: The first reason is that, simply, if you want to take advantage of the full range of opportunities that are available to you as a public equities investor, you have to invest in international small-cap. According to the World Bank, around 90% of all listed companies globally are actually outside of the U.S., and that means that there are entire industries that are more or less inaccessible to public equities investors who limit their activities to the U.S. Some of these industries are actually really attractive and allow investors to participate in significant long-term value creation.

Second is that long-term investors in international small-caps have done quite well over time. A hypothetical investor who had invested in the international small-cap benchmark the MSCI ACWI ex USA Small Cap Index, since its inception in 1994 would have produced positive 5-year returns in over 80% of monthly rolling periods; and those returns would have also beaten the large-cap equivalent of the benchmark MSCI ACWI ex USA Large Cap Index in 80% of monthly rolling periods. And you get those attractive returns with only moderately higher volatility than international large-cap and with substantially lower volatility than emerging markets.

International Small Cap Has Consistently Beaten International Large Cap
Batting Average of MSCI ACWI ex USA Small Cap vs MSCI ACWI ex USA Large Cap
Monthly Rolling Average Annual Return Periods from the Index Inception (5/31/94) through 9/30/23

Past performance is no guarantee of future results.

It's also an ideal hunting ground for active management, and we think an asset class where active managers have a reason to exist. It's incredibly vast, and it's also highly inefficient. Nearly 30%, for example, of the companies in our benchmark have one or even no sell-side analysts covering the stock. That means that if you're an investor with a disciplined process and with patience, you can come across gems trading at reasonable or even attractive valuations.

FG: Perhaps more importantly, why do you think quality is the best approach to capturing the opportunities in international small-cap?

MF: Our investment philosophy is premised on the simple belief that what drives share prices in the long term is company value creation, and that the only companies that create value, mathematically speaking, are those whose returns on invested capital exceed their cost of capital. Now if you can invest in a company with consistently high returns that can also effectively reinvest capital, then you have a company that can harness the power of compounding returns.

Companies with consistently high returns on invested capital ("ROIC") compound over time, which is why it's a force that's often hard to overwhelm in the long term. We think that investing in quality allows you to be a genuinely long-term investor because if you want to fully harness the power of compounding, you need to hold for a long time. In our Strategy, we look for highly resilient companies because they will eventually face obstacles, from economic slowdowns to inflation and other unexpected events. We think investors can achieve this needed resilience by investing in a business with quality attributes—a strong balance sheet, pricing power, durable competitive advantages, and the like.

FG: So building on that, why has the Strategy’s performance in the past 3 years been underwhelming?

MF: The power of companies with relatively high ROIC compounding can be overwhelmed from time to time. We can see dislocations between value creation and share price performance, especially when macro sentiment and thematic investing take a front seat. Admittedly, we've been in the longest such dislocation since the inception of the Strategy, and it's been frustrating.

There's been a confluence of contributing factors. With thematic investor preferences over the last 3 years jumping from COVID beneficiaries—think of the Pelotons and the Zooms of the world—to reopening beneficiaries—think airlines and hotels—to inflation beneficiaries—for example, energy stocks last year soared 27%, while the benchmark as a whole was down 20%. High return on invested capital businesses have simply fallen out of fashion. Over the last three years, companies with the strongest balance sheets, those in the top quintile and their net debt to EBITDA within the MSCI ACWI ex USA Small Cap, underperformed those with the worst balance sheets, those in the bottom quintile.

Of course, there are things that we could have done better. There are businesses, for example, that produced a great price performance that we evaluated, but we declined because they didn't pass our stringent quality hurdles. We call those “false negatives.” Then there are a few companies that turned out not to be as good as we thought. These are the “false positives” that we really want to avoid. We believe we keep those types of mistakes to an absolute minimum, but we do occasionally make them.

But the silver lining is that overall our companies are in great operational shape. In fact, if we look at our operational scorecard, our companies are actually even stronger than they were 3 years ago. Their weighted average returns on invested capital are a bit higher, their balance sheets are a bit stronger. There's not a single loss-making company in the portfolio, and our companies continue to post high single digit annual sales growth. We believe that over time, share prices will continue to reflect that operational strength.

