RVT - RVT: Small-Cap Exposure At A Deep Discount

2023-05-09 12:58:06 ET

Summary

• RVT is a CEF focused on small-cap companies with the average market cap of their holdings at $2.66 billion.
• This has been a relatively weaker area of the market, contrasting the strength we are seeing from the major indices.
• At a large discount and an attractive managed distribution plan, this could be an interesting name to consider.

Written by Nick Ackerman, co-produced by Stanford Chemist. This article was originally published to members of the CEF/ETF Income Laboratory on May 8th, 2023.

Royce Value Trust ( RVT ) is currently trading at a deep discount. The fund isn't experiencing the same strong run this year as the major indices, such as the S&P 500. Then again, this fund carries a significant weighting towards smaller-cap companies rather than the large-cap S&P 500 names. The S&P 500 is generally considered the broader 'market' measurement but has benefited tremendously from the mega-cap tech names. The 'market' wouldn't be doing so well without those.

Besides gaining exposure to small-cap companies that can often exhibit chances for strong returns over the long term, RVT is also trading at an attractive discount. So you get companies that are relatively better valued as well as a discount on top of those companies. Of course, the caveat being here that small-cap companies tend to be relatively more volatile. They are more sensitive to economic slowdowns, which is presumably why they have been experiencing a relatively more challenging time in terms of performance. The outlook at this time seems to be that a recession is fairly certain sometime in the next year.

The fund has had plenty of success historically, beating out its benchmark. That's over the long term and the shorter term, where the fund's underlying portfolio has held up relatively better. However, the fund's market price performance has been lacking more recently, which has opened up an attractive discount.

The Basics

• 1-Year Z-score: -2.14
• Discount: 13.52%
• Distribution Yield: 8.44%
• Expense Ratio: 0.86%
• Leverage: N/A
• Managed Assets: $1.687 billion
• Structure: Perpetual

RVT's objective is "long-term growth of capital." To achieve this, the fund will "normally invest at least 65% of its assets in the equity securities of small- and micro-cap companies." The limiting factor is "such companies are those that have a market capitalization not greater than that of the largest company in the Russell 2000 Index at the time of its most recent reconstitution."

At the present time, the fund isn't leveraged according to the latest quarterly update at the end of March 2023 . However, according to the fund's annual report in each of the last five years, the fund can and has employed a rather mild amount of leverage. The maximum borrowings for the fund can go up to $150 million. On December 31st, 2022, they had listed roughly $66 million in borrowings. As a small-cap-oriented company that will generally experience greater volatility, keeping leverage to a minimum seems smart.

As interest rates have been rising, their borrowing costs on leverage have also been rising. That's another reason why keeping leverage minimum and allowing it to be utilized opportunistically can make much more sense.

According to its annual report, the fund's expense ratio came to 0.86%. This would have been 0.97% if leverage had been included. However, on their website, the fund's expense ratio appears fairly meaningfully lower at 0.63%.

One other fairly odd thing about RVT is that they also have a performance-based fee. That's why we could be seeing a discrepancy in the expense ratios. Incentive fees are often associated with more complex funds, so it's a bit unusual to see one for this type of CEF. In this case, though, it seems that it works to the shareholder's benefit in the way it is designed, as it isn't really based on a low hurdle. So this ultimately isn't exactly the typical type of incentive fee style that we are used to seeing either.

As compensation for its services under the investment advisory agreement, Royce receives a fee comprised of a Basic Fee (“Basic Fee”) and an adjustment to the Basic Fee based on the investment performance of the Fund in relation to the investment record of the S&P SmallCap 600 Index (“S&P 600"). The fee is payable monthly.

The basic fee starts initially at 1% annually. This is then adjusted by .05%, either up or down relative to each percentage point that the fund performs against the S&P SmallCap 600 Index. The max increase or decrease is limited to a 0.5% change or a range of 0.50% and 1.50%.

However, they also add that there won't be any fee "for any month when the investment performance of the Fund for the rolling 36-month period ending with such month is negative." In my previous article , all the way back in 2021, I pointed this out as a negative, but I think I'm warming up to the idea. Seeing an advisory fee get reduced while the fund underperforms could benefit other funds.

Performance - Attractive Discount

Despite the underlying portfolio being able to outperform its benchmark over the longer-term and the shorter-term periods, the fund still trades at an attractive discount.

They aren't completely untouchable, though. In the 15-year time frame and for the MTD for May, the fund did underperform its benchmark. Additionally, I'm sure if you spend enough time, you could find other periods where the fund had underperformed too.

This outperformance is something that they boast about. Understandably as it's fairly rare for a CEF to top its benchmark with higher expenses so regularly. Another way of looking at the performance would be the breakdown they provide in their latest fact sheet . That points out outperformance in each peak-to-peak cycle of the market.

