Lauren Romeo On Today’s Opportunities In Quality Small-Caps by Lauren Romeo, The Royce Funds

Portfolio Manager Lauren Romeo discusses holdings and sector and industry positioning for Royce Small-Cap Leaders and Premier Funds in the current environment in which high-return business models are helping to drive performance.

Why do you think that many of the high-ROIC (return on invested capital) stocks that populate Royce Small-Cap Leaders and Premier Funds have done well so far this year after the relative lag of the last few years?

We’ve definitely seen a dramatic turnaround for many high ROIC small-caps so far this year, though the move began after the June 23, 2015 peak for the Russell 2000 Index.

 Small-Caps
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Small-Caps

This shift reflects a rotation away from low-ROIC growth stocks with price momentum and into stocks of solidly profitable companies with strong balance sheets and proven, high-return business models.

After years of playing second fiddle, these companies offered investors compelling absolute and relative valuations. Correlation levels among small-cap stocks have also declined over the last year. All this has created more of a stock picker’s market in which individual companies’ business fundamentals are increasingly driving price performance as much, if not more so, than momentum or sector allocation.

Year-to-date results for both Small-Cap Leaders and Premier have benefited from a combination of effective stock selection, particularly within the Industrials, Information Technology, and Consumer Discretionary sectors, and our underweights and outperformance in Health Care, which so far has been the worst-performing sector in the Russell 2000 in 2016.

Can you discuss a few of your stocks that have done well so far in 2016?

Three holdings come to mind. Thor Industries (NYSE: THO), from the Consumer Discretionary sector, has captured more than a third of the market for recreational vehicles (RV) with its roster of strong brands such as Airstream, Dutchman, and Keystone.

RV sales are nearing pre-recession levels, driven by healthy consumer spending on durable discretionaries and the favorable demographics of retiring Baby Boomers along with a new tailwind in the form of an influx of first-time buyers from “Generation X,” 30 to 50 year olds.

We see Thor’s recent acquisition of its competitor Jayco as significantly strengthening its position in the entry level RV space, which is one of the faster-growing segments of the RV market thanks to these value-conscious Gen X buyers. This has helped Jayco’s entry level Jay Flight model, for example, to be the best-selling travel trailer in the U.S. for the past 10 years.

Cognex Corporation (Nasdaq: CGNX) is the market leader in machine vision technology that captures and analyzes visual information in order to automate tasks that previously relied on human eyesight. The company has reaped the benefits of increasing automation in manufacturing and item-tracking-intensive industries such as consumer electronics, automotive, and logistics.

Cognex also continues to expand its addressable market by leveraging its proprietary vision software and systems into new markets such as ruggedized mobile computing.

As Chuck Royce recently discussed, we see companies involved in automating industrial processes as a major source of opportunity. Many of them are profitable, high-return companies with attractive niches and what we think is considerable long-term growth potential.

Circor International (NYSE: CIR) is an industrial company that makes highly engineered flow-control valves capable of withstanding extreme pressures, temperatures, and corrosive environments.

With 85% of sales coming from the energy industry, revenue growth has been depressed by the severe drop in the price of oil and the associated cutbacks in capital spending in the energy industry over the past two years. However, its shares have come back strong so far in 2016.

We think management has done a first-rate job increasing operating margins throughout this period, which sets the stage for significant earnings leverage when sales growth resumes. Management is also working to refuel growth via new product development, expansion into adjacent product markets and underserved geographies, and acquisitions.

Let’s talk about the investment thesis for a few names that you’ve recently been buying that have either disappointed and/or have not yet taken off.

There are two holdings that have struggled this year that we think have a lot of potential over the long run. Lazard (NYSE: LAZ) has a franchise in the global financial advisory business and, in our estimation, an underappreciated asset management segment.

Market volatility and economic uncertainty have fueled concerns about a deceleration in mergers and acquisitions activity (“M&A”) while also pressuring fund flows.

We believe these near-term headwinds are more than fairly discounted in Lazard’s valuation. An uptick in restructuring revenue, mostly from energy and mining, has partially cushioned a near-term slowdown in M&A. In addition, while they’re inherently cyclical, most of the important drivers of a vibrant M&A environment remain in place.

For example, there are attractive borrowing costs (even if rates rise off their current historic lows), the need for larger companies to supplement limited organic revenue growth, the improving economic outlook, and C-Suite confidence.

The stock also currently has a 4% dividend yield, and management has a history of shareholder-friendly capital allocation including dividend increases, special dividends, and share repurchases.

Marcus & Millichap (NYSE: MMI) is a leading commercial real estate sales brokerage firm. Its stock has declined in anticipation of slower sales and earnings growth as the commercial real estate recovery slowly matures.

But we believe the company can outpace its industry’s growth over the long term with its primary focus on less cyclical, private sales (deals from $1 million to $10 million), growth in new agents and improving productivity of existing brokers, and market share gains as it expands into underserved locales and specialty properties (such as industrial, office, and hospitality) beyond its core multifamily and retail focus.

Marcus & Millichap’s local market presence and knowledge, national footprint, and database of proprietary listings create both a positive network effect and a competitive advantage. If the commercial real estate market experiences a more severe correction, the company should weather the storm because of its highly variable cost structure and rock solid, debt-free balance sheet, which features more than $5 per share in cash.

Can you provide details on any sector or industry dynamics that are influencing portfolio construction?

In both Small-Cap Leaders and Premier Funds our bottom-up approach has led us toward a cyclical sector bias over the last several years. This is not a macro call but rather a function of where we have identified the most attractive risk/reward opportunities among high or improving ROIC companies.

Our Industrials holdings reflect a blend of traditional machinery and equipment companies along with a fair amount of professional services and other asset-light business models.

In Information Technology, lofty valuations and/or lack of earnings have limited our investments in emerging tech areas such as cloud computing and social media. However, many of our holdings have benefited from other significant secular trends such as industrial automation and the rising capital intensity in semiconductor manufacturing as design and process complexity increases with each successive advance in technology.

Market pullbacks motivated by concerns about rising interest rates and global growth in 1Q followed by Brexit in 2Q created opportunities for us to add to capital markets stocks within the Financial sector, particularly in the asset management area.

Our holdings in the

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