FG: Spend a second here, Mark. Can you elaborate on that last point? Specifically around why should operational performance be honored by the market?

MF: Sure. And I want to be careful here because we don't try to predict the future and especially future share prices. But if we use history as a guide, just as we think that there have been unprecedented headwinds to the Strategy, we also think that there are now unprecedented mean reversion opportunities. How so? At the asset class level we found that since the inception of our benchmark, whenever 5-year annualized returns are below 5%, the next 5 years have historically been quite attractive. 100% of the time the annual returns over the next 5 years were positive, and that return was 14%, which is more than twice the since inception average.

Above-Average Returns Have Tended to Follow Low-Return Periods
Subsequent Average Annualized 5-Year Performance for the MSCI ACWI xUS SC Index Following 5-Year Annualized Return Ranges of Less than 5% from 5/31/99 through 9/30/23

Past performance is no guarantee of future results.

Second is at the quality level. High return on invested capital stocks this year hit two standard deviations of underperformance against the benchmark. Now the last time this happened was in the run up to the 2007-2008 Financial Crisis. And what happened when the crisis unfolded? And over the next few years? Quality stocks quickly reverted to two standard deviations of outperformance against the benchmark.

Small-Cap International High Quality Has Recently Lagged International Small-Cap by a Large Amount
International High-Quality vs. MSCI ACWI xUS Small-Cap 3-Year Average Annualized Trailing Excess Returns
From 3/31/03 through 9/30/23

International High Quality: The top quintile of securities within each MSCI ACWI xUS SC FactSet sector, sorted by ROIC. Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock). The calculation is a simple weighted average that excludes cash, all non-equity securities, investment companies, and securities in the Financials sector with the exceptions of the asset management & custody banks and insurance brokers sub-industries. As of 9/30/23, 20% of International High Quality was excluded from the ROIC calculations.
Past performance is no guarantee of future results.

A third factor is at the currency level. As we know, the dollar is incredibly strong on purchasing power parity, and some currencies of the companies in which we invest, like the yen for example, have lost a lot of ground versus the U.S. dollar. We don't hedge currencies, and we're not economists, but if we believe that currencies oscillate around their purchasing power parity implied rates over the long term, then we could be in for some meaningful currency tailwinds in the future.

FG: That all sounds compelling, but what are the catalysts? When would you expect mean reversion to occur?

MF: It's really hard to time the markets. What's clear to us is that the Strategy requires time. Investors must genuinely be long term. They must be capable of riding out periods of volatility. But I would offer up some observations. First is that relative valuations in international small-caps are extremely compelling. Relative to the U.S. market, international small-caps, we think, appear to be on sale. For example, at the end of 3Q23, the cap rate on the Russell 2000 Index was 4.7%, which was close to the 10-year Treasury yield. Our benchmark’s cap rate at the end of 3Q23 was 6.5%. We calculate cap rate by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its enterprise value (market cap, less cash and cash equivalents, plus total debt, minority interest, and preferred stock). Now, if you consider that the market cap of Apple alone is more than 80% of the market cap of our entire benchmark of over 4,000 companies, then it's clear that as the market becomes increasingly focused on valuations, it would only take a small reallocation into international small-cap to really move the needle.

We also think that recession can be a friend to relative performance. Companies with strong balance sheets and pricing power, those that provide low-cost but mission critical products or services, look best positioned to weather a difficult economic environment.

FG: How are you currently positioning the portfolio to navigate this environment?

MF: We're always fine tuning around the edges and trying to learn from past mistakes, but it's important to emphasize that our process does not change. We look for companies that possess a set of desired characteristics, and we're unapologetic about requiring those characteristics.

But that said, there are two things I'd highlight. The first is that we're focusing on preservation of capital. Our first priority is not to lose client money, and so our entire process is designed to exclude and control key risk factors. We think that being attuned to risk has become particularly important this year when the market, we've observed, has become increasingly complacent about risk, especially valuation risk. None of our companies are risk free, and so our valuation discipline also requires that our companies command an equity risk premium—that is, that their cap rates need to exceed the 10-year U.S. Treasury yield. Out of the 60 companies that we held at the end of the third quarter, only one holding—a less than 1% position—didn't meet that criteria, and that's because it received a private equity takeout during the quarter.

