How did Royce Small-Cap Total Return Fund in 1Q24 and over longer-term periods?

Chuck Royce: The Fund, which is part of Royce’s Quality Value Strategy, Fund advanced 4.3% for the quarter, outperforming its benchmark, Russell 2000 Value Index, which was up 2.9% for the same period. The portfolio also outperformed its benchmark for the 1-, 3-, 5-, 10-, 15-, 20-, 25-, 30-year, and since inception (12/15/93) periods ended 3/31/24. I’m very pleased with the Fund’s results—in particular since Miles and, later, Joe joined us. They’ve helped to refine and evolve the approach over the last few years in what I think are highly effective ways.

How did performance shake out at the sector and industry level in 1Q24?

Miles Lewis: We were pleased that five of the portfolio’s eight sectors made a positive impact on quarterly performance. The sectors making the largest positive contributions were Industrials, Information Technology and Financials while the largest negative impacts came from Real Estate, Energy and Communication Services.

What about for the Fund’s industry groups?

Joe Hintz: At the industry level, trading companies & distributors (Industrials), insurance (Financials), and electronic equipment, instruments & components (Information Technology) contributed most for the quarter, while banks (Financials), real estate management & development (Real Estate), and leisure products (Consumer Discretionary) were the largest detractors.

Which holding contributed and detracted most in 1Q24?

ML: The Fund’s top contributor in 1Q24 was Advance Auto Parts (“AAP”), an auto parts retailer with roughly 6,300 stores in the U.S. and Canada. We see it as a great fit for the Fund—it’s a fundamentally a good business, undergoing temporary and fixable issues that’s also on a trajectory of improvement. Its shares rose after the company issued guidance at the end of February that reflected optimism for both a modest recovery for fiscal 2024, and the new CEO’s strategic initiatives and organizational changes. In early March, AAP reached an agreement with activist investors to appoint three highly qualified directors to its board, which also seemed to drive its stock higher. AAP has been exploring a sale of its crown jewel “Worldpac” asset, and the stock appeared to also run up on rumors of strong interest from private equity buyers.

Which holding detracted most in the first quarter?

JH: The top detractor was Kennedy-Wilson Holdings, a real estate investment firm whose stock took a hit with fourth quarter earnings that were hurt by a decline in the fair value estimate for its co-investment portfolio—which is a non-cash charge that was required to estimate the fair value of certain of the company’s investments at a specific point in time. Management attributed the decline in the estimate to the higher cap rates associated with the rise in interest rates since 2022 while emphasizing three points: the underlying properties are generating growing cash flow, that many have cost bases well below their “fair value,” and that its partners in the investment vehicles in which the properties are held plan to hold the assets for the long term. Nevertheless, this second sequential decline in value unnerved investors, including ourselves, and we sold our position in the portfolio during March.

At the sector level, how did the Fund perform versus its benchmark?

JH: The portfolio’s advantage over its benchmark was primarily attributable to stock selection in the quarter, with the Financials, Information Technology and Industrials sectors making the most significant positive impact versus the benchmark. Conversely, stock selection and a lower weighting in Energy, lack of exposure to Health Care, and stock selection in Consumer Discretionary detracted most from relative results in 1Q24.

What is your outlook for the Fund?

ML: Though the Fund outperformed in 1Q24, it was a challenging backdrop for our style of owning high-quality businesses at attractive valuations. Lower quality, higher growth, and speculative stocks did best within small-cap. While we acknowledged a few mistakes and moved on from some holdings, we also saw certain technology holdings benefit, in part from their role as “picks and shovels” providers in the rapidly growing AI space. After a solid, rather mundane reporting season for most community and regional banks, the issues that surfaced at New York Community Bank (one of the last banks to report earnings) caused a broader sell-off in the group. We used that weakness to bolster positions we thought were indiscriminately sold off. As was the case in 2023, insurance—our largest overweight in Financials by a considerable margin—offset the weakness in banks, even as fundamentals remained robust and valuations attractive. Strong stock selection in relatively more idiosyncratic opportunities, such as Advanced Auto Parts, Repay Holdings, and Air Lease also did well. We saw more opportunities to trim or exit rather than buy and build, as we sold seven names off while adding only two. Though the outcome is both distant and unknown, we’ve already begun to discuss potential election outcomes with management teams. With an ever-changing interest rate backdrop and the election, we think 2024 will likely provide interesting opportunities and, as always, we will be prepared to take advantage of any volatility.

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