Royce Investment Partners Comm – GuruFocus.com

What are some of the challenges and opportunities you have found in today’s market, particularly in the recent uptick?

First, the Russell 2000 fell 31.9% from its high on 11/8/21 to its most recent low on 6/16/22, which is within the historical range of small-cap bear market declines. In fact, the average drop from the 1979 inception of the Russell 2000 was also 31.9%. Given all the negative sentiment in the current market, the odds favored a rally. The catalyst for the 22% rally through 8/15 included signs that inflation may be stabilizing and quarterly earnings growth prospects that were less dire than expected.

Although the rebound in risk-taking within small caps was broad, it was led by lower quality companies and more speculative sectors. These dynamics created a challenging near-term relative return environment for quality that followed several quarters of small-cap companies with the highest returns on invested capital. As a result, valuations for companies with the kind of high-performing, durable business models we look for in our small-cap Premier Quality strategy remain reasonable.

Can you talk about a high confidence (or noteworthy) holding that has been successful so far in 2022?

acrose (HERE, Financial) supplies materials and structures for critical infrastructure projects. Over the past four years, management has implemented a ROI-driven portfolio transformation and simplification plan so that its higher-return, less-cyclical growth businesses now generate the majority of returns. Arcosa’s Construction Products segment, strengthened by $1.4 billion worth of strategic acquisitions, primarily sells lightweight, recycled, natural aggregates such as sand, gravel and crushed stone, which are used in public works projects as well as in residential and non-residential private construction. . Aggregates tend to be local monopolies because the low-value/high-weight nature of the product generally makes the cost of transportation beyond a 50-mile radius prohibitive. Reserve ownership and permitting barriers for new sites further limit competition. These factors keep prices stable in cyclical downturns and build pricing power when volumes are healthy.

So far in 2022, its shares have been buoyed by healthy price and volume gains in its core growth businesses, as well as signs of falling demand in more cyclical commodity businesses that management has timed correctly. We believe that Arcosa still has a long way to go to create more value for shareholders in the long term. In Building Products, it has intentionally positioned its aggregates platform in states with healthy fiscal budgets, approved infrastructure spending plans, and/or net population growth, such as Texas and Arizona. We believe these forces should drive strong organic growth, while the $1 trillion US infrastructure bill should amplify and reinforce these multi-year tailwinds. The positive outlook for its engineered structures segment, which is a scale-advantaged domestic producer of utility support structures and telecom towers, is reflected in strong ordering and healthy backlogs driven by strengthening of the public service network, the integration of renewable energy sources, the expansion of coverage, and the construction of next-generation telecommunications networks.

Arcosa’s free cash flow generation, combined with other non-core business divestments, for example the expected closing of the sale of its storage tank business in the second half of 2022, provide management with more resources to finance attractive internal growth investments and additional resources. complementary acquisitions, particularly in the fragmented Construction Products business.

Can you also talk about a high-trust (or notable) position that hasn’t done well so far and why you think you can bounce back?

Ziff Davis (ZD, Financial) acquires and operates Internet and digital media brands in high-value verticals such as technology, gaming, healthcare and shopping. Its portfolio of proprietary sites includes PCMag.com, Spiceworks, IGN, What to Expect, MedPages, and RetailMeNot. The category focus and domain expertise of its brands, supported by the editorial content and tools that Ziff Davis produces for the sites, engage consumers with “high purchase intent” products or services in specific product categories. each site. These capabilities allow the company to deliver a more targeted audience and better returns on the digital ad dollars marketers spend on their sites. Advertising accounts for the majority of Ziff Davis’ revenue, which has historically grown by expanding its share of spend with existing clients and adding new advertisers. Your remaining sales come from subscriptions.

Their businesses share several attractive qualities, such as the recurring nature of subscriptions, persistent advertising customers, as reflected in a historical net revenue retention rate of more than 100%, and high contribution margins associated with leveraging content among millions of visitors to drive ad sales. With no physical inventory and relatively low capital intensity, the company generates approximately 20% free cash flow for every dollar of sales. Management also has a long history of creating value by reinvesting excess cash flows in digital media acquisitions that enhance existing verticals or provide a foothold in new ones.

Shares of Ziff Davis are down roughly 20% so far in 2022. Digital ad spending is normalizing from the peaks of the pandemic just as corporations are cutting ad budgets due to lower consumer spending in the face of inflation and higher interest rates. While we cannot predict the depth and duration of the spending decline, we are optimistic that favorable secular trends and Ziff Davis-specific initiatives should allow the company to achieve its mid- to high-single-digit annual organic revenue growth by long term. E-commerce penetration of total sales activity is forecast to remain on an upward trajectory as consumers continue to spend more time on digital than traditional media. As a result, digital media continue to monopolize the share of traditional media, having already obtained 60% of advertising investment. Recently enacted privacy laws and user tracking policies instituted by Apple and Google enhance the value of ads served based on publisher-owned data, such as that Ziff Davis collects from sites it owns, as opposed to those who use data from united third parties. from sources not directly related to the end customer.

Short-term operational challenges are also creating opportunities for long-term value creation. Digital media valuations (both public and private) have shrunk to more reasonable levels that neither the industry nor Ziff Davis has seen as an active buyer in the last ten years. With a proven and systematic acquisition approach, prodigious free cash flow generation and over $1 billion of liquidity (including $650 million of cash on hand), we believe the company is in an excellent position to move into the offensive at prices that could generate cash. in cash returns above its historical target of 20%.

What is your outlook for small-cap quality?

We believe that short-term volatility in financial markets, primarily as a result of macroeconomic uncertainty, should support quality as small-cap investors seek refuge in companies with durable business models, strong balance sheets and consistent cash flow generation. free box. While the quality small-cap companies we invest in are not immune to recessions, as we saw during the global financial crisis and again during the pandemic, the sustainable competitive advantages that quality companies possess provide them with the financial wherewithal not only to survive in a tough economy but also to go on the offensive and take on or acquire weaker competitors. They often emerge in an even stronger position when conditions improve. The ability to self-finance growth also gives quality companies the financial flexibility to invest during a downturn to better position themselves to capitalize on secular growth drivers impacting the industries they serve, including automation, digital transformation, a higher infrastructure spending and higher capital intensity in semiconductors. . The case for small caps in general, and the quality cohort within the asset class in particular, would also appear to have valuation on their side. Portfolios within each of Royce’s premium strategies have superior return characteristics in aggregate, but generally trade at attractive valuation measures in absolute terms and relative to Russell 2000. We continue to believe that owning a portfolio of companies with Resilient business models that generate returns on invested capital far exceed their cost of capital and are led by management teams adept at allocating capital, which should produce above-average long-term returns for investors.

Ms. Romeo’s thoughts and opinions regarding the stock market are hers alone and, of course, there can be no guarantees regarding future market movements. There can be no guarantee that the past performance trends described above will continue in the future.

The performance data and trends described in this presentation are presented for illustrative purposes only. Past performance is not a guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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