RVT - RVT: Swap Growth For Small-Cap Value Stocks To Combat Inflation

Summary

• Royce Value Trust provides an alternative to risk-on investors that have lost faith in growth stocks after Tuesday's CPI report.
• Regression analysis suggests that small-cap value could hit the big time soon, and Royce Value Trust is ideally placed to benefit from a change in market risk attribution.
• The fund's IR ratio suggests its managers provide value for money. In addition, the CEF's fee structures are favorable.
• Royce Value Trust is a cyclical asset with a favorable dividend yield. We think the time to bet on it has presented itself.

Earlier today, VanEck released an interesting article that outlined the year-to-date performance of small-cap stocks. The article set a baseline to work from, which we decided to take advantage of by elaborating on a few features while also recommending a suitable asset.

In addition, Tuesday's CPI report could alter the outlook for small-cap value stocks. As such, we decided to look for a "best-in-class" small-cap value instrument, which we discovered in Royce Value Trust ( RVT ), a North American closed-end fund ("CEF"). In our opinion, U.S. small-cap equities, and Royce Value Trust in particular, possess the necessary attributes to outperform the broader market in the coming quarters.

Without further ado, let's get started with the analysis.

Style-Based Assessment

Before diving into Royce Value Trust itself, let's discuss a few market-based dynamics that could support the asset's trajectory.

Firstly, Tuesday's U.S. CPI report revealed a surprise, as inflation settled higher than anticipated. By the looks of things, the market started pricing a rapid decline in inflation before January's inflation numbers were unveiled, as growth stocks and general high-beta securities outperformed the broader market. However, the scenario changed after the report, as investors started pricing inflation uncertainty again.

Although many market analysts believe that the appetite for risk-on assets is on hold (after Tuesday's report), we argue that there will merely be a shift from growth stock proclivity to small-cap-centric investing. Moreover, we think small-cap value stocks will dominate proceedings.

What's our premise?

Well, there's no doubting the fact that higher-than-estimated inflation generally trumps growth stocks , as they rely on lower discount rates. However, higher inflation will likely not have the same effect on small-cap stocks.

As displayed in the regression analysis below, small-cap stocks (size) tend to outperform during recessionary environments and during economic recoveries. This matters because these two phases are often sequential and presently embody the current macroeconomic and financial market environments. To elaborate, we think the two most likely outcomes for the macro environment in 2023 are a recession or an early-stage recovery (or even both). Moreover, the U.S. experienced a down market last year, and small-cap stocks tend to rebound sharply after year-over-year weakness.

Collectively, we think investors were bargaining on consistent inflation in 2023. Although inflation has proven to remain inconsistent, we believe investors will retain their risk-on appetite despite a disappointing January CPI report, which leads us to believe that small-cap and small-cap value stocks, in particular, are ideally placed to benefit from the current market environment.

Royce Value Trust's Portfolio

Although Royce Value Trust is exposed to cash and bonds, more than 95% of its portfolio is allocated to equities, with a style drift towards small and microcap value stocks.

Based on basic observation, the CEF is very cyclical, with its exposure to industrials, financials, consumer cyclical companies, and basic materials leading the way. In addition, the CEF's hefty exposure to technology adds risk; however, we think its tech bets onboard secular risk rather than cyclical risk.

Royce Value Trust hosts nearly 480 securities, and its top ten holdings span but 11.63% of the fund's portfolio. Therefore, it won't help to assess its primary constituents on an individual basis, as their idiosyncratic risks are diversified. In essence, the fund is diversified to the extent that company-specific events will have little effect; instead, the CEF's expected returns hinge on style-based factors and the market's risk attribution.

Royce Value Trust has a price-to-book value of 2.1x and a price-to-earnings multiple of 14.1x. In our opinion, the CEF's P/B multiple isn't terrific, as you ideally want to see your value stocks trading at a P/B below 1. However, its price-to-earnings ratio is likely justified, as its average constituent has a tremendously appealing earnings yield of 28.95% and cash flow growth of 9.42%. Therefore, we think the fund's valuation multiples are justified by embedded growth across its constituents' income statements.

Risk-adjusted Return Assessment

A key attraction to Royce Value Trust is its managerial value additivity. Although minimally constrained, the CEF tracks the Russell 2000, which serves as its benchmark by default.

A fund's active return measures a portfolio manager's worth as it assesses a fund's excess returns versus its excess risk when compared to a benchmark. Thus, Royce Value Trust's IR of 0.1 presents much to cheer about.

Furthermore, the CEF has positive Sharpe and Sortino ratios, indicating that Royce Value Trust presents favorable volatility-adjusted returns and manages downside volatility effectively. Although many academics will say that Sharpe and Sortino ratios above one are preferred, we believe anything safely in positive territory is acceptable.

Dividends and Expenses

If you're looking for dividends, then Royce Value Trust is a CEF that should be on your watchlist. The fund distributes quarterly and exhibits a 5-year incremental dividend growth rate of 2.62% , illustrating consistency. More importantly, the CEF's distributions have provided solid yields during the past decade, with its lower bound still providing an upper quantile dividend.

Lastly, the CEF has an operating expense of merely 0.73x , which we consider a bargain. Furthermore, Royce Value Trust's performance fees are penalized whenever the fund achieves a negative month, dragging down its managers' weighted-average incentives and providing a more justified deal to its investors.

All in all, we think the fund compensates its investors well while not demanding too much in fees.

Noteworthy Risks

The first notable risk pertaining to Royce Value Trust is its subdued price return. The CEF has traded flat since its inception in the 1990s, providing most of its gains via dividends. Thus, it has to be said that the fund's long-term investment profile is questionable.

Much of the CEF's flat performance is due to its cyclicality. At a beta coefficient of 1.25x and with a style-based investment thesis, Royce Value Trust should be considered as a conviction play instead of a buy-and-hold.

Lastly, the persistence of inflationary instability could result in a market correction, wiping out most of 2023's year-to-date gains. Therefore, systemic issues need to be phased into an analysis of Royce Value Trust.

Concluding Thoughts

Royce Value Trust could be a "best-in-class" closed-end fund in 2023, given the current intersection between increased risk appetite from investors and sustained inflation uncertainty. Quantitative metrics suggest that the fund is well-managed; however, cyclicality has been a regular theme since its inception.

We see lucrative total return prospects on the horizon for Royce Value Trust. Thus, we assign a strong buy rating to Royce Value Trust with a 12-month holding period.

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