RVT - RVT: Reiterate Buy On Positive Seasonality For Small-Caps

2023-09-29 08:50:42 ET

Summary

• The Royce Value Trust is a small-cap-focused CEF that has been in operation since 1986.
• The Royce Value Trust Inc. has a consistent track record of outperforming the Russell 2000 index on all time frames.
• In the near term, small-caps tend to have pronounced outperformance into year-end as fund managers 'chase' performance.
• Longer-term, unless we see a replay of the Dot-com bubble, the return gap between large-caps and small-caps are at historic wide levels and should narrow, favouring small-cap stocks.

I initiated on the Royce Value Trust Inc. ( RVT ) about a year ago with a positive article , noting RVT's strong attributes like a phenomenal track record and an attractive distribution yield. However, I had not expected the rise of the 'Magnificent 7' , a group of AI-related mega-cap companies that have become market darlings in 2023. While the Magnificent 7 have galloped to double, and even triple digit returns, most small-cap stocks have only gained modestly in 2023, with some even down on a year to date basis.

The Royce Value Trust, with its focus small-cap companies, have likewise underperformed the markets overall, returning 7.2% on a 1-year basis compared to 16.8% for the SPDR S&P 500 ETF Trust ( SPY ) (Figure 1).

As we enter the final few months of the year, I believe RVT's YTD underperformance may improve due to seasonality and an unusually wide spread between large-cap and small-cap performance.

Brief Fund Overview

For those not familiar, the Royce Value Trust Inc. is a U.S. small-cap focused closed-end fund ("CEF") that has been in operation since 1986. It is lead managed by Chuck Royce, a renowned expert in small-cap investing with over 60 years of industry experience.

Impressively Consistent Track Record

RVT's main selling point is the fund's stellar long-term track record. Historically, the Royce Value Trust has outperformed the Russell 2000 on all time frames, from 1 year to 35 years (Figure 2).

While the RVT fund may lead or lag the Russell 2000 by a few percent in any given year, over the long run, RVT beats the index more often than not (Figure 3).

Moreover, the RVT fund's track record is earned by being incrementally better than the Russell 2000 Index year-in and year-out, unlike other investment professionals that swing for the fences to deliver huge outperformance over a short period of time, but end up crashing and burning once their particular fad is over (ahem, paging Ms. Cathie Woods).

While RVT's per annum outperformance may seem small, for example the RVT fund has returned 9.6% since inception vs. 9.0% for the Russell 2000 index, when compounded over many years, the 0.6% p.a. outperformance can turn into a sizeable 51% difference in total assets (Figure 4).

Higher Returns And Lower Risk

Another key attribute of the RVT fund that I find attractive is the fund's risk profile. The RVT fund has historically outperformed the Russell 2000 during market drawdowns, returning a median -28.1% during the past 10 drawdowns vs. -34.5% for the index (Figure 5).

This has led to the RVT fund delivering higher returns with lower volatility over the past 3, 5, and 10 years compared to the Russell 2000 Index (Figure 6).

High Yielding Managed Distribution yielding 8%.

To cap it all off, the RVT fund pays a high, but manageable distribution, with a current quarterly distribution of $0.26 / share or 8.0% yield.

RVT has a managed distribution policy ("MDP") that pays a quarterly distribution at an annual rate of 7% of the average of the prior four quarter-end net asset values ("NAV"). This means that when investment performance is strong, investors are rewarded with a higher distribution yield. This is a refreshing difference compared to many CEFs like the Brookfield Real Asset Income Fund ( RA ) that promises to pay an unsustainably high distribution yield, depleting the fund's NAV and ultimately leading to the distribution being cut.

Seasonality Favours Small-Caps Into Year-End

Returning to the main point of this article, I believe investors may want to consider taking a position in small-cap funds like RVT into year-end. First, small cap equities have very pronounced seasonality from October to December (Figure 7).

The explanation behind year-end rallies are varied, but one theory is that when markets have done well during the first 9 months of the year, institutional fund managers who are lagging their indices need to 'chase' performance. Since small-caps tend to be higher beta and offer more 'bang for the buck', they are often the instrument of choice for year-end performance chases. This causes small-caps to historically outperform large caps in the final two months of the year (Figure 8).

Technically, many pension plans and institutional investors get an injection of new capital at the beginning of the year that must be invested in a relatively short period of time. Therefore, towards the end of the year, nimble traders tend to front-run this investment 'flow' and bid up assets.

Finally, towards year-end, company executives tend to make forecasts and budgets for the next year, which gets released to investment analysts as 'guidance'. Since companies tend to be optimistic, these forecasts will likewise tend to paint a rosy picture, which gets 'rolled forward' in analysts' models, leading to ratings and target upgrades, buoying stock prices.

While the actual explanation for 'year-end rallies' is hard to pin down, we know from empirical evidence the effect does exist.

Wide Performance Gap Between Large And Small-Caps Is Likely To Close

Looking longer-term, the 5-year trailing return gap between the S&P 500 and the Russell 2000 is now 46% (measured on a monthly basis between August 2018 to August 2023) (Figure 9).

Short of the historic period during the Dot-com bubble, this is near the widest gap in trailing 5-year returns between the S&P 500 and the Russell 2000 (Figure 10).

Unless we are looking at a replay of the Dot-com bubble, a narrowing of this return spread should be expected in the coming quarters/years and would favour small-cap investments like RVT compared to large-caps funds and indices.

Risks To RVT

Of course, there is the possibility that the 'AI revolution' driving returns for the 'Magnificent 7' morphs into a full-blown bubble like the Dot-com bubble in the late 90s. If that were to happen, then the small-cap focused RVT fund may continue to underperform the markets as investors continue to push mega-caps like NVIDIA Corporation ( NVDA ) to new heights. However, just as we saw in the period following the Dot-com bubble in Figure 10 above, eventually fundamentals will cause stocks to return to reality and small-cap underperformance will mean-revert, and we should expect the RVT fund to outperform.

Another risk to RVT is if the U.S. economy falls into a recession, then the RVT fund may continue to underperform since small-cap stocks tend to suffer larger drawdowns than large-cap stocks. However, given the large performance gap between the large-caps and small-caps, I believe small-cap stocks may actually have less downside in any coming recession.

Conclusion

The Royce Value Trust is a best-in-class small-cap focused CEF that has historically outperformed the Russell 2000 Index. In the near-term, I believe a year-end rally is possible and small-caps tend to outperform into December. Longer-term, unless the 'AI revolution' turns into a full-blown mania, the wide returns gap between small-caps and large-caps is unsustainable and should narrow, favouring small-cap funds like RVT. For investors looking for small-cap exposure, I believe RVT is a solid choice. I rate RVT a buy .

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