Legg Mason IF Royce US Smaller Companies: October 2020 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
• The fund features on our Wealth Shortlist of funds chosen by our analysts for their long-term performance potential

How it fits into a portfolio

The fund aims to deliver long-term growth by investing in unloved higher-risk 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.

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 bags 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.

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.

The US has experienced volatility since coronavirus first hit markets, and Romeo has taken this opportunity to reshape some of the portfolio. Since March, she’s sold 10 holdings that together, only made up a small part of the portfolio. The sale proceeds from these lower conviction ideas were reinvested into eight new companies, which appeared undervalued. This includes Meridian Bioscience and speciality property and casualty insurer ProSight. We view this action by Romeo to take advantage of higher conviction opportunities positively.

Culture

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.

Franklin Templeton recently acquired Legg Mason Asset Management, which means Romeo’s fund now sits under the Franklin Templeton umbrella. The fund’s investment philosophy and process remains the same though, and Romeo retains autonomy over the fund.

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.

Cost

The fund has an ongoing annual charge of 0.99%, but we’ve secured HL clients an ongoing saving of 0.33%. This means you’ll pay a net ongoing charge of 0.65%. The fund discount is achieved through a loyalty bonus, which could be subject to tax if held outside an ISA or SIPP. The HL platform fee of up to 0.45% per year also applies.

Performance

The fund’s made attractive returns since Romeo became a co-manager of the fund in 2010 but has not 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 many of the companies the manager favours have remained undervalued and out of favour, holding back returns.

It's been a similar story over the past year, the fund is behind its benchmark and the value style has held back returns. This narrow breadth of growth delivered by US smaller companies was evident in the last quarter with the Russell 2000 index gaining 2.0% over the period but just 45% of stocks in the index actually rising in value*. While this style has been out of favour for some time, we are pleased to see Romeo stick to her approach of investing in undervalued companies she believes have strong longer-term prospects.

All investment styles come in and out of favour and we believe the fund has the potential to do better when the current preference of most investors for high-growth companies changes.

Over the last 12 months software company Simulations Plus, semiconductor systems provider Nova Measuring Instruments and asset manager Artisan Partners have been among the most significant contributors to the fund’s 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.

*Source: Franklin Templeton July – September 2020.

Past performance is not a guide to the future. Source: Lipper IM to 30/09/2020

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