Learn more about Royce Micro-Cap Fund in our Third Quarter "In the Spotlight"

Volatile. Vulnerable. Too illiquid. Highly speculative. Under-followed. Immature businesses or fallen companies. Not a genuine asset category.

Back in the 1970s, we grew accustomed to hearing small-cap stocks described, at times even dismissed, in these terms. The conventional wisdom at the time held that small-cap was best suited to a high-risk, high-reward, typically short-term, strategy, and suited for little else.

We were part of an adventurous and dedicated minority that insisted small-cap held plenty of stable, well-managed names with sterling financial characteristics and terrific prospects for long-term growth. Yet small-cap still had at least a couple of decades to go before gaining an appreciable level of institutional recognition as a professional asset class.

Interestingly, this growing acceptance occurred around the same time that significant changes began to take place within small cap in the early '90s. The more sizable small-cap companies—an area that we now define as those companies with market capitalizations from $500 million to $2.5 billion—began to act more along the lines of their larger siblings in mid-cap and large-cap, with more mature businesses, greater trading volumes and fewer liquidity issues.

However, most of what constitutes the world of small-cap—then and now—still lurks beneath, as it were, this market cap range. The area that we have been calling micro-cap since the early '90s, the one that we currently define as those companies with market capitalizations up to $500 million, still behaves as small-cap once did. Trading volumes are often thin, liquidity issues exist, and the businesses generally offer a mix of newer, entrepreneurial companies and those whose shareholders have fled in the wake of serious operational or managerial trouble.

So while many see an asset class to be avoided at all costs, we see a world teeming with potential opportunity. What keep us active and enthusiastic micro-cap investors are the very attributes that helped to first draw us to small-cap investing more than 35 years ago.

Arguably the most dynamic locale in the equity marketplace, micro-cap contains the lion's share of companies offering new products and services and also often serves as the launching pad for significant reclamation projects initiated by talented and ambitious new management teams as they seek to make tattered companies whole again.

In Royce Micro-Cap Fund (RMC), we look for what we believe are the best values in this large (more than 4,100 companies as of March 31, 2009), diverse and vibrant sector. Portfolio Manager Jenifer Taylor focuses on companies with strong balance sheets, high returns on invested capital and the ability to generate free cash flow (the same basic approach that we use in most other Royce-managed portfolios).

Jenifer joined Royce in 2000 as an Analyst with an extensive background in small-cap and micro-cap stocks. She began to work with Whitney George on the Fund shortly after her arrival and became RMC's assistant portfolio manager in 2004. She began to co-manage the Fund with Whitney in 2006 before becoming primary portfolio manager in 2009.

In an effort to manage risk and reduce the inherent volatility of the asset class, Jenifer keeps the Fund diversified—it held 204 positions as of May 31, 2009. These efforts are critical. In spite of the asset class's creeping professionalization—Russell now sponsors not just a micro-cap index, but micro-cap value and growth indices as well—Jenifer and our other portfolio managers agree that micro-cap is likely to remain a domain of limited appeal and does not appear to be destined for the higher level of efficiency achieved by its larger small-cap siblings any time soon. Owing to our long-term success with micro-cap stocks, we wouldn't want it any other way.