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This transcript has been edited for clarity. The podcast was recorded on 8/23/22.
Steve Lipper: Hello and thank you for joining us. This is Steve Lipper. I’m the Senior Investment Strategist here at Royce Investment Partners. Today, we have two of the portfolio managers for Royce’s Small-Cap Opportunistic Value Strategy, Brendan Hartman and Jim Harvey. They manage the strategy along with Jim Stoeffel and Kavitha Venkatraman. We’re excited to hear about what their view of the market is, and where they’re seeing opportunities. Let’s first, though, look back before we look forward, setting the context on the journey so far this year. Brendan, coming to you first—can you discuss how the strategy has performed so far in 2022?
Brendan Hartman: Thanks, Steve. As you would expect, and as the Strategy always has, we’ve slightly underperformed the Russell 2000 Value on a year-to-date basis in a down market, although we are slightly ahead of the Russell 2000 Index on a year-to-date basis. But if you dive a little bit deeper, you’ll see we underperform going into the June lows, as the Strategy always does—our downside capture is a bit more than the benchmark’s. But then when the market recovered from those lows, over the last two months, we outperformed the Russell 2000 Value Index over that time period. So, as expected with this strategy, we have a bigger downside capture but an even greater upside capture.
SL: Thanks for that review, Brendan. Let’s turn to you, Jim, about positioning for the recovery. What have you been doing in the portfolio so that your investors can position and participate well in the recovery?
Jim Harvey: Thanks, Steve. It’s in these types of markets where we look to create long-term outperformance by buying things that nobody else really is interested in. We’re following the same discipline, the same approach that’s been adhered to over three or four decades, and that’s leading us to a bunch of different sectors and industries. One area that we’re interested in right now, in which we’re well positioned, is in the return and the normalization of vehicle manufacturing—autos and trucks.
We’ve all read about the challenges that the global supply chain has created in a bunch of different sectors and industries, but autos have really been hit particularly hard. Part of the reason there is because of the semiconductor content in automobiles and automobile parts, so we own parts companies, we own companies that provide systems, seating, tires, and all sorts of different auto parts, so we’re well-positioned there, as we see normalization within the OEMs [original equipment manufacturers].
We also own U.S. retailers that should benefit when volumes resume, and we own some newer economy plays within the auto space as well where you’ve seen the services, these apps where you can buy and sell new and used cars, and we’re well positioned there. And Brendan has recently used one of them, doing a little due diligence internally.
SL: Great examples, Jim. Really clear about how, as we have normalization in the cycle, in the auto and truck—both production and sales—that there’s an opportunity to participate in the rebounding profits and stock prices. So, Brendan, let’s come back to you. This is certainly a very interesting time. What are the things that are capturing your attention as interesting, or intriguing investment areas?
BH: No doubt, Steve. There’s a lot of intriguing macro themes that are running through the markets and through our portfolios. One of the themes that we’ve spoken to our investors in the past about is the recovery and commercial airplane production. That recovery is following both the grounding of the Boeing 737 MAX after several horrific crashes, pre-COVID, and then the COVID grounding of all the flights, caused a big ripple throughout the aircraft supply chain, and now that’s normalizing, as you all know. People are getting back to traveling again, planes are full, the airports are full.
So, the supply chain is struggling to catch up with demand, as both Boeing (BA, Financial) and Airbus (XPAR:AIR, Financial) increase the production of their single aisle aircraft. And we have multiple investments in that industry. Everything from the special alloy metals companies that are making the parts that are going into the engines and the airframes, as well as the electronics companies. That is a theme that we were playing before COVID, but now it’s even stronger with a rebound in travel.The other really interesting theme that’s pervasive across the economy right now is the re-shoring of global supply chains. When COVID hit, and all the supply chains became disrupted, as you just heard Jim Harvey mention, the auto supply chain took it on the chin and is still nowhere close to being back to normal. A lot of that had to do with the shortage of semiconductors.
Now you have all these companies scrambling to re-shore their supply chains and start making things in North America again and eliminating the risk of having production in Asia, or Europe, or Eastern Europe. The war in Ukraine has certainly exacerbated that risk. So, we’re playing multiple investment themes across that re-shoring trend, and it’s everything from semiconductor manufacturing—we own semi cap equipment companies that will benefit from the re-shoring of semiconductors—aided, of course, by the recent government stimulus bill. But it’s broader than just the semiconductor space, Steve. It really is prolific across industries.
SL: Brendan let’s stick with you for a moment about that and maybe explore that a little more deeply. From talking previously, one of the areas that re-shoring and reimagining supply is having a big effect is in energy. Your team has some thoughtful approaches to energy. Can you share that with us?
BH: That’s a great point, Steve. The energy space, we think, is really different this time. By that, I mean there’s capital discipline in North America across the exploration in production companies. It’s been forced upon them by shareholders and bondholders, and the days of these companies just drilling holes in the ground and not making money are over. Now they have a return on capital focus. We own some of the suppliers and the service companies, as well as some of the small-cap E&P [exploration & production] companies that are all North American focused. We think that industry will have less of a boom-and-bust cycle than in the past, given that capital discipline. But really, Steve, we’re coming off the bottom in North American energy production, so we think there’s a multi-year growth outlook for North American energy, and that’s obviously been exacerbated by the war in Ukraine, and the disruption of energy supplies over there. North American natural gas is being liquified, and it’s being shipped over to Europe to try and help alleviate their energy shortage.
As you know, Steve, you and I have discussed in the past, we’ve owned many of the tanker and shipping companies for several years. The original investment case was predicated on a supply situation where there were no new ships being built. You had supply being constrained, the older ships get scrapped, there’s higher, more strict environmental regulations that take out older ships. You had that going on, and then the market really tightened with the war in the Ukraine. So, some of the shipping stocks have been our best performers year-to- date.
SL: Those are some great examples, Brendan. It makes all the sense in the world that you positioned early and really benefited from the shortage in supply and in shipping, and it looks like maybe multiple years in domestic energy production. Jim let’s come back to you. This Strategy has a number of themes that it consistently executes against, and you find some of those themes have greater sets of opportunity at different points in the cycle. Which of the themes are you finding the best new ideas today?
JH: Right now, I would say that the most interesting area, in terms of themes that we’re looking at, is Interrupted Growth companies. These are companies that have longer-term, sort of high-growth profiles, but have been brought down with this market. It’s been the growthier companies that have been brought down the hardest. These are longer duration types of plays that have been hurt as interest rates have increased, and as we’re approaching this sort of uncertainty within the economy.
Previously, they were out of touch just because of the valuations, so we just would not look there. But now, they’ve been brought back to earth. They trade within valuation ranges that we feel comfortable with, especially on a price to sales basis. And there are lots of them. We’ve been to a few conferences lately where these companies have presented, and suddenly there’s this whole new opportunity set of companies that we could be looking at.
SL: That sounds great. Are there any in particular that you’d walk us through?
JH: There are a few. One is in the digital advertising space. We own companies that cater to insurance companies, particularly auto insurance companies. As we’re all familiar, if you watch college football, pro football, or any kind of sports, you find yourself bombarded with ads for auto insurers. Auto insurers are one of the highest spending advertising companies out there. So, we own a few companies that attract consumers for those auto insurers, and a few things are happening in that business right now. One is that insurance companies have to go on a state-by-state basis to achieve better rates, and that takes a little bit of time. When that happens, they pull back on spending. In general, we’re just in a weaker economy, so all sorts of advertisers have pulled back a bit. But we’ve seen this movie before. What happens is, once those rates get reset, and once we’re in a more normalized environment, this spending resumes,…