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Trends: Value Trends: Volatility Market Perspective Investment Approach

Volatility in Micro-Caps Can Open the Door to Investment Opportunity

By Jenifer Taylor Last updated May 01, 2012

As of May 1, 2012, a micro-cap company, as defined by Royce & Associates, is one with a market capitalization of less than $750 million. A dynamic and vast realm of the financial marketplace, nearly 19% of Royce's net assets under management are linked to micro-cap companies. As you will see, this underfollowed, oftentimes misunderstood asset class offers unique opportunities not found elsewhere in equities.

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

These are just a few of things that have been said about micro-cap stocks over the years. Of course, we have been investors in the smallest of small-cap stocks for more than 35 years, so our take is a bit different.

While many see an asset class to be avoided at all costs, we see a world full of potential opportunity. In fact, the same attributes that draw us to small-cap stocks are what keep us active and enthusiastic micro-cap investors.

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.

Of course, short-term volatility is hard to watch and even harder to stomach. And volatility, especially in the short run, is definitely an issue with micro-cap stocks. For example, the Russell Microcap Index enjoyed a terrific first quarter of 2012, gaining 15.3%, outpacing both the small-cap Russell 2000 Index, which was up 12.4%, and the large-cap Russell 1000 Index, which rose 12.9%. However, this came on the heels of several quarters of underperformance, which included the very bearish third quarter of 2011 and the more bullish fourth quarter of 2011.

These recent short-term results are one reason why we believe that a long-term investment perspective is crucial to the success of any investment approach that involves micro-caps. Our view is that holding micro-cap stocks over full market cycles (and other long-term periods) has the potential to diversify and enhance returns.

In December 1991, we launched our first fund dedicated to the space, Royce Micro-Cap Fund. Today, we hold micro-cap companies in more than 17 of our open-ended portfolios, with allocations ranging from 1% to 89% of net assets. See funds with more than 10% exposure to micro-cap in the chart below.

As companies have grown and market capitalizations have risen over the years, so too have our definitions of small- and micro-cap companies. In 1995, the highest market capitalization found within the Russell 2000 was $750 million. At that time, Royce defined micro-caps as companies with market caps up to $300 million.

By the end of 2010, the upper range of the Russell 2000 had grown to more than $2.2 billion. This evolution of smaller companies growing up in market cap has led us to raise the market cap ceiling of micro-caps from $500 million to $750 million as of May 1, 2012.

While micro-caps have matured into a recognized asset class as opposed to a risky (and often avoided) subset of the small-cap market, they remain under-followed and under-researched. Many institutional investors shy away from micro-caps because the stocks tend to be less liquid, making it difficult to buy and sell large numbers of shares.

The relative absence of a significant institutional presence in the space, combined with less research coverage, can make micro-caps a challenging asset class. At the same time, careful and disciplined active managers such as ourselves can seek to use volatility to our advantage, especially in the short run, for example, by putting risk into the market when others are removing it.

When it comes to micro-cap businesses, we use a disciplined approach that emphasizes financial strength in the form of low-debt balance sheets, high returns on invested capital, and the ability to generate free cash flow.

It's also important for us to compensate for the frequent additional risk of owning micro-caps by broadly diversifying our micro-cap holdings. Whereas small operational problems at a larger company can be fixed without necessarily affecting share price, similar problems at a micro-cap company can create a significant strain on the balance sheet, dramatically affecting its share price.

A strong balance sheet can help to reduce these kinds of financial and operational risks, which is why low (or no) debt continues to be our first filter and most important metric.

As Jen Taylor, portfolio manager for Royce Micro-Cap Fund and Royce Capital Fund–Micro-Cap Portfolio, notes, "In the case of micro-caps, we like to see a little more cash on the balance sheet vis-à-vis assets as a backstop against the stock price slipping. Usually if a company has cash, and very little debt, you don't see stock prices that drop too far below the cash value."

"The micro-cap category includes some of the least-known companies, those with valuations that more often than not reflect that lack of understanding or underdog status."

Generally, requiring an asset to equity ratio of less than two-to-one (for non-financials) helps us to whittle down this enormous universe of companies—more than 3,000 in the U.S and more than 13,000 domiciled internationally. While the number of investment choices seems daunting, the total market capitalization makes up only about $1.96 trillion or approximately 10% of the world's market cap. With so much opportunity, we began to research international micro-caps several years ago, which led us to launch Royce International Micro-Cap Fund on December 31, 2010.

When asked why investors might want to devote a portion of their portfolio to micro-cap stocks, Jen Taylor responded, "The micro-cap category includes some of the least-known companies, those with valuations that more often than not reflect that lack of understanding or underdog status."

