Royce Micro-Cap Fund Performance Discussion

This discussion comes from our June 30, 2011 Semiannual Review and Report to Shareholders.

Micro-cap stocks struggled through the first six months of 2011, and the diversified portfolio of Royce Micro-Cap Fund (RMC) was unfortunately no exception to this rule. The Fund was up 2.9% for the year-to-date period ended June 30, 2011 versus a gain of 6.2% for the small-cap Russell 2000 Index and a 3.1% result for the Russell Microcap Index, the Fund's new benchmark. (We chose the Fund's new benchmark because it better reflects the Fund's security selection universe.)

During the mostly bullish first quarter, RMC gained 7.5%, behind the Russell 2000, which was up 7.9%, but ahead of the Russell Microcap Index, which climbed 6.8%. This pattern held through April, but when share prices began to plummet following the interim small-cap high on April 29, the Fund lost ground against both indexes. (The Fund was down 6.3% from smallcap high on April 29 through June 30, 2011, versus respective losses of 4.1% and 4.9% for the Russell 2000 and Russell Microcap Indexes.)

For the second quarter as a whole, RMC fell 4.3% versus a decline of 1.6% for the small-cap index and a loss of 3.5% for its micro-cap benchmark. Following stellar years in 2009 and 2010, some give-back was not surprising, particularly for this more volatile segment of the small-cap asset class during a period in which volatility made a highly visible comeback. We were therefore only mildly disappointed by the Fund's results through the first six months of 2011.

Longer-term market cycle results were far more encouraging. RMC rose 166.9% from the market low on March 9, 2009 through June 30, 2011 compared to a gain of 148.6% for the Russell 2000 Index and 147.1% for the Russell Microcap Index. From the interim small-cap peak on July 6, 2010 through the end of June 2011, the Fund gained 39.2% versus gains of 41.9% and 37.4%, for the small-cap and microcap indexes, respectively.

Strong market cycle performances played a pivotal role in the Fund's average annual total returns through the end of June. RMC outpaced the Russell Microcap Index—for which returns date back only as far as 2000—for the one-, three-, five- and 10-year periods ended June 30, 2011, while also beating the small-cap index for the three-, five-, 10-, 15-year and since inception (12/31/91) periods. The Fund's average annual total return since inception was 13.8%.

Following the heady results of the previous two calendar years, many portfolio positions were sold or trimmed after reaching or, in some cases, exceeding our price targets as we actively sought to better position the portfolio for the years ahead. When this activity was accompanied by a volatile market, it made the necessity of re-stocking painful. However, it also opened up numerous opportunities, as valuations in the first half looked highly encouraging to us, whether in existing holdings or newer positions. We were very pleased with the state of the portfolio at the end of June, its recent performance notwithstanding.

Smith Micro Software provides software and services for laptops, tablets and other devices. We liked its balance sheet and have high regard for its core business, though it is highly cyclical. Its stock performance has often been tied to the success of new product launches that utilize its technology, which has made for considerable volatility. The stock began to underperform Wall Street's expectations early in 2011 and failed to recover any value during the June rally as it continued to move more of its business to tablet software at a pace most investors deemed too slow. We held a modest position at the end of June, though we built our stake in the first half.

We also had confidence in the prospects for Sigma Designs, which makes integrated system-onchip solutions for IPTV (Internet protocol television). It has suffered the typical fits and starts of many new, highly niche-based tech businesses, which kept investors away during the first half. It too failed to participate in the late rally, which kept its stock attractively cheap through the first half. We increased our position in March, May and June.

Xyratex's stock price revived a bit in June, though not nearly enough to keep it from being a detractor to first-half performance. The company makes hard disks for large-scale data storage needs. High expectations for its business led its share price to rise in the second half of last year, and helped lead to a vicious sell-off when middling results were announced earlier this year. Its disappointing stock performance led us to add a bit to our position in January.

A steadily rising stock price led us to take gains in Heritage-Crystal Clean, which performs industrial and hazardous waste services for small and mid-sized businesses. Our initial attraction was to its interesting business, pristine balance sheet and very attractive valuation.

We sold our shares of SMART Modular Technologies in June following the announcement of its acquisition in May, which helped to boost its share price. Although we made modest trims late in the first half, we otherwise substantially increased our position in top-ten holding and strong performer Universal Stainless & Alloy Products during the first half. The company, which manufactures specialty steel products, saw its stock get very cheap in the downturn. New management helped to make the company more efficient and its subsequent improved results attracted other investors.

The sum of all contributions to and detractions from performance for all securities would approximate the Fund's year-to-date performance for the period ended June 30, 2011.

See our June 30, 2011 Semiannual Review and Report to Shareholders for a complete list of holdings for Royce Micro-Cap Fund as of June 30, 2011.

View the complete list of holdings for Royce Micro-Cap Fund as of the current quarter end.

Current month-end performance may be obtained from our Prices and Performance page.