What are some of the challenges and opportunities you have found in today’s market, especially during the recent recovery?
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 since the 1979 launch of the Russell 2000 was also 31.9%. Given all the negative sentiment in the current market, the odds were in favor of a rally. The catalyst for the 22% rebound through 8/15 included signs that inflation may be plateauing and a less dire than expected quarterly earnings growth outlook
Although the “on risk” rebound in small caps was broad based, it was led by lower quality companies and more speculative sectors. This momentum created a difficult near-term relative performance environment for quality that followed several quarters of outperformance by small cap companies with the highest returns on invested capital. As a result, valuations of companies with the kind of sustainable, high-return business models we seek in our Small-Cap Premier Quality strategy remain reasonable.
Can you discuss one high-trust (or otherwise notable) turnout that has been successful so far in 2022?
Acrosa (TO THAT, Financial) provides materials and structures for critical infrastructure projects. Over the past four years, management has implemented a portfolio simplification and transformation plan focused on return on investment, so that its less cyclical, higher-return growth businesses now generate the bulk of the profitability. Arcosa’s building products segment, with strategic acquisitions worth $1.4 billion, primarily sells natural, recycled and lightweight aggregates such as sand, gravel and crushed stone, which are used in public works projects as well as in private non-residential and residential construction. . Aggregate companies tend to be local monopolies because the low value/high weight nature of the product generally makes shipping beyond a 50 mile radius prohibitive. Reserve ownership and permit barriers for new sites further limit competition. These factors maintain price stability during cyclical downturns while providing pricing power when volumes are healthy.
So far in 2022, its stock has been supported by healthy price and volume gains in its core growth businesses, as well as signs of demand dips in more cyclical commodity businesses than management. correctly sized. We believe Arcosa still has a long way to go to create more long-term shareholder value. In construction products, it has intentionally positioned its aggregates platform in states with healthy fiscal budgets, approved infrastructure spending plans and/or net population growth like Texas and Arizona. We believe these forces should drive strong organic growth, while the US$1 trillion infrastructure bill should both broaden and reinforce these multi-year tailwinds. The positive outlook for its Engineered Structures segment, which is a domestic producer of utility-scale support structures and telecom towers at scale, is reflected in order strength and healthy order books thanks to network hardening of public services, the integration of renewable energy sources, the expansion of coverage, and the construction of new 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 – provides management with more resources to finance attractive internal growth investments and additional investments from targeted acquisitions, particularly in the fragmented Construction Products business.
Can you also talk about a high-confidence (or otherwise notable) stake that hasn’t done well so far and why you think it can bounce back?
Ziff Davis (ZD, Financial) acquires and operates digital media and Internet brands in high-value verticals such as technology, gaming, healthcare and shopping. Its portfolio of owned sites includes PCMag.com, Spiceworks, IGN, What to Expect, MedPages and RetailMeNot. The focus on categories and the expertise of its brands, supported by the editorial content and tools produced by Ziff Davis for the sites, attract consumers with a “high purchase intention” of the products or services in the categories. specific to each site. These capabilities allow the company to deliver a more targeted audience and better returns on the digital advertising dollars that marketers spend on its sites. Advertising represents the majority of Ziff Davis’ revenue, which it has historically grown by increasing its spend share with existing customers and adding new advertisers. Its remaining sales come from subscriptions.
Its businesses share several attractive qualities, such as the recurring nature of subscriptions, loyal advertising customers, as evidenced by a historical net revenue retention rate in excess of 100%, and high contribution margins associated with exploiting the content of million visitors to boost advertising sales. With no physical inventory and relatively low capital intensity, the business generates about 20% free cash flow for every dollar in sales. Management also has a long track record of creating value by reinvesting excess cash flow into digital media acquisitions that enhance existing vertical markets or expand into new ones.
Ziff Davis’ stock has fallen about 20% so far in 2022. Digital ad spending is normalizing after pandemic spikes, just as companies are cutting ad budgets due to lower consumer spending in the face of inflation and rising interest rates. While we cannot predict the extent and duration of the spending decline, we are optimistic that favorable secular trends and specific Ziff Davis initiatives should enable the company to achieve long-term single-digit annual organic growth. E-commerce penetration of total sales activity is expected to remain on an upward trajectory as consumers continue to spend more time on digital media than traditional media. As a result, digital media continues to take market share from traditional media, having already garnered 60% of advertising spend. Recently enacted privacy laws and user tracking policies instituted by Apple and Google enhance the value of advertisements served based on proprietary publisher data such as that Ziff Davis collects on sites it owns. as opposed to those that use collated third-party data. from sources with no direct relationship to the end customer.
Short-term operational challenges also create opportunities for long-term value creation. Digital media valuations (both public and private) have contracted to more reasonable levels than either the industry or Ziff Davis has considered an active buyer over the past decade. With a proven and systematic acquisition approach, prodigious free cash flow generation and over $1 billion in liquidity (including $650 million in cash), we believe the company is in an excellent position to transition to the attack at prizes that could make money. on cash returns above its historical target of 20%.
What is your outlook for small cap quality?
We believe short-term volatility in financial markets – primarily the result of macroeconomic uncertainty – should support quality as small-cap investors seek refuge in companies with sustainable business models, strong balance sheets and a constant free cash flow generation. Although the quality small-cap companies we invest in are not recession-proof, as we have seen during the global financial crisis and again during the pandemic pullback, the enduring competitive advantages that owning quality companies gives them the financial means not only to survive a difficult economy but also to go on the offensive and take shares or acquire weaker competitors. They often emerge in an even stronger position when conditions improve. The ability to self-fund growth also gives quality companies the financial flexibility to invest in downturns to better position themselves to take advantage of the age-old growth drivers affecting the industries they serve, including automation, digital transformation, increased infrastructure spending and increased capital intensity in semiconductors. . The case for small caps in general – and in particular the quality cohort within the asset class – would also appear to have valuation on its side. The portfolios of each of Royce’s top quality strategies have superior profitability characteristics overall, but generally trade at attractive valuation measures on an absolute basis and relative to the Russell 2000. We continue to believe that holding a portfolio of companies with resilient business models that sustainably generate returns on invested capital well above their cost of capital and led by expert capital allocation management teams are expected to deliver above-average long-term returns for investors .
Ms. Romeo’s thoughts and opinions regarding the stock market are solely her own and, of course, there can be no assurance as to future market movements. There can be no assurance that past performance trends as 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 indicative of future results. Historical market trends are not necessarily indicative of future market movements.