What were your thoughts on the first quarter of 2026?

Francis Gannon: It was certainly a roller coaster ride for investors and asset managers alike, though we were pleased with how it wound up. The Russell 2000 and Russell Microcap Indexes each survived the volatility and bearish trend by finishing the quarter with positive returns. Small- and micro-cap indexes were alone among the major U.S. indexes to finish the quarter in the black. The Russell 2000 Value Index was up 5.0%, and the S&P SmallCap 600 Index gained 3.6%.

Chris Clark: All things considered—and there was a lot for all of us to consider in the quarter—it was a terrific showing for small-caps relative to large-cap. The Russell 1000 Index declined -4.2% in 1Q26, the mega-cap Russell Top 50 Index lost -7.9%, and the Nasdaq fell -7.0%, so we saw a significant rotation not just away from the Mag 7 but also from larger names more broadly. It was notable that cyclical value and quality performed well, as we saw from the respective results for Russell 2000 Value and S&P SmallCap 600.

FG: To get a sense of how volatile the market was, we had a -10.1% intra quarter correction for the Russell 2000 from its year-to-date high on January 22nd through its year-to-date low on March 20th. To Chris’s point about there being a lot to think about, I suspect that some people may have forgotten how many other things were happening, or at risk of happening, before the war and rising energy prices began to dominate the headlines.

I’d say that the fog of war applies to more than not knowing what your opponent is planning or trying to decipher what the end game of the conflict might be. Today, it also covers a list of concerns that pre-date the war: Sticky inflation, increased unemployment, fear of a large-cap bubble, a sluggish housing market, low consumer confidence, and unease about private credit potentially having a bubble of its own. These issues are still relevant, which is giving all of us a lot to think about as the year rolls on.

Miles Lewis: I agree. There’s a ton of turmoil beneath the surface. Beyond the unwinding of the AI trade in mega-cap names, we’re also seeing industries and sub industries that are just getting slaughtered because investors are convinced that AI will make these businesses obsolete by doing the most if not all the work they’re currently doing. Trying to separate which companies appear positioned to eventually survive and thrive from those that might not make it is both an exciting and daunting challenge for our team.

FG: The Russell 2000 was down -7.9% from its last 52-week high through the end of March. We wanted to see how the average stock in the index had performed for that same period, and what we found was really interesting—the average stock in the small-cap index has fallen -29.4%. That gives us an idea of how many small-cap stocks have been performing poorly, which you don’t see unless you look under the hood. And when the average stock in the Russell 2000 has suffered a deep decline, subsequent returns for the Russell 2000 were often better than the Russell 1000’s over the subsequent 3-year period—which is another useful data point for our confidence in small-cap’s ongoing leadership.

Small-Caps Have Typically Beaten Large-Caps Following Deep Small-Cap Downturns
Russell 2000 3-Year Returns Subsequent to Russell 2000 Average Stock off 52-Week High Range from 3/31/97 through 3/31/26

Past performance is no guarantee of future results.
Batting Average refers to the percentage of periods in which the Russell 2000 Index outperformed the Russell 1000 Index.

As of 3/31/26, the average Russell 2000 stock was -29.4% off its 52-week high.

Brendan Hartman: We’ve seen similar dispersion in Royce Small-Cap Opportunity Fund’s portfolio so far this year. Going stock by stock, we have a handful that are up triple digits—which is great, of course—while others are down in the -50% to -60% range, and that’s just year to date, which is more divergence than we sometimes see in a year, never mind a quarter. It certainly makes it clear which of our Strategy’s investment themes are working. We also reevaluated our hardest hit companies to determine if our investment thesis was still intact.

Which industries and sub industries have been hurt the most so far this year?

ML: Software, IT services, and professional services were the areas where most of the pain has been concentrated. In Royce Small-Cap Total Return Fund, our holdings involved in professional and IT services lost ground—all out of investors’ fear of AI-driven obsolescence. (The Fund doesn't hold any software companies.) The typical software business model is SaaS (Software as a Service) where the companies charge fees for both installation and the ongoing use of their products via licensing agreements. Prior to the recent anxieties about AI, it was seen as an appealing area because it’s an asset light business with recurring revenue. Needless to say, that view is being upended. IT services and professional services are facing similar challenges regarding their long-term viability.

