article 04-14-2015

What's Next for Active Small-Cap Investing?

Chuck Royce, Charlie Dreifus, Bill Hench, Lauren Romeo, Francis Gannon, and Steve Lipper discuss small-cap performance in the first quarter, the U.S. economy, current portfolio positioning, and their thoughts on why the next few years will not look like the last five for small-caps.


The following is a summary of The Royce Funds' semiannual Financial Professional only webcast held on April 1, 2015 featuring CEO Chuck Royce, Co-CIO Francis Gannon, and Portfolio Managers Charlie Dreifus, Bill Hench, Lauren Romeo, and Steve Lipper.

First Quarter Performance and the U.S. Economy

After a slow January, a bullish February, and a mixed March, equities enjoyed a solid first quarter of 2015. Small-caps, as measured by the Russell 2000 Index, led the broad-based indices (the Russell 1000 Index and S&P 500), though all three made new highs during the three-month period ended March 31, 2015.

Looking at the Russell 2000, Health Care was the best-performing sector by a wide margin, with biotech and pharmaceuticals driving results. Consequently, the Russell 2000 Growth Index was ahead of the value component of the Russell with a respective gain of 6.6% versus 2.0%.

First quarter performance represented an extension of what's been happening in the market over the past five to six years. Many investors continue to show a preference for higher interest-bearing stocks like Utilities and REITs, though both areas appear to have peaked.

Energy continued its significant decline in the first quarter. Relative to small-caps, there is twice the energy component in the large-cap asset class, which contributed to the former's renewed performance leadership. Additionally, U.S. small-cap stocks are generally more U.S.-centric whereas large-caps have more of a multinational orientation, and investors are currently favoring U.S. equities.

The U.S. economy continues to strengthen at a moderate pace, though it did pull back a bit in the first quarter. A rise in interest rates, which could happen as early as later this year, would suggest that the economy has healed. However, the real "litmus test" will be what the economic data reveals in the coming months.

As a firm, we have been hearing some encouraging words from company management teams, such as improving CAPEX due to higher capacity utilization and rising demand from non-residential construction.

From a relative performance standpoint, risk-conscious approaches such as our own continue to remain out of favor as a preference for high yield and fast growth continues to be a dominant investment trend. But we are convinced that our style of investing in companies with high returns on invested capital and low leverage has long-term advantages. The laws of economics can be suspended, but they can't be repealed. We are a firm that believes in discipline, and while we have seen our fair share of performance challenges over the past few years, we believe our portfolios are fully furnished to benefit from a more normalized environment. 

Current Opportunities and Portfolio Positioning

As bottom-up stock pickers, our sector weightings are often at odds with the market. Our portfolios, in general, have a cyclical bias, with higher weightings in Industrials, Information Technology, and Consumer Discretionary and lower weightings in Financials, Utilities, and Consumer Staples. Our stock selection criteria also tends to favor quality, as measured by returns on invested capital.

Industrial technology and non-residential construction are currently attractive areas to us, as well as energy services businesses and retail. Lower energy costs are benefiting consumers, and in a consumer-driven economy, we are finding many opportunities in more economically sensitive areas of the small-cap market.

The evaluation of management and their adaptability to the current environment is also an important decision in our portfolio building process. Temporary headwinds for a company with good management create compelling buying opportunities. As value investors, we are attempting to purchase superior businesses at average or below-average prices. We are finding that many of the kinds of companies that we favor are trading at low valuations, and when the trends of the past few years reverse, we believe investors will once again return to companies with sound fundamentals.

From the March 9, 2009 low there has been a huge advantage for the inferior company. Access to inexpensive capital as a result of the Fed's monetary stimulus programs provided more highly levered companies a lifeline that they would not typically receive following a recession. As a result, the quality company—the type of company we typically invest in—lagged. But it is our very strong conviction that quality will resume a stronger position in the next five years as the effects of QE begin to subside and interest rates rise.

"The Strange Case of the Current Small-Cap Cycle"

From the April 29, 2011 small-cap peak through the first quarter, there have been three factors that have substantially impacted relative performance—a declining cost of capital, lower-than-usual volatility, and above-average market returns on a trailing three- and five-year basis for small-caps.

Low volatility environments have historically been challenging for most active managers including ourselves. Differentiation lies at the core of active management, and opportunities to purchase what we deem to be attractively undervalued companies occur more frequently when stock prices are volatile. Furthermore, when the cost of capital declines and the yield spread drops, it creates a potential advantage for the kind of highly leveraged stocks that we typically avoid. Finally, while the high return periods of the past few calendar years are not the norm, they have nonetheless been challenging for investment approach which ultimately seeks to protect more during down markets.

