article 07-09-2015

Micro-Caps Look Attractive in an Expanding Economy

Portfolio Manager Bill Hench discusses the recent changes to Micro-Cap Opportunity, managing risk with a concentrated portfolio, where he's been finding value, and his outlook going forward.

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Can you describe some of the recent changes that were made to Royce Micro-Cap Opportunity Fund?

On May 1, 2015, we changed the Fund's name to Royce Micro-Cap Opportunity Fund—it used to be Opportunity Select—and made a few changes to the way it operates.

However, it's important to point out that we're still using the same opportunistic, theme-based approach and investing in the same types of companies as before—those with attractively low P/B and P/S ratios.

As its new name suggests, Micro-Cap Opportunity now focuses even more fully on micro-cap stocks. It's also no longer allowed to engage in short sales, write call options, or borrow money for investment purposes. Although we used the first of these practices frequently since the Fund's inception in August 2010, none of them were ever a significant part of our investment focus.

Broad diversification is one important way that you and Buzz Zaino try to manage risk in Royce Opportunity Fund. How have you attempted to manage risk in Micro-Cap Opportunity, a portfolio that has generally held less than 100 names?

I'm primarily trying to manage risk in two ways: First, Micro-Cap Opportunity holds companies that show more evidence of positive change beginning to happen. Either the turnaround process appears to be under way or their sector or industry looks closer to rebounding. So these businesses are often a little further along the road to earnings recovery than some of what Buzz and I hold in Opportunity Fund.

I'm willing to buy at a marginally higher valuation in exchange for what looks like more stability in many cases. That allows me to run a relatively more concentrated portfolio.

Second, I'm very careful about position weightings, just as we are in Opportunity Fund. Generally, in Micro-Cap Opportunity, no single company will exceed 4% of total assets, which I think provides a sufficient amount of diversification from a risk management perspective.

What factors have contributed to the portfolio's strong results during the first half of 2015?

A number of sectors and industries have rebounded nicely so far in 2015. Many of these names, especially in the Consumer Discretionary and Information Technology sectors, had very depressed stock prices during 2013 and 2014.

This, by the way, is a very important part of how Buzz and I work—whether times are good or bad, we are always looking at companies that have fallen on hard times but show the potential to come back. In these two particular areas, steady increases in employment and capital spending, as well as declines in commodity prices such as oil and metals, helped set the stage for recovery.

Many of the portfolio's year-to-date successes in tech fall into our Interrupted Earnings theme. In my view, several have long growth trajectories that are just getting under way.

For example, Aerohive, which develops cloud-managed mobile networking platforms, added Apple as a reseller of its products in May, which gave its shares a lift. I also like the longer-term prospects for holdings such as A10 Networks, which offers application networking, load balancing, and DDoS protection solutions, and Limelight Networks, a digital content provider.

Holdings involved in residential housing also did well in the first half. Builders FirstSource, which makes and supplies structural building products for residential new construction primarily in the southern and eastern U.S., is one example.

As with many of the portfolio's retail and tech-based positions, I continue to hold most of these housing-related companies because I expect that industry's recovery to last.

I've been very active in the non-residential construction industry over the last couple of years. It hasn't seen the same kind of rebound that residential has yet, but I anticipate that it will recover as the economy continues to grow.

What sectors and industries have you been most active in over the last year or so?

I've been very active in the non-residential construction industry over the last couple of years. It hasn't seen the same kind of rebound that residential has yet, but I anticipate that it will recover as the economy continues to grow.

I hold Encore Wire, which makes electrical building wire and cable products primarily for commercial and industrial buildings. Its shares suffered when copper prices fell lower but it should eventually benefit from higher volumes.

General Cable, which makes fiber optic wire and cable products, is still in the early turnaround stages. Its stock was very cheap—making it a great value in my estimation—when I began to build a position in the company.

I also hold a few optical equipment businesses—including Oclaro, a laser and optical components maker—whose shares were first purchased when the companies looked both very inexpensive and fully capable of resumed growth. Capital spending in the industry is just beginning to bounce back from very depressed levels.

What is your outlook for small-cap and micro-cap stocks going forward?

Overall, my outlook is very positive. I think the market will need time to fully digest the first quarter's slowdown in economic growth and the likelihood of increased interest rates in the short run.

However, I think the economy will keep growing, which should help a number of micro-cap companies, especially those that have been flat or down over the last couple of years, as earnings begin to fully recover in 2016.

Important Disclosure Information

Bill Hench is a Portfolio Manager of Royce & Associates, LLC, investment advisor to The Royce Funds. He serves as portfolio manager for Royce Micro-Cap Opportunity Fund and Royce Opportunity Fund. He also serves as assistant portfolio manager for Royce Low-Priced Stock Fund. The thoughts and opinions expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. 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. Royce Micro-Cap Opportunity Fund invests primarily in micro-cap companies, which may involve considerably more risk than investing in larger-cap stocks. The Fund generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) Royce Opportunity Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss.

Percentage of Fund Holdings as of 6/30/15 (%)

  ROS ROF RLP
Aerohive Networks 1.95 0.00 0.00
A10 Networks 1.80 0.30 0.00
Limelight Networks 1.94 0.14 0.00
Builders FirstSource 1.67 0.21 0.00
Encore Wire 1.07 0.83 0.00
General Cable 2.66 0.90 0.73
Oclaro 1.18 0.15 0.00

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.

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