Commentary

Jenifer Taylor, Whitney George and David Nadel

How has the year 2007 been for micro-cap investing so far?

JT: It's been a very interesting year for the micro-cap asset class, with a noteworthy demarcation between the first and second halves. Clearly, the credit crisis has had a growing impact over the course of the year.

In the first half, micro-cap valuations seemed fairly rich to us. They were being propped up by the continuation of the takeover and private equity euphoria that took hold last year. The minute a company would announce any sort of disappointment, rumors – whether substantiated or not – would circulate about its potential takeover. The actual M&A activity that has occurred included both strategic buyouts and private equity takeovers. In our minds, this activity was a bit overplayed and artificially supported frothy valuations.

In Royce Micro-Cap Fund alone, several holdings have been acquired in 2007, which has helped to fuel performance.

Can you discuss how the market changed in the second half?

JT: In early June, the landscape started to shift as the market corrected. The subprime credit crisis began to unravel, and investors' preferences within the micro-cap market moved toward more established, larger companies. By larger, we mean those in the $300 to $500 million market-cap range, as opposed to those with market-caps less than $300 million.

The performance disparity within the micro-cap sector also reflected a preference for companies with stronger balance sheets, and those more likely not to have potential credit issues. This dynamic worked to our benefit, since the Fund had a weighted average market capitalization of $312 million at the end of June – comfortably in the higher range of the micro-cap world – and because the Fund invests in companies with strong fundamentals.

We also finally began to see valuations decline from the frothy levels as the takeover bubble began to lose some of its hotter air. This shakeout was a good thing for us at Royce, because we have tended to perform relatively well as the market cools down. You could see this resilience in Royce Micro-Cap Fund's third-quarter results.

We have also been seeing the commodity markets strengthen in the fourth quarter, with crude oil at $100 a barrel and with gold climbing above $800 an ounce. Of course, this has helped the Fund, given its exposure to the Natural Resources sector.

How has Royce Micro-Cap Fund performed this year?

JT: The Fund gained 10.1% in the first half, besting both its small-cap benchmark, the Russell 2000 Index (+6.5%), and the Russell Microcap Index (+4.4%).

This outperformance provided us with a nice advantage going into the bearish third quarter. However, we held on relatively well during the summer rout, losing just 0.9%, compared to declines of 3.1% for the Russell 2000 Index and -4.6% for the Russell Microcap Index. Through the end of October, we're up 14.24% , versus 6.12% for the Russell 2000 Index and 0.97% for the Russell Microcap Index. We think that our long-term results are even more noteworthy, as shown in the table below.

Throughout this year, as the negative impact of the credit crisis has increased, we've managed to hold our ground. The Fund's strong relative performance can certainly be attributed to our emphasis on investing in what we deem to be quality micro-cap companies with strong, healthy balance sheets. We also have benefited from having little to no exposure to the financial services and real estate sectors, which have been among the hardest hit sectors in both the stock market and the economy.

Which sectors have helped the Fund the most this year?

JT: Natural Resources, Industrial Products, Health and Industrial Services have been the Fund's best-performing sectors this year.

Some of the Fund's notable holdings in the Natural Resources sector include three Canadian businesses: Tesco Corporation [NASDAQ: TESO], which designs and manufactures oilfield products such as drilling and hydraulic systems. Northern Orion Resources [TSE: NTOWF], a precious metals company was taken over, as was steel processor and distributor Novamerican Steel [NASDAQ: TONS]. African Platinum [TSE: AFRPF] was also acquired. Within the Health sector, bioanalytical device maker and top performer BioVeris [formerly BIOV] was acquired by the Swiss company, Roche Diagnostics.

(As of 10/31/07, TESO represented 0.81% of the Fund's net assets; NTOWF, 0%; AFRPF 0%; TONS, 0.43%; and BIOV, 0.0%. For a complete listing of portfolio holdings as of 9/30/07, click here.)

How has the credit crisis affected the micro-cap asset class?

JT: The micro-cap market seems to have bifurcated into two segments: one comprised of companies that have longer histories of solid performance, greater stability, and healthier balance sheets – the types of micro-cap companies that Royce favors. The other segment is comprised of micro-cap companies that are in the earlier stages of development and, therefore, might require capital or credit to execute their business plans, which may be more difficult to ascertain.

In terms of industry sectors, the market has thus far been pretty narrow in its response to the credit crisis, with banks, financial services and real estate companies having suffered the most. As the crisis continues to unfold, it seems  highly likely that we will see a negative impact in other areas of the economy. For example, some areas of the consumer sector are starting to pull back, due to consumer credit concerns and higher oil prices.

Has the landscape improved in the third quarter?

JT: The overall stock market, including micro-cap stocks, rebounded across the board in the month of October. On the other hand, November has been volatile, and so I would not call it an "improved" landscape.

In May, shareholders of Royce Micro-Cap Fund voted to allow the Fund to invest up to 25% of its net assets in foreign securities. Formerly, the Fund's foreign investments were capped at 10%. What is the significance of this change? (See the May 2, 2007 prospectus supplement.)

JT: This change marks a natural evolution for us. We've been slowly increasing the Fund's non-U.S. exposure since 2000, especially as we focused on the Natural Resources sector. We first invested overseas in mining and precious metals companies, and Canadian energy companies. With Natural Resources opportunities alone, it makes sense to continue to look offshore, given what we believe is a long-term global bull market for hard assets – a super cycle that Whitney George identified early on.

With the increasing significance of various global economies, we believe it's prudent for us to apply our disciplined value approach to opportunities outside the U.S., if only as a hedge against weakness here in the U.S. And we are not making any fundamental exceptions to the types of companies we will invest in overseas; we are using the same valuation metrics and adhering to the same basic investment disciplines.

Is David Nadel helping to expand our international reach?

JT: David is definitely focusing a lot of his attention internationally, but not exclusively. He is a seasoned small-cap value analyst and portfolio manager, with global experience. We also get a helping hand from our London-based Research Analyst Mark Rayner, who has considerable experience with European companies.

Thank you, Jenifer

Royce Micro-Cap Fund: Performance Comparison