Multiple rounds of QE and the Fed's zero interest-rate policy have disproportionately benefited certain types of businesses, more levered businesses, such as bond-like substitutes—including REITs and Utilities—and more momentum-oriented businesses, such as biotech and Internet software.

We strongly believe that the next few years will not look like the last five. Rates will rise in the foreseeable future and both the market and the U.S. economy continue to move in a more normalized direction. We are confident that a risk-conscious approach will make a big difference in this kind of setting.

Royce Featured Funds Average Annual Total Returns as of Quarter-End 3/31/15 (%)

  Average Annual Total Returns Annual Expenses
Fund QTR1 One-
Date Gross
Pennsylvania Mutual 1.15 0.11 11.57 11.64 8.17 10.63 14.952 N/A 0.93 0.93
Premier 2.64 -0.01 9.06 11.23 9.85 11.12 12.03 12/31/1991 1.09 1.09
Micro-Cap -0.28 -3.64 3.72 6.45 7.17 9.29 11.74 12/31/1991 1.56 1.56
Low-Priced Stock 0.53 -4.81 0.91 4.26 5.88 8.34 10.78 12/15/1993 1.51 1.49
Total Return 1.77 2.57 12.90 12.12 7.80 10.17 11.16 12/15/1993 1.18 1.18
Heritage 1.19 -0.45 8.46 9.64 8.86 8.87 13.04 12/27/1995 1.49 1.49
Opportunity 1.11 -2.81 14.66 12.81 8.74 10.30 12.88 11/19/1996 1.17 1.17
Special Equity 2.41 4.32 11.68 11.45 8.74 11.97 9.78 5/1/1998 1.13 1.13
Value 3.32 2.23 9.31 9.80 8.57 N/A 10.90 6/14/2001 1.48 1.48
Value Plus 4.78 5.25 13.05 11.24 8.21 N/A 12.33 6/14/2001 1.49 1.49
100 0.46 -3.01 7.82 9.09 8.86 N/A 10.38 6/30/2003 1.51 1.51
Dividend Value 1.10 -1.23 10.56 11.56 8.77 N/A 9.06 5/3/2004 1.52 1.52
Global Value 2.37 -7.52 0.22 3.96 N/A N/A 4.13 12/29/2006 1.84 1.70
International Smaller-Cos -0.51 -9.79 2.95 4.22 N/A N/A 4.43 6/30/2008 2.08 1.70
Special Equity Multi-Cap -0.58 8.00 13.80 N/A N/A N/A 14.41 12/31/2010 1.46 1.24
Russell 2000 Index 4.32 8.21 16.27 14.57 8.82 7.19 N/A N/A N/A N/A
Russell Microcap Index 3.14 3.79 17.37 14.69 7.11 N/A 7.69 N/A N/A N/A
Russell 1000 Index 1.59 12.73 16.45 14.73 8.34 4.43 14.99 N/A N/A N/A
Russell Global Small Cap Index 3.89 1.23 10.22 9.16 7.29 6.78 4.41 N/A N/A N/A
Russell Global ex-U.S. Small Cap Index 3.66 -3.21 6.73 6.25 6.66 6.73 3.61 N/A N/A N/A

1 Not Annualized
2 For Pennsylvania Mutual, the average annual total return shown is for the 40-year period ended as of the date shown above rather than since the Fund's inception.

Important Performance and Expense Information

All performance information 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 30 days of purchase, may be subject to a 1% redemption fee payable to the Fund (2% for Royce Global Value and International Smaller-Companies Funds). Redemption fees are not reflected in the performance shown above; if such fees were reflected, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. All performance and expense information reflect results of the Fund's oldest share class (Investment 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 5/1/14. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses through April 30, 2015 to the extent necessary to maintain net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) to no more than 1.24% for the Service Class of Royce Special Equity Multi-Cap Fund, to no more than 1.49% for the Service Class of Royce Low-Priced Stock Fund, and to no more than 1.69% for the Service Class of Royce International Smaller-Companies Fund. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses through April 30, 2024 to the extent necessary to maintain net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) to no more than 1.99% for the Service Class of Royce International 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.

Important Disclosure Information

Mr. Royce's, Mr. Fockler's, Mr. Gannon's, Mr. Dreifus's, Mr. Hench's, Ms. Romeo's, and Mr. Lipper's thoughts concerning the stock market are solely their own 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. The Royce Funds invest primarily in securities of micro-cap, small-cap, and/or mid-cap companies, which may involve considerably more risk than investing in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) 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. Frank Russell Company is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. The Russell 2000 Index 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 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. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The Russell Global Small Cap Index is an index of global small-cap stocks. The Russell Global ex-U.S. Small Cap Index is an index of global small-cap stocks, excluding the United States. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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