How did Royce’s International Small-Cap Premier Quality Strategy perform in 1Q23 and over longer-term periods?
Mark Fischer: The mutual fund that we manage in the Strategy, Royce International Premier Fund (Trades, Portfolio), advanced 7.2% for the quarter, outperforming its benchmark, MSCI ACWI ex USA Small Cap Index, which was up 4.7% for the same period. The portfolio also beat its benchmark for the 1-, 5-, 10-year, and since inception (12/31/10) periods ended 3/31/23. We were very pleased with how the Fund performed and especially liked how the portfolio rebounded after a challenging year in 2022.
How was performance at the sector level in 1Q23?
Mark Rayner: Seven of the portfolio’s eight equity sectors made a positive impact on quarterly performance, with the biggest positive contributions coming from Industrials, Information Technology and Materials. Health Care was the lone detractor at the sector level, while our two lowest weightings—Real Estate and Consumer Discretionary—made the smallest positive impact.
What about at the industry level in the first quarter?
MR: Machinery from the Industrials sector; software, which is part of Information Technology; and chemicals from the Materials sector were the largest contributors to first-quarter performance. Each was among our largest portfolio weightings at the end of March. Only two areas detracted from 1Q23’s results: health care equipment & supplies from the Health Care sector, and commercial services & supplies in Industrials. The smallest contribution came from real estate management & development in the Real Estate sector.
Which countries had the biggest effect on first-quarter performance?
MF: Japan, the United Kingdom, and Germany—our largest country weightings at the end of March—contributed most at the country level for the quarter, while Australia and South Korea were the only detractors.
What was the portfolio’s top contributor at the position level for 1Q23?
MR: OdontoPrev S.A. (BSP:ODPV3, Financial) is the largest provider of corporate dental care plans in Brazil. Corporate customers pay OdontoPrev a small monthly membership fee, and in return their employees gain access to OdontoPrev's partner network of 30,000 dentists who they can book for regular cleanings or other dental procedures. We are attracted to OdontoPrev’s high-margin yet asset-light business model, which enables it to generate strong cash flows and returns on invested capital, as well as its structural growth prospects supported by Brazil’s expanding middle class. Compared to almost 80% in the U.S., we estimate that only 13% of Brazilians have private dental coverage today. There was no material news flow about the company in January, so we suspect improving macro sentiment around Brazil contributed to its strong share price performance for the month. In addition, OdontoPrev’s management was on the road in November and December of 2022, attending investment conferences and meeting with existing and new investors, which may have also contributed to its strong share price performance in 1Q23.
What was the top detractor in the first quarter?
MF: Restore (LSE:RST, Financial) is a UK-based support services company. Its main business is Records Management, which represents around 70% of group operating profit. In this segment, the company provides storage and retrieval solutions for paper-based and other corporate documents to around 6,000 clients within secure, generally out of town locations. Restore holds literally millions of these storage boxes and charges clients around $4-5 a year per box for the service. Customer contracts typically run for five years, but very often boxes remain with Restore for 20 years or more. Box growth is only around 1-2% per year, but when combined with annual price increases, this hugely sticky and repeatable business grows on average at mid-single digits. Restore has been using the cash from this very reliable business segment to grow into complementary services such as document shredding, scanning, installation and recycling of office IT, and high-end office relocation, all areas where there is a natural cross-selling opportunity with the storage business. Restore also enjoys scale advantages from being the U.K.’s number 1 or in each of its business lines.
The trading statement that was released in November 2022 appeared to continue weighing on Restore’s stock price. This report had especially highlighted a slowdown in the U.K.’s IT equipment market. It is worth noting that on February 1st the stock jumped some 14% after the company published a more positive trading update, which also included an optimistic outlook statement. The latter highlighted the opportunity for margin expansion in 2023 through price increases put through in January, as well as the benefits of further efficiency gains.
At the sector level, how did the Fund perform versus the MACI ACWI ex USA Small Cap in the first quarter?
MR: The Fund’s advantage was almost entirely attributable to sector allocation decisions in the first quarter. Our substantially lower weight in Financials, along with effective stock selection, was the largest sector-based source of outperformance, followed by the same combination in Real Estate. Our significantly larger exposure to Industrials was also additive. Conversely, our higher exposure and, to a lesser degree, stock picks in Health Care detracted from relative results in the quarter. Stock selection also hindered relative results in Communication Services, as did the portfolio’s cash holdings.
What is your outlook for the Strategy?
MF: Twelve months ago, we noted how investors in international small caps were responding to higher inflation—principally by buying energy stocks and raw materials companies—and to rising interest rates, mainly by buying banks and low multiple, lower quality companies with often elevated levels of debt. Fifty-two weeks later, inflation and higher rates remain with us, while banks, energy, and raw materials companies are no longer at the top of investors’ shopping lists. The reality of dealing with rapidly increasing operating and financing costs for the first time in perhaps decades, the heightened recession risks these create, and the recent collapse of Silicon Valley Bank and ensuing banking crisis has reversed, we believe, investors’ priorities. The focus appears to have shifted again toward fundamental business characteristics such as pricing power, loyal customers, and conservative balance sheets. We of course have always focused on such qualities, rooted in the conviction that these characteristics coincide with sustainable value creation that in turn drives superior long-term investment performance. So, while a year has made a world of difference in the stock market, we have stuck to our knitting and kept our investment parameters unchanged. That said, we continually seek to upgrade either the attractively low valuation or the quality of the portfolio, and in the first quarter identified what we see as two attractive additions with very defensive business models and predictable revenue streams.