One area that can help the performance is due to the way that the performance-based advisory fee works. When the fund underperforms, the fee is reduced, and that can help retain more assets for the fund to rebound with during recovery. While the fund is performing well, they take a higher cut, but the upside can be limited so it doesn't become too egregious.

Past performance doesn't guarantee future results. That's where the fund's discount can come in to help. With a sharp decline in the fund's share price more recently, the fund has sped to an attractive discount. The divergence between the fund's share price and the NAV price looked to begin right when the banking crisis began. That is the sort of uncertainty that can hit small-cap names due to an expectation for weaker economic conditions and tightening credit.

However, in this case, there was such an overreaction that the fund has been pushed to a wider discount than it had experienced in the last year. On top of this, while we aren't quite at the lows in terms of what discounts we can see in weaker periods such as 2016 and 2020, we are getting nearer to those levels.

Distribution - Managed Plan

The first thing that one might notice is the fund's distribution paid out has been shrinking steadily.

Well, this is actually by design. This fund pays a managed distribution plan. As NAV declines, the payout for shareholders declines. As the fund is doing better and NAV climbs, the payout for investors will also climb.

For RVT, the distribution is based on "7% of the average of the prior four quarter-end net asset values, with the fourth quarter being the greater of these annualized rates or the distribution required by the IRS regulations." Being that they are a regulated investment company or RIC, they have to pay out the majority of their income and capital gains. That means the year-end distribution can deviate from this plan to stay compliant and avoid excise taxes.

As is the case with most equity funds, the fund will rely significantly on capital gains in order to fund its distribution. For RVT, this is even more so as the underlying portfolio companies are small. Therefore, they retain most of their cash in order to fund growth rather than payout dividends. That being said, they do have some NII. This could be thanks to their generally more moderate expense ratio relative to other CEFs.

RVT's Portfolio

RVT had been a fairly active fund in 2022, with its turnover rate coming in at 60%. That was more active than each of the preceding four years. In total, they carry 477 holdings and note that the "top 200 holdings represented 85% of the Fund's equity investments" as of the end of March 2023. Therefore, the last 277 holdings make up just 15%, presumably with each holding being a smaller and smaller allocation of the pie.

It also suggests that there is plenty of diversification with this fund if it takes 200 holdings to get to even 85% of the fund's total allocation. When looking at the top ten, this is reflected, too. We only have to get to the eighth largest holding, and we are already sub-1% allocations.

While carrying such a high number of holdings can generally limit outperformance against a benchmark - as it can also limit underperformance - it's quite interesting to see that hasn't been the case for this fund. Again, most of the standard time frames of performance against the benchmark have shown RVT to exceed.

We can start to get outperformance if they strategically allocate the fund to various sectors within the small-cap space. That seems to be the case, as their sector weights are actually fairly different from the benchmark. This data is as of the March 31st, 2023, close.

The most notable detractor here seems to be the fund's allocation to industrials, tech and materials relative to the Russell 2000 Index. Contrasting that is the slightly lower allocation to financials, which can mean a lot during a banking crisis. An additional noteworthy detraction in portfolio weightings comes in from having a smaller allocation to healthcare as well. Finally, energy is also a relatively smaller weighting for the fund, but it isn't overly large for the Russell 2000 either. Interestingly, those are actually some of the worst-performing sectors on a YTD basis.

Utilities are also a weaker performer, in which RVT allocates only a negligible amount, and the Index also only carries a fairly small amount. That's where we can get the type of performance of RVT being up 3.35% YTD compared to Russell's increase of 0.40%. This wasn't just a recent change either, as the sector weightings at the end of March were similar to how they entered the year.

Interestingly, they added a bit to the financial sector in the first quarter. They were perhaps picking up some good values during the banking crisis.

Conclusion

RVT has been a strong performer against its benchmark over time and in the shorter term. Portfolio positioning showed that they entered the year being underweight to underperforming sectors relative to its benchmark. That's definitely one way to outperform despite carrying nearly 500 total holdings. Of course, past performance is no guarantee of future success. That being said, the fund's discount also gives investors a potentially attractive time to consider this fund. Discounts can always widen further, too, but we are over the fund's last decade average and pushing near some of the lows met in prior uncertain periods of 2016 and 2020.

Overall, the current market and economic conditions are fairly uncertain. That has pushed RVT's performance lower in the last year before rebounding some this year as it focuses on small-cap companies. Small-cap companies are naturally more sensitive to economic conditions. For a longer-term investor, that can mean the opportunity is relatively cheaper for small-caps and getting a discount on top of that.

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