Investors often vacillate between CEFs and ETFs, not knowing for sure what the right answer is. It very much depends on each individual’s situation and the respective asset class. For many retired investors where regular cash-flow is a must, the CEF asset class is usually the answer. Other investors would do well to utilize ETFs, especially for equities, when they are not in need for a regular stream of cash. However, irrespective of the investor type, if a structure comes along where the asset manager has consistently outperformed an index throughout time, the choice is a no-brainer, with the outperforming structure preferrable over other choice. The Royce Micro-Cap Trust (NYSE:RMT) is such an instrument. We covered this name more than a year ago, and with the market expecting mid- and small-caps to outperform this year in a ‘soft-landing’ scenario, we feel it is time to revisit this outstanding CEF.
RMT is an equity CEF that focuses on micro-cap stocks. The respective equities have market capitalizations between $50 million and $1 billion, and can present very attractive opportunities for active, savvy managers. The CEF had a robust 2023, posting a performance exceeding 15%, performance which was in-line with the iShares Russell 2000 ETF (IWM) and above the iShares Micro-Cap ETF (IWC). Throughout time, though, RMT’s active portfolio construction approach has produced superior results:
As a retail investor, this is exactly the type of graph you want to see. An active instrument which outperforms the index, and does so consistently. As we can see from the above graph, the teal line is consistently above the orange line, meaning the outperformance is not due to a one-time event / stock choice, but has more to-do with the day-to-day stock selection and management acumen.
In this article, we are going to re-visit RMT’s composition, frame it in today’s market environment, and articulate why we think RMT is a good choice for a retail investor’s portfolio.
CEF composition and holdings
When looking at the Morningstar style box, the fund falls in the micro-cap section:
Although there is an iShares offering for a micro-cap ETF, its performance is poor historically, and we see RMT benchmark itself against the Russell 2000, hence we are going to go with that methodology as well.
Micro-cap equities, are stocks from small capitalization companies:
The average market capitalization for RMT holdings is $676 million, which pales in comparison to the S&P 500 components as an example. The median constituent market cap for S&P 500 stocks is $30.4 billion, while the Russell 2000 sports a $2.13 billion average market cap.
Small caps come with their own risk and rewards. While they are much more volatile and have a higher probability of going under when compared to large caps, they can also produce returns in the multiples, depending on the business.
RMT’s portfolio is focused on tech and industrial companies:
Information technology makes up 22.1% of the portfolio, followed by industrials at 19%. Most of the portfolio companies come from the U.S., with the jurisdiction making up over 73% of the fund’s holdings.
There has been a lot of discussion around funding impacts for small caps in a higher interest rate environment, with many small enterprises utilizing floating rate debt via bank revolvers for a high percentage of their liquidity:
Small cap stocks tend to feel the impact of changes in interest rates more than their large cap equivalents. Not only do small cap companies have a greater dependency on shorter term financing to help them survive but they tend to rely more heavily upon floating rate debt, strengthening the immediate impact of any increases in interest rates upon their profits.
As rates come down, funding costs for small caps should come down as well, alleviating one of the concerns of the current environment. Lower costs of funds should translate into a higher profitability, which in turn yields a higher equity value.
As opposed to tech mega-caps, the RMT portfolio is cheaply valued at only 15x earnings. Starting valuations matter, especially when entering a sector which can see gains via multiple expansion. When buying a company or sector at P/E ratios above the historical average, the probability of significant total returns in the short end is reduced.
For a ‘soft landing’ rotation is the name of the game
The media now abounds with references to a soft landing, with even Janet Yellen referencing one:
“What we’re seeing now I think we can describe as a soft landing and my hope is that it will continue,” Yellen said on CNN on Friday.
Yellen also pointed out that the U.S. avoided a recession in 2023 and criticized economists who had been predicting that, saying in the interview, “there has been a lot of pessimism about the economy that’s really proven unwarranted.”
A soft landing should translate into a growth environment, with no recession. While tech mega-caps have weathered 2023 very well due to the AI revolution, their P/E ratios are stretched. We believe that a soft landing will see capital rotate into undervalued sectors, namely mid- and small-caps. Coupled with the funding benefits of lower rates, a goldilocks environment should translate into high returns for this sector.
Microcaps are not as volatile as you would think
One of the main concerns with this asset class is around drawdowns. Very volatile asset classes with deep drawdown are not desirable for retail investors. Surprisingly, RMT is not that volatile:
Outside the Covid crisis, RMT has had normalized drawdown when compared to both the Russell 2000 and the S&P 500. During the 2021/2022 drawdown period, RMT had a better drawdown profile than IWM, and only 5 points wider than the S&P 500.
RMT is certainly a fund which is on the more aggressive side of portfolio construction given the risk/reward offered and the size of the drawdowns, but for the current transition from high rates into lower Fed Funds, this asset class is an ideal place to allocate capital with an attractive starting valuation.
Discount to NAV
Outside of the Covid period, the CEF has had a fairly stable discount to NAV:
We can see the CEF’s discount to nav moving in a tight -10% to -13% range. Significant deviations from its historic range can be bought or sold, but the fund is currently within its average.
RMT is an equities CEF. The fund represents an actively managed portfolio of micro-caps, mainly from the U.S. The CEF has done an outstanding job in outperforming the Russell 2000 historically, and has a fairly stable discount to NAV. RMT offers investors a 9% supported yield, and should benefit from a soft landing via capital rotation. With overstretched multiples in tech mega-caps, we see funds being allocated to mid- and small-caps into the new year, flows which should benefit a long term performer like RMT. At only 15x P/E, this CEF offers a compelling entry point for today’s environment.