We've also been adding incrementally to existing holdings or initiating new positions where we see outsized dislocations between value creation and share prices. And that can often be particularly pronounced when a company's growth slows. But provided that we believe growth and business quality haven't been permanently impaired and that companies remain value creative, then those types of situations often allow us to take advantage of our long-term investment time horizon and build positions at attractive cost bases, which then sets us up for strong future outcomes.

FG: What sectors or regions have you found particularly compelling?

MF: We're of course completely bottom up, and our exposure is a byproduct of the opportunity set available. But one market where we have found an ever greater opportunity set in recent years is the U.K. That's also reflected in our increased weighting over the last 3 years. The country, generally speaking, enjoys strong corporate governance practices. It's also home to many outstanding and globally leading businesses. And interestingly, these businesses often generate the majority of their revenues outside the U.K.—the U.S., for instance—or have simply negligible revenues from inside the U.K. But their listing in the U.K. has penalized them heavily in recent years.

You can blame Brexit or a more difficult economic backdrop, and a number of other factors. For example, U.K. equity funds have seen nearly 30 months of consecutive net outflows, while U.K. pension funds have reduced their exposure to U.K. stocks from over 50% in the late ‘90s to just over 5% in 2021. That sucked out nearly £400 billion in demand. That results in valuations that have derated to around 30-year lows relative to global equities. Naturally, that makes for a fertile hunting ground for us.

FG: Can you give an example?

MF: Sure. One of the companies that we bought in the second quarter of this year is Auction Technology Group or ATG. This is a U.K. listed business, but it generates more than 80% of its sales from North America, and we were able to buy it at a 70% discount to its peak price.

It operates a number of leading online marketplaces for auctioneers who sell arts and antiques or industrial and commercial equipment. These marketplaces allow the auctioneers to list their products online rather than just in person. In doing so, they can significantly expand their reach to a global buyer base and then drive-up winning bid prices. At the same time, ATG offers them various value-added services such as digital marketing or payments or strategic advice, to name a few.

Now this company screens really well for us. It produces attractive returns because as a platform the company requires minimal invested capital, but at the same time it also generates EBITDA margins of about 40%. It also has an equity ratio of approximately 70%, and it’s posted attractive double-digit growth.

The company also provides a compelling customer benefit in that, again, it provides auctioneers with access to a large and diverse buyer base, it provides sellers with a trusted mechanism to sell their product at the highest possible price, and then it offers bidders unparalleled choice, convenience, and trust. It sells into the operating budgets of a diversified customer base of almost 4,000 auction houses, none of which make up more than 2% of sales. We estimate that they also spend the equivalent of less than 3% of their revenues for access to ATG's marketplaces, which—when you consider that around a third of all their winning bids come from online bidders through ATG—is quite a minimal price to pay. ATG's customer churn as a result is also low at just 3% a year. That loyalty also stems from the indomitable network effect that they enjoy, where the more bidders are drawn to ATG's marketplaces, the more auctioneers they attract. That in turn draws even more bidders.

Now in the long term, we think that this company enjoys a number of structural growth tailwinds. For example, the number of auctioneers using the platforms continues to grow. But more important, ATG's business benefits from the ongoing digital transformation of the auction industry. Auctioneers are amongst the last frontiers, we found, to fully embrace digitalization and in the words of a former Christies employee with whom we spoke, people are all shifting online.

To top it all off, the company has been rolling out incremental functionality, for example, payment functionality, which we think over time can more than triple its percentage take rate on the transactions that they complete. So back in Q2 when we looked at it, investors were skittish about the difficult macro backdrop, and they feared that this and continued reopening post-COVID would slow down the company's growth trajectory. We were able to take advantage of this sentiment.

FG: Thank you, Mark for a timely update on international small-cap investing and the Royce International Small-Cap Premier Quality Strategy. Thank you for your time today.

MF: Thank you, too.

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