Indeed, the micro-cap space keeps growing in number. Although one quarter is not trend setting, first quarter 2012 IPO activity in the U.S. jumped 31% compared to the first quarter of last year, hitting a five-year high. Interestingly, of the 42 deals, only two raised more than $500 million and not one raised $1 billion. With an average deal size of just $141 million and activity heavily skewed toward smaller, growth-oriented issuers, we at Royce are happy to see the pipeline of ideas expand.

Performance and Expenses Through 3/31/12


AVERAGE ANNUAL TOTAL RETURNSAnnual Expenses
TickerMicro-Cap(%)1yr3yr5yr10yrSince
Inception		Gross
Operating
Expenses		Net
Operating
Expenses
Royce International Micro-Cap Fund
ROIMX 89.28% -12.28% n.a.    n.a.    n.a.    -7.45% 2.12% 1.88%
Royce Micro-Cap Discovery Fund
RYDFX 82.98 % 2.03% 23.60% -0.08% n.a.    5.65% 3.04% 1.49%
Royce Micro-Cap Fund
RYOTX 81.50 % -8.24% 29.00% 3.85% 9.05% 12.98% 1.54% 1.54%
Royce Opportunity Fund
RYPNX 49.96 % -4.19% 36.56% 2.45% 8.43% 12.54% 1.18% 1.18%
Royce International Smaller-Companies Fund
RYGSX 28.15 % -11.22% 25.12% n.a.    n.a.    5.63% 2.40% 1.74%
Royce Global Dividend Value Fund
RGVDX 26.35 % -4.88% n.a.    n.a.    n.a.    -1.94% 2.07% 1.88%
Royce Special Equity Fund
RYSEX 22.88 % 5.06% 23.03% 6.83% 8.96% 9.37% 1.16% 1.16%
Royce European Smaller-Companies Fund
RISCX 20.00 % -12.52% 29.13% 0.38% n.a.    1.33% 2.67% 1.79%
Royce Low-Priced Stock Fund
RYLPX 18.23 % -10.93% 27.76% 3.77% 7.60% 12.49% 1.64% 1.53%
Royce International Premier Fund
RYIPX 18.11 % -6.97% n.a.    n.a.    n.a.    -3.59% 2.07% 1.88%
Royce Value Plus Fund
RYVPX 17.88 % -3.05% 23.28% 0.24% 10.09% 12.13% 1.44% 1.44%
Royce Pennsylvania Mutual Fund
PENNX 16.24 % -1.55% 27.23% 3.27% 8.24% n.a.% 0.90% 0.90%
Royce Global Value Fund
RIVFX 15.00 % -12.04% 28.89% 5.09% n.a.    6.43% 1.93% 1.78%
Royce Dividend Value Fund
RYDVX 14.75 % 0.63% 28.13% 5.03% n.a.    8.50% 1.58% 1.51%
Royce Total Return Fund
RYTRX 13.38 % 0.66% 23.77% 2.64% 7.21% 10.88% 1.17% 1.17%

Important Performance and Expense Information

All performance information in this Review reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee payable to the Fund (2% for Royce Global Value, International Smaller-Companies and European Smaller-Companies Funds). Redemption fees are not reflected in the performance shown above; if they were, performance would be lower. Current performance may be higher or lower than performance quoted. Current month-end performance information may be obtained at www.roycefunds.com. All performance and expense information reflects results of the Fund’s oldest share Class (Investment Class or Service Class, as the case may be). Gross operating expenses reflect each Fund’s gross total annual operating expenses, including management fees, any 12b-1 distribution and service fees, other expenses, and any applicable acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s prospectus dated 5/1/11. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses through April 30, 2012 to the extent necessary to maintain net annual operating expenses, other than acquired fund fees and expenses, to no more than 1.49% for the Service Class of Royce Dividend Value, Low-Priced Stock, and Discovery, and to no more than 1.69% for the Service Class of Royce Global Value, International Smaller-Companies and European Smaller-Companies Funds. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses through April 30, 2021 to the extent necessary to maintain net annual operating expenses, other than acquired fund fees and expenses, to no more than 1.99% for the Service Class of Royce Discovery, International Smaller-Companies, and European Smaller-Companies Fund. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by any applicable Fund through its investments in mutual funds, hedge funds, private equity funds and other investment companies.

Shares of a Fund’s Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Fund’s Investment Class. The Royce Funds invest primarily in securities of micro-cap, small-cap and/or mid-cap companies, which may involve considerably more risk than investments in securities of larger-cap companies (see “Primary Risks for Fund Investors” in the respective prospectus).

Important Disclosure Information

Jenifer Taylor serves as portfolio manager of Royce Micro-Cap Fund and Royce Capital Fund – Micro-Cap Portfolio and serves as an assistant portfolio manager of the Royce International Micro-Cap Fund. She is a portfolio manager of Royce & Associates, LLC, investment adviser for The Royce Funds. The thoughts in this piece are solely those of the person speaking and, of course, there can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Securities of foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic or other developments that are unique to a particular country or region. Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index. The Russell 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. 


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