Given this dynamic, what is the rationale for the IT services and software stocks that you’re still holding?

BH: Our companies in both areas are very niche, and most still have strong fundamentals, including earnings, but the rest of the market just does not want to own them. We haven’t been adding to these holdings yet. We're waiting for a catalyst that suggests that these companies have a good chance to survive the sell off. Some of these companies have strong franchises, so we think there’s a good chance they pull through. But it’s still too early to tell.

ML: I think the best example of a likely survivor is one that we've talked about recently, The Hackett Group. Hackett is an IT services company that specializes in benchmarking data and thought leadership around best-in-class systems and capabilities. Hackett is in the midst of a strategic pivot to better monetize its benchmarking data and institutional knowledge that has been built over the decades, ultimately moving from a project-based revenue model to one with a higher mix of recurring revenues and software capabilities. Its shares were down more than -33% in the first quarter and around -55% off its 52 week high.

The Hackett Group (Nasdaq: HCKT)
12/31/25-4/2/26

Past performance is no guarantee of future results.

The stock has gotten crushed because the market is treating Hackett like an IT services business that will fall by the wayside because nobody is going to need consultants in the future. We think that view is fundamentally flawed for a couple of reasons. First, even if everybody starts adopting AI models and tools, we still need people with the expertise to help implement those things. Second, Hackett owns own proprietary benchmarking data, much of it used by Fortune 500 companies. Our view is that AI makes this data more valuable, not less valuable. IBM announced a few weeks ago that it’s partnering with Hackett to leverage their AI tools and their benchmarking databases, and when the press release came out, Hackett’s stock still fell. That gives you an idea of how down the market is on these business models.

What do you own that has been working so far this year?

BH: A lot of our technology hardware, semiconductors, and semiconductor capital equipment stocks have been on fire thanks to AI CapEx spending. We’ve been net sellers there as our names have gotten more expensive. Some of them were up more than 100% in the first quarter. As you might expect, our holdings that are involved in defense electronics have also done very well. So have our positions in natural gas and shipping. All of these areas are benefiting from the war with Iran. Our energy holdings are mostly in natural gas as opposed to oil, but almost any stock with energy exposure has done well so far this year. Companies exposed to the improving the power grid infrastructure have also been doing well because of the enormous amount of power needed for AI data centers. Many of these companies have multi-year backlogs, which is encouraging.

ML: The first area for our team is Industrials, where most of our holdings in more traditional areas have performed well so far this year. Next are Consumer Discretionary companies that cater towards the low-income consumer. Both Academy Sports & Outdoors and Advanced Auto Parts have done well year to date. Some think that lower income consumers are spending their tax refunds on these discretionary items, but we’re being cautious because rising oil and gas prices could change that pretty quickly.

Academy Sports & Outdoors (Nasdaq: ASO)
12/31/25-4/2/26

Past performance is no guarantee of future results.

Advance Auto Group (NYSE: AAP)
12/31/25-4/2/26

Past performance is no guarantee of future results.

We own a specialty chemicals company called Element Solutions, where 70% of its end markets are electronics companies, which are benefiting pretty significantly from AI but in an indirect fashion. Element provides the chemicals that go on printed circuit boards—and data centers use bigger, more complex boards that require more of their chemistry, which is a big uplift in their business. That stock has done really well this year. So, tech, industrials, and a couple of pockets of consumer have been our top performers.

Element Solutions (NYSE: ESI)
12/31/25-4/2/26

Past performance is no guarantee of future results.

Are any companies you own benefiting by using AI for innovation and/or greater efficiency?

BH: I’d say that every company we meet with these days talks about how they’re using AI to reduce costs, improve efficiency, and expand market share, etc. We’ve even been hearing about it from trucking and transportation companies. But it’s still early for a lot of these companies. Our job is to separate the wheat from the chaff because it's such a hot topic that I think every company has a slide in their deck promoting how they’re using it. Three years ago, it was an ESG slide—now it's an AI slide. But the scope of change is real, and the bullish case for a large share of the small-cap market is rooted in the productivity improvements from AI that will help these companies.

