FTF Royce US Smaller Companies: October 2023 fund update

• The fund is managed by Lauren Romeo, who is supported by a highly experienced team at Royce with support from Franklin Templeton
• Romeo invests in her own fund and is rewarded based on its long-term performance, aligning her interests with investors
• The fund offers a differentiated approach to a lot of other US equity funds which means it has the potential to perform quite differently
• This fund is on our Wealth Shortlist of funds chosen by our analysts for their long-term performance potential

How it fits in a portfolio

The FTF Royce US Smaller Companies fund aims to deliver long-term growth by investing in unloved high quality US smaller companies, with the potential to come back into favour or recover in future. It could be a good way to add US exposure to a global portfolio, or work well alongside other US funds focused on larger, more growth-style companies. Smaller businesses are often among the most innovative and offer lots of growth potential, but they're higher risk than their larger counterparts.

Manager

The fund is managed by Lauren Romeo, who joined Royce and Associates in 2004. She started out as assistant manager of the fund, before being appointed co-manager in 2010 and lead manager in 2011. We like the Royce team’s disciplined approach and think Romeo is an engaging and experienced fund manager with a passion for investing in smaller companies. Romeo is supported by a team with lots of experience, including the firm’s founder Chuck Royce who has been investing client money since 1972. We believe that the fund harnesses the skills of a talented team with a sensible investment approach. Romeo is also named as co-manager on some other funds in the US that invest with a similar philosophy as this fund. We’re satisfied that these responsibilities are manageable.

Process

Romeo aims to invest in companies that are unpopular with investors and buy their shares at a price significantly lower than she feels they’re worth. They might be facing headwinds in the shorter term, so it's important they don't have too much debt. Romeo and her team spend a lot of time meeting with a company's managers to make sure they've got the skill and experience to turn the business around. They also speak to customers, suppliers and competitors to make sure the managers are executing their plan.

This analysis leads Romeo’s team to decide what they think a company's shares are worth. She thinks this process provides opportunities to spot companies that are undervalued. This could also provide some support when markets are weaker – if a company's share price is already lower than it should be, it might not fall quite so far as those that are more expensive. They won't get it right every time though and even when they do, it can take some time for other investors to realise the opportunity and to see the share price rise. This means there will be periods where the fund underperforms and seems at odds with the wider market, so this style of investing requires patience.

In recent months, Romeo believes that with rising interest rates, economic uncertainty and the recent banking sector scare, businesses’ valuations are returning to normal. She has used this opportunity to add to several companies including AMN Healthcare. Romeo believes that the recent pressure on share price is a normalisation post pandemic however, she sees favourable demand trends persisting over the long term. Footwear designer and producer Steve Madden was also added to the portfolio. Again, the share price has been under pressure recently due to retailers dealing with inventory control and uncertain consumer spending. However, the company has a strong balance sheet and long-term opportunities. Romeo also initiated positions in auction company Ritchie Brothers, industrial company Crane NXT and technology company Enpro.

Several companies were also sold, including semiconductor equipment maker Kulicke & Soffa which was sold due to valuation reasons. Communications software provider Consensus Cloud Solutions was sold after a loss of conviction following its attempt to enter the healthcare market. Industrial company Gibraltar Industries was also sold after a series of poor acquisitions which have proven to be problematic. 

The manager thinks markets might continue to be driven by uncertainty and caution, given the worries about the economic challenges ahead. Romeo feels a challenging outlook re-emphasises the case for a higher quality approach through investing in businesses with durable business models and strong balance sheets that are able to consistently generate cash. She believes that the fund is made up of better quality businesses than many others in the index but trading at attractive valuations. 

Culture

The fund is managed by Royce and sits under the Franklin Templeton umbrella. Smaller company value investing is Royce's specialism – it’s what they do and is where their expertise lies. This single focus distinguishes the firm from other asset managers in the US. Fund managers at Royce are required to invest substantial amounts in the funds they run and have variable bonuses based on the long-term performance of their funds. We feel this is a positive and ensures alignment with the interests of investors.

ESG integration

Romeo considers ESG (Environmental, Social and Governance) issues when researching individual companies. She thinks these factors have the potential to affect the long term value of the investment and thinks sound understanding of how these factors could affect businesses is an important part of managing risk in the fund.

Franklin Templeton was previously a laggard on ESG integration. But since its integration with Martin Currie (as part of the Legg Mason acquisition), the group has made significant strides forward, in part because of its ability to leverage Martin Currie’s expertise. Responsibility for carrying out ESG analysis sits with individual analysts and portfolio managers, and all stock research must consider the material and relevant governance, social and environmental factors that could impact a company’s ability to generate sustainable returns.

All investment teams have access to a dedicated ESG team, which tracks emerging themes, shares industry best practice and conducts independent analysis. There is a firm-wide commitment to avoid controversial weapons. Franklin Templeton fund managers and analysts engage with executives and board members of the organisations they invest in to review issues they believe are material to the firm’s long-term prospects. They also vote at shareholder meetings wherever possible, informed by three third-party voting advisors. The firm publishes regular ESG-focused articles and a comprehensive annual stewardship report. It also outlines its voting activity on a fund-by-fund basis, although voting rationale is not available.

Cost

The ongoing charge for this fund is 0.73%, but HL clients benefit from a saving of 0.33%, resulting in a net ongoing charge of 0.40%. This saving is provided through a 'loyalty bonus', which is tax-free in an ISA or SIPP. However, they may be subject to tax in a Fund and Share Account. The HL platform fee of up to 0.45% per annum also applies.

Performance

The fund’s made attractive returns since Romeo became a co-manager in 2010 but hasn’t managed to keep up with the broader US market of smaller companies. This is disappointing, and we would have expected the fund to perform better given the manager’s bias towards higher-quality smaller companies. But the manager’s investment style, and so many of the companies she invests in have remained undervalued and out of favour for much of this period, holding back returns. We typically expect the fund to hold up relatively well when markets are falling. In contrast, we expect the fund to lag the peer group when markets rise quickly.

Over the last 12 months the fund has performed well. It’s delivered a return of 10.87%* to investors, some way ahead of the Russell 2000’s return of -0.37% and the IA North American Smaller Companies peer group average return of -1.41%. We’re pleased to see the fund has performed well over this period where value focused funds have benefitted from a rotation away from growth. Past performance isn’t a guide to the future. Our analysis suggests Romeo continues to add value through her stock selection. Her investments in fragrance producer Inter Parfums and technology solutions company Onto Innovation were among the biggest contributors to performance over this period. In contrast, the fund’s investment in industrial company Forrester Research and technology company Faro Technologies were among the largest detractors from performance.

We believe a well-diversified portfolio should have exposure to a mixture of different investment styles, asset classes and geographies, and we think this fund offers something quite different. All investments fall as well as rise in value, so you could get back less than you invest.

Annual percentage growth

Past performance isn't a guide to the future. Source: *Lipper IM to 30/09/2023.

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