Commentary

Jack Fockler with Chuck Royce

The Middle Way

We have talked a great deal over the last several years about the way in which we saw the small-cap market bifurcating in the early '90s, changes which led us to generally diversify more among micro-cap stocks (those with market caps up to $500 million) and to take larger positions in a more limited number of holdings in the upper tier of small-cap (where market caps range from $500 million to $2.5 billion).

In the current decade, we observed another change. While it was a less dramatic event, it was still significant to the way that we invest.

It took place in the upper reaches of the smaller company universe, or rather near the line that separates small-cap stocks from their mid-cap peers. As small-cap stocks matured—that is, as trading volumes grew and spreads between bid and ask shrank—these companies began to look increasingly similar to those mid-cap stocks with market caps between $2.5 billion and $5 billion. This led us to investigate this mid-cap area more thoroughly.

As Small Migrates to Mid

We had made previous forays into mid-cap companies, mostly, as it were, by default. While our practice is to set trigger prices on the up and down side whenever we purchase a stock, we also regularly re-evaluate our portfolio holdings. Over the years, there have been instances in which a small-cap company has migrated into mid-cap territory. When the business fundamentals remain strong and the company's prospects continue to look promising, we typically choose to hold (or occasionally build, if permitted by prospectus) the position.

Thus, our move into mid-caps comes from a confluence of two factors—our experiences with maturing small-caps and our observation that small- and mid-cap companies were behaving more and more alike.

Royce Value Fund Launched in 2001

When we introduced Royce Value Fund in June 2001, we saw it as a variation on the theme that we first struck with Royce Premier Fund in the early '90s. In the latter portfolio, we typically hold 50-60 small-cap stocks. While Royce Value Fund also holds a limited number of companies (by which we mean 100 or fewer), it will usually hold more positions than Premier. Also in contrast to Premier, its holdings are drawn from both the small- and mid-cap segments of the stock market.

The selection criteria for the Fund is vintage Royce. We seek companies with strong balance sheets, high internal rates of return, a history of earnings and the ability to generate free cash flow. The key distinction, then, is the Fund's embrace of the mid-cap asset class.

Fertile Small- and Mid-Cap Ground

In the years just prior to and since the Fund's inception, we have seen what we thought were great opportunities in mid-cap companies. These years have also seen the common ground between small- and mid-cap companies expand to the degree that we tend to think of those stocks with market caps between $500 million and $5 billion as a single group. The businesses in both sectors tend to be established, the stocks more liquid and institutional interest robust. Royce Value Fund gives us the necessary exposure for investment in this fertile small- and mid-cap ground.

We think that the Fund's performance and volatility scores bear this out as shown below. For the periods ended 9/30/07, the Fund consistently outperformed the Russell 2000 Index, along with what we believe are respectable volatility scores for the five-year period ended 9/30/07.

We think that Royce Value Fund is an appropriate choice for a risk-conscious investor seeking exposure to small- and mid-cap companies.

Royce Value Fund vs Russell 2000: Performance* and Volatility** Comparison