Fund Performance

Royce Capital Fund – Small-Cap Portfolio did all right on an absolute basis in 2014 but came up short versus its benchmark. The Fund gained 3.2% for the calendar year compared to a 4.9% increase for the small-cap Russell 2000 Index for the same period. The Fund narrowly underperformed the small-cap index in four of the last five calendar years, periods that include three years with strong absolute returns. While satisfied with these absolute results, we would prefer not to play catch-up with the benchmark over an extended period.

The first half of the year was quietly bullish. Capital Small-Cap gained 1.9% in the year's first six months before small-cap prices quickly headed south after the third quarter began. For the quarter as a whole, the Fund held its value comparatively well, falling 6.4% versus a decline of 7.4% for the Russell 2000. Capital Small-Cap was unable to maintain this advantage, however, when small-cap stock prices began to recover in October. Although a volatile period like the preceding one, the fourth quarter was also markedly bullish. The Fund climbed 8.2% during the year's final three months versus a 9.7% gain for the benchmark. Over longer-term spans, Capital Small-Cap's relative results were better. The Fund outpaced the Russell 2000 for the 10-, 15-year, and since inception (12/27/96) periods ended December 31, 2014. Capital Small-Cap's average annual total return since inception was 11.9%. We are very proud of the Fund's long-term performance record.

What Worked... And What Didn't

Information Technology led all of the Fund's sectors, followed by solid net gains for Financials, Consumer Discretionary, Health Care, and, to a lesser degree, Industrials. Chemed Corporation operates two very different businesses—hospice care provider Vitas and plumbing and drain cleaning service company Roto-Rooter—and is slotted in Health Care. Each is a solid cash flow business, but its shares appeared to benefit most from a "no news is good news" scenario regarding Vitas. In 2013 this business became the target of a Justice Department investigation concerning Medicare enrollments and billing rates. Vitas offers more critical care than is typical in the hospice industry, which might have helped to trigger the inquiry. However, margins for critical care are not much higher than for other elements of hospice care, and the firm is one of the few able to deliver it on a nationwide basis. The lack of any additional news seemed to quell concerns about the investigation, and reassured investors flocked to the stock. We like the consistency and brand value of Roto-Rooter and Vitas's status as one of the few hospice providers with coast-to-coast reach.

Two retailers rebounded in 2014. The Cato Corporation is a discount fashion retailer. Its improved sales may have been partly the result of the better employment picture and lower energy prices. It was a top-10 position at the end of the year. DSW sells footwear and accessories. The company's important women's shoe lines were doing poorly until DSW began to manage its inventories more effectively and some new trends helped spark sales. It was a top 20 position at the end of 2014. We had less luck with two other consumer-related holdings. Tween girl retailer Justice and plussize women's retailer Lane Bryant continued to struggle in 2014, which drove down the stock price of multiline fashion business Ascena Retail Group. Nu Skin Enterprises settled some issues with the Chinese government by paying fines and improving training, restructuring its debt covenants, and reversing a cash flow problem. This was all good news, but we think the firm also needs improved sales in China to engineer a comeback.

Energy was the leading detractor by a wide margin while net losses in Consumer Staples and Materials were more modest. Unit Corporation is a long-held position and was Capital Small-Cap's twenty-fifth largest at year end. Operating primarily as a contract drilling company, 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. The Fund's top performer in the first half, Unit was experiencing double-digit production growth, introducing a new advanced drilling rig, and showing strength in its midstream operations. Then oil prices collapsed by almost 50% in the second half of the year. While there is still much to like about this distinctive business, its short- and intermediate-term prospects are very tough to read in what is almost guaranteed to be a highly challenging environment for the energy industry in 2015.

Current Positioning and Outlook

The portfolio remained heavily overweight in the Consumer Discretionary and Information Technology sectors, which together comprised more than half of net assets at year end and reflected our confidence for strong growth potential in these areas. Nine of the Fund's top-10 positions at the end of 2014 came from one of these two sectors. We expect interest rates to remain low and for the economy to keep growing. In our view stocks should benefit from earnings growth, and we have positioned the portfolio for this kind of environment.

Average Annual Total Returns as of Quarter-End 12/31/14 (%)

* Not Annualized

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

Important Performance, Expense, and Disclosure Information