Royce Capital Fund–Small-Cap Portfolio was up 1.9% for the year-to-date period ended June 30, 2014 versus a 3.2% gain for its small-cap benchmark, the Russell 2000 Index, for the same period.

The first quarter saw a widespread slowdown in the speed of smallcap returns following the dynamic second half of 2013, which was not entirely unexpected considering last year’s blistering pace. Capital Small-Cap rose 0.7% for the first quarter of 2014, trailing its benchmark’s 1.1% advance. A slight downturn that lasted from early March through mid-May made for a rockier second quarter, though June was in general a positive month that did much to bring small-cap results back into the black. For the second quarter, the Fund rose 1.2% compared to 2.0% for the small-cap index. Capital Small-Cap did, however, beat the Russell 2000 from the index’s early March high through the end of June. Although we always like to see the Fund hold a down-market advantage, in light of the last few years of relative underperformance, this edge during a brief bearish phase offered mostly cold comfort. The Fund did outpace the benchmark for much longer-term periods. Capital Small-Cap beat the Russell 2000 for the 10-, 15-year, and since inception (12/27/96) periods ended June 30, 2014. The Fund’s average annual total return since inception was 12.1%. We are very proud of the Fund’s long-term performance record.

When selecting stocks for the Fund's portfolio, we focus first on balance sheets, looking for businesses with low debt, which is frequently a sign of financial strength. We next look for high returns on invested capital (ROIC). Like a strong balance sheet, high ROICs are in our view a proxy for quality. We also want the company to be trading for what we believe is an attractively low share price vis-à-vis its worth as a business. In order to evaluate this, we typically use capitalization rates, which we define as operating income divided by enterprise value. We want to understand the return on our investment as if we were buying the whole company.

Our challenge through the most recent cycle has been the unfashionable status of this disciplined, value-oriented approach. With a still highly accommodative Federal Reserve pouring money into the economy while keeping interest rates essentially at zero, the cost of debt is historically low and access to cash is extremely easy. This has the effect of reducing the appeal of conservatively capitalized, steadily growing businesses while increasing the demand for both fast growth (often regardless of profitability) and high yield (often regardless of underlying quality). While there have been some signs that this is changing, a large-scale flight to quality has not yet occurred, certainly not in the small-cap space. We remain, however, squarely focused on both long-term and absolute results and are hopeful for a shift in sentiment in which fundamentals will matter more than momentum and yield.

Five of the Fund's eight equity sectors contributed to first-half returns, with Energy holding a considerable edge, followed by notable net gains for Information Technology. The Fund’s two top performers both came from the energy equipment & services industry. Unit Corporation is a long-time position—and the Fund’s third largest at the end of June— that we have owned continuously since 2002. It operates primarily as a contract drilling company, though it also explores for and produces oil and natural gas, and engages in midstream activities. These related businesses make it an outlier in an otherwise rigidly specialized industry. Unit reported double-digit production growth, introduced a new advanced drilling rig, and enjoyed continued strength from its midstream operations. Matrix Service builds natural gas storage tanks and provides construction and maintenance services to the oil, gas, power, petrochemical, industrial, and metals industries. Increased demand for its services, a complementary acquisition, and ongoing strength for natural gas helped both operating results and its stock price. We reduced our position as its price soared.

Shoe Carnival is a family footwear retailer that endured the same dismal results that most other retailers did in the first half, including The Buckle and Ascena Retail Group. We held our position in Shoe Carnival and added shares of The Buckle as its stock price declined. In the case of the former, we like its plan to expand the number of stores and raise the quality of the women’s shoes it sells. After a turn as the portfolio’s top contributor in 2013, Nu Skin Enterprises earned a less esteemed status for the semiannual period. The company develops and distributes personal skin care products worldwide. Its share price suffered mightily after an article in a Chinese newspaper accused the firm in January of running a pyramid scheme, and an investigation by the Chinese government followed. The firm paid modest fines in March and began to tighten up its training procedures. We were hopeful that Nu Skin could right itself at the end of June.

Average Annual Total Returns as of Quarter-End 6/30/14 (%)

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

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