ML: I was on the phone with the CFO of one of our bank holdings recently, and the gist of our conversation around AI was that the bank employs roughly 1,000 people today, and the hope is that in three years, they’ll have roughly 1,000 employees. This is coming from a company that has grown pretty significantly over time. But this doesn't mean they're laying people off; it means that they’re getting more productivity out of the people they have due to AI. If we think about what that means, the operating leverage in their business as they grow is massive. In fact, I think financial services in general are probably going to be one of the biggest beneficiaries because the administrative work is so labor intensive, and AI is changing that.

Is the earnings driven case for small cap leadership intact given all of the recent volatility in the market?

BH: Yes, I think so. All of the structural elements are still there. I was looking at earnings data recently on how the Russell 2000’s earnings for the fourth quarter were pretty robust, which tracks with what we saw for our portfolio. There are obviously headwinds that weren’t there a few months ago due to the war: consumer confidence is lower, energy prices are higher, and there’s more uncertainty about the pace of economic growth, so the 2026 estimates for every asset class have come down—but the consensus forecast is still for more than 20% earnings growth on average for small-caps this year.

Where have you been looking for investments over the past couple of months?

BH: We're always adding new ideas, especially turnarounds or interrupted growth themes. We keep a list of companies we’ve owned in the past, and we’ve gone back to a few of them because the prices have fallen, or the turnaround is in a more advanced stage, or there’s a new management team that we like. Our activities haven’t been concentrated in any single industry or industries. We've added some healthcare and consumer companies as well as a few bank stocks that Miles and his team helped us with. It’s interesting because with all the volatility that we’re dealing with, the areas that are attracting our attention are mostly the same ones we’ve been actively researching and investing in since last summer. From an investment standpoint, there's been consistency amid all this volatility.

ML: We're trying to lean into things that we think are attractive and where the AI risk or perceived risk looks minimal. Some of our activity has been devoted to those stocks that have gotten hit because of the perceived AI threat I mentioned earlier. We’ve started to see some pretty significant insider buying in some names that have been hit hard, which is somewhat reassuring in terms of our confidence in our thesis. We think certain names in Consumer Staples are interesting. The market really hates that sector right now, which is interesting because it’s often considered a bit of a safe haven when markets sell off. We all have to eat, people have to buy certain equipment, someone has to clean and maintain sites like hospitals and assisted living facilities, schools, etc. Over the last six to nine months, we’ve also been seeing more companies which we consider super high quality trading at the very low end of the last 10 or 15 years’ trading range.

FG: In Royce Small-Cap Fund, which Miles is also involved in, we’re seeing similarly attractive valuations for what we think are top quality names in different industrial areas and retailers. For example, we’ve been adding to our positions in Interparfums, which develops, distributes, and markets prestige fragrances under exclusive brand licenses and owned labels, and Quaker Houghton, a chemical company. These are companies that we know really well—we’ve held them for decades.

What is your long-term outlook?

BH: In spite of the very uncertain near-term picture, our long-term outlook hasn’t changed—we’re very constructive on small-cap. The combination of better earnings growth and lower valuations versus large-cap is powerful. Certain Mag 7 companies are becoming more asset heavy with huge CapEx spending that’s benefiting our portfolio because many of our companies are providing the picks and shovels for all this activity. Add reshoring to that, along with investments in power generation and transmission distribution, and the long-term prognosis is very promising.

ML: We think of our portfolio as a potentially potent combination of high quality companies that trade at very attractive multiples. Many of these are strong cash generative businesses that tend to do well in pretty much any environment. We also think that in uncertain environments like the current one, it’s good to own companies with pricing power and management teams that are effective capital allocators who can take advantage of volatility by making acquisitions and gaining because they have the cash flows and cash-rich balance sheets to be aggressive in environments like this one.

FG: We’re all confident that small-caps can sustain market leadership and are working to use short-term volatility to our long-term advantage and create market-beating returns. We also want to remind investors that the opportunity still exists to build one’s small-cap allocation at attractive valuations. The current period looks to us like an especially opportune time to invest in select small-caps for the long run.

CC: There’s one last point that I think is important. At the end of March, the Russell 2000’s 5-year annualized total return was 3.8%. Since the inception of the small-cap index at the end of 1978, whenever the average annualized 5-year return was 5% or less, subsequent 3- and 5-year returns were positive 100% of the time—and were higher than each period’s average annualized returns since inception. So, I think we’re in a very promising period for small-cap leadership and disciplined active small-cap management.

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