Commentary

Jack Fockler with Whitney George

"Adapt or perish, now as ever, is nature's inexorable imperative."

-H.G. Wells

The injunction above has been adapted to serve in any number of arguably ‘unnatural’ contexts since 1939 when Wells penned it, probably because of its obvious applicability to nearly any walk of life. We have certainly heeded it through the years, fine-tuning our disciplined value approach in response to the changes that have come to smaller-company investing since 1972. Probably the most significant change began to occur in the 1990s, when many companies in the upper tier of the small capitalization range began to behave more like their mid- and large-cap peers: Institutional coverage increased, trading spreads narrowed and liquidity grew. Small-cap, we observed, was growing up.

This maturation led us to incorporate a more concentrated portfolio approach, i.e., limiting the number of holdings from the upper tier of small-cap, an area we currently define as those with market capitalizations between $500 million and $2.5 billion. What ensued in 1991 was Royce Premier Fund, our first portfolio with a limited number of companies drawn from the upper reaches of the small-cap marketplace that also met our highest standards for company quality.

To the idea of a changing small-cap universe and the creation of limited portfolios that reflected these shifts, we added another adaptation when we introduced Royce Value Fund (RVV) in June 2001. Through most of our history, we have kept at least a casual eye on the mid-cap sector, if only because certain successful small-cap companies would outgrow their original asset class and move up to the mid-cap neighborhood. Our attention became more focused during the ‘90s as more sizeable small-caps began to share more common ground with mid- and large-cap companies. When that decade closed, we thought that it made sense to add mid-caps to the mix of certain portfolios.

The impetus, then, behind the creation of Royce Value Fund was to adapt the limited portfolio approach that we believed worked so well with Royce Premier Fund. However, instead of holding just 50-60 positions, we broadened the scope to include up to 100 names—the portfolio held 73 positions as of June 30—and to invest in both small- and mid-cap stocks, those with market caps from $500 million to $5 billion. RVV’s selection criteria is familiar Royce territory—we seek companies with strong balance sheets, high internal rates of return and the ability to generate free cash flow, that are also trading well below our estimate of their worth as a business.

Co-managers Whitney George and Jay Kaplan work hard to keep risk at bay while seeking to provide strong returns over full market cycles and other long-term periods. Now with more than seven years of history behind it, we think that the Fund has adapted quite well (see the table below for the performance comparison). We have been particularly pleased with its performance thus far in 2008.

Although we always caution against reading too much into any short-term performance period, we have been happy to see that the Fund has not only resisted capitulation to the recent turmoil that has rocked stocks of every size and shape, it has flourished.

We think that the Fund’s performance history shows that a limited portfolio of generally less than 100 small- and mid-cap positions offers an effective approach in today’s smaller-company universe.

Performance: Royce Value Fund versus Russell 2000*