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This 7.2% Yield Equity Style CEF Is Attractive in Many Ways

If you like to generate high income from your investments, this disciplined small cap CEF yields 7.2% and it is currently attractive in multiple ways. For example, its discount to NAV, its well-seasoned management team, its attractive style tilt, its US economy-focus, its impressive long-term track record, its long-term total return potential, and its ability to help you diversify away from the traditional high income sectors (where so many income investors have over concentrated their risks), all while using great discipline to pay you the steady high income payments you need. If you’re managing your own investments, this CEF can be an attractive addition to your diversified, long-term, high-income-focused, investment portfolio. We own it.

Overview: Royce Value Trust (RVT)

Royce Value Trust (RVT) is the first small-cap closed-end fund (it was launched in 1986), and it currently yields an attractive 7.2%, paid quarterly. The fund’s primary investment objective is long-term capital appreciation, which it seeks to achieve by investing more than 65% of its assets in common stocks, convertible preferred stock and convertible debentures with current income being a secondary objective. RVT primarily invests in the US, with ~85% of net assets being US-based, through a diversified portfolio of industries as seen in the chart below[1].

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The fund has an impressive average annual total return of 10.3% since inception through 3/31/19. It is also encouraging to note that the fund’s officers, employees, and their families currently own more than 475,441 shares (~0.6% of total outstanding shares) of the fund’s outstanding common stock.

RVT’s Investment Approach:

The fund’s core approach combines multiple investment themes and offers wide exposure to very attractive small-cap stocks (generally market caps up to $3 billion). Specifically, RVT invests in companies with high returns on invested capital or those with strong fundamentals, and prospects trading at what Royce believes are attractive valuations. RVT also evaluates investment prospects by looking at fundamentals such as positive cash flow, low leverage, effective management and an identifiable catalyst for earnings growth.

Within the small-cap segment, the fund’s investments are directed towards what management considers to be value stocks rather than growth stocks (although a style chart shows it’s a mix of both, by traditional index definitions). Also, cyclical businesses are given priority over defensive businesses because of the higher return potential within an active long-term strategy. Specifically, while cyclical business are generally more volatile, the fund’s investment criteria of targeting companies with low leverage and strong cash flows helps the strategy significantly reduce risk. The fund invests in a diversified portfolio of companies, with top 10 positions accounting for 15% of net assets, as highlighted in the table below[2].

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Also worth mentioning, small cap stocks tend to generate a significantly higher percentage of their revenues and business in the United States than do large cap stocks. Arguably, it can be very attractive to invest in the US right now, and this fund offers an attractive way to do that, particularly as compared to large cap funds. 

The Management Team:

Investing legend Chuck Royce has been managing this fund since its inception, and they’re going to have to carry him out in a pine box because he isn’t leaving. However, he has been building up an impressive management team over many years to help him manage the fund, and to carry on it’s impressive long-term track record when his time does come (hopefully many years away still).

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History of Outperforming the Russell 2000:

The Russell 2000 index is a stock market index comprised of 2000 small-capitalization companies which is used by investors to benchmark small-cap fund performance. And as seen in the chart below[3], in terms of average annual total returns, RVT has outperformed the Russel 2000 index over almost every time period.

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Even during periods of market decline, RVT has bettered the Russel 2000, outperforming the index in seven out of nine downturns of 15% or more from the index’s prior historical high since the fund’s inception.

Also interesting to note, 2018 saw the eleventh decline of 20% or more from a previous small-cap peak. In nine of the previous 10 periods, the subsequent average one-year return from the first day on which the index declined 20% from its peak was a positive 19.4%[4] (the exception came in 2008-09).

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Expenses and Leverage:

RVT’s annualized operating expenses (including advisory fees) relative to average net assets were 0.74% for the three months ended 3/31/19. This is comprised of 0.63% of fund management and administration expenses, and 0.11% of interest expense. As of 12/31/2018, the fund had total debt of $45.0 million, which equates to leverage of 3.33% to net asset value.

For color, this is a very competitive management fee/expense ratio for a small cap fund, especially considering the strong management team and impressive long-term track record. And the leverage ratio is very reasonable. Some equity funds use up to 30% leverage! Leverage is a risk because it can magnify returns in the good times, but also magnify losses in the bad times. The 3.33% leverage ratio in this fund is enough to help keep this fund exposed to the market in light of its operating expenses and frictional cash, but it’s not so much that investors should be concerned (they don’t need to be in our view—the leverage is reasonable).

Distribution Yield:

You might be wondering if this fund invests in small caps (which usually offer dividends of only around 1%) how on earth does it yield 7.2%. The answer: long-term capital gains. The largest portion of the distribution has always been in the form of long-term capital gains which is in line with the fund’s investment objectives. It can also be beneficial to investors in multiple ways.

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One benefit of taking capital gains to pay the distribution is discipline. If you are a do-it-yourself investor, you can get busy with life and forget to sell some of your investments to generate income. Also, as an individual you’ll probably pay higher trading costs than a big fund (eg RVT) due to economies of scale.

Another benefit of generating some of your income needs from capital gains is diversification of risks. Specifically, many income-focused investors over concentrate their risks in investments that pay high yields. By investing in this fund, you get the benefit of owning a segment of the market that is not known for paying big income—but you still get regular big income payments thanks to managements disciplined long-term capital gains activity. A great way to add some important diversification to your nest egg while still generating attractive high income—considering adding some RVT to your diversified long-term income-focused investment portfolio.

Discount to NAV:

The fund is currently trading at a discount of 11.6% to its NAV. As seen in the chart below[5], this is in line with the historical discount to NAV over the last 5 years, but it is still attractive.

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The main reason this is attractive is because it’s like you’re buying a basket of small cap stocks at an 11.6% discount to their market price. You still get all the long-term earning power and growth power of these holdings—you just get them on sale—at an attractively discounted price. Of course, as you can see in the earlier chart above, the discount can get bigger or smaller (this is typical for a closed-end fund), but we’d still much rather buy a quality fund at a discount instead of a premium.

Risks:

Perhaps the biggest risk associated with this fund is simply the volatility risk. Small cap stocks can be volatile at times. However, this fund reduces that risk by holding a diversified basket of small cap funds. Also, RVT management does a good job building up attractive long-term gains over time and then generating income for investors based on those gains. The fund’s long-term annual average total return of over 10% exceeds the amount that’s being paid out as income. Also, don’t underestimate the risk-reducing benefits of diversifying your income-focused investment portfolio with exposure to an attractive style (small caps) that has powerful long-term upside and is often unfortunately left out of many income-focused portfolios.

Conclusion:

RVT is an attractive small cap closed-end fund if you like disciplined high-income generated from a strategy that offers significant diversification benefits when combined with traditional high-income categories (such as REITs, bonds, and large cap dividend stocks, to name a few). Further, we believe small cap stocks are particularly attractive now given their exposure to the strong US economy. RVT is an excellent way to play this style opportunity given its strong management team, discount to NAV, prudent use of leverage, reasonable management fees, and long-term track record of success. If you are looking for an attractive non-traditional, high-income investment, RVT is worth considering. We currently own shares.


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