article 12-31-2013

Royce Capital Fund — Small-Cap Portfolio Manager Commentary

Royce Capital Fund–Small-Cap Portfolio finished 2013 with a terrific absolute return even as it came up short on a relative basis. The Fund gained 34.8% for 2013 versus 38.8% for its small-cap benchmark, the Russell 2000 Index, for the same period. Relative underperformance notwithstanding, we were mostly pleased with Capital Small-Cap’s calendar-year results. While recent underperformance periods remain a source of frustration for us, the Fund did manage in 2013 to narrow the gap somewhat between its recent performances and those of its benchmark. This was accomplished in an environment that, especially in the first half of the year, was often not conducive to our disciplined approach.

This approach emphasizes companies with strong balance sheets, high returns on invested capital, managements that prioritize the prudent allocation of capital, and positive cash flow characteristics that are also trading at what we think are attractively discounted valuations. Companies that possess these attributes trailed the market throughout the last three years. However, in the second halves of both 2012 and 2013 there were signs of a shift. For example, in the second quarter of 2013, when taper talk helped to usher in a round of volatility (and declining stock prices), we also saw encouraging levels of differentiation at the company, industry, and sector levels.

During the first quarter, the Fund rose 7.6% versus 12.4% for the Russell 2000. The Fund then rose 4.5% in the more volatile second quarter while its benchmark gained 3.1%. The markets became roiled in the aftermath of the Fed’s announcement in May that it would likely begin to taper its monthly bond-purchase program, which took place just after the 2013 low for the 10-year Treasury yield on May 2. From this date through December 31, 2013, Capital Small-Cap rose 24.8% versus 25.0% for the small-cap index. The Fund enjoyed a robust third quarter, though it fell behind its benchmark, gaining 9.1% compared to 10.2%. The fourth quarter was initially similar to the first and third—placidly bullish—until an unsettled December brought a short squall of volatility. The end result was a stronger relative performance for the Fund, up 9.9% versus 8.7% for the Russell 2000. The Fund maintained its advantage over the small-cap index, outperforming the Russell 2000 for the 10-, 15-year, and since inception (12/27/96) periods ended December 31, 2013. Capital Small-Cap’s average annual total return since inception was 12.4%. We are proud of the Fund’s long-term record on both an absolute and relative basis.

Consumer Discretionary led the Fund’s sector groups by a wide margin in 2013, though Financials, Information Technology, and Consumer Staples also made notable net contributions. The latter sector was home to the Fund’s top performer for the calendar year. Nu Skin Enterprises develops and distributes personal care skin products worldwide. After enjoying a strong first half, its share price gained additional momentum in the year’s last six months. In October, the company announced stronger-than-anticipated third-quarter earnings and raised its full-year guidance for 2013, driven by the success of a limited-timeoffer for its new weight management system. We reduced our position through much of 2013.

G-III Apparel Group—the Fund’s fifth-largest holding at year-end—benefited from investors recognizing the value in its growing product line and licensing deals. As the U.S.’s largest coat maker, the stock suffered for years from a seasonal bias as a “one-quarter stock”—after winter sales peaked (or when the winter was mild), its share price would often suffer. We added shares in the fall and winter of 2011-12 when warmer weather was helping to drive its price down. The company has been diversifying into dresses and sportswear, owns brands such as Wilsons Leather, Vilebrequin, and G.H. Bass, manufactures for Calvin Klein, Kenneth Cole, Cole Hahn, Tommy Hilfiger, and Ivanka Trump, and holds licenses for the NFL, NBA, MLB, and NHL. This impressive roster, along with growing profitability, drove the increase in its stock price, particularly after the firm raised guidance for fiscal 2013 in early June and then announced record earnings in its fiscal third quarter. We began to take gains in July. Deckers Outdoor makes footwear and accessories for outdoor activities. It operates various brands, most prominently boot maker UGG, which accounts for more than 80% of net sales. Its stock struggled in 2012 with rising sheepskin prices, a warmer-than-usual winter, and a dismal European market. Wall Street then appeared to think that UGG boots had been only a fad. We suspected otherwise and built our position in 2012 before taking gains as its share price rose in 2013.

Wireless product maker NETGEAR saw its price slide through most of 2013. It dealt with a weak market in Europe, an acquisition in April that has not yet resulted in new product adoption, and a product execution problem in its storage business earlier in the year. Though we sold some shares in the fourth quarter, we built our stake through the end of the because we think the firm remains well positioned to benefit from the global growth for wireless products. A significant contributor in 2012, clothing retailer American Eagle Outfitters has since struggled with stiff competition and declining sales. We sold some shares in 2013, though we still think this well-managed business with a strong niche in teen clothing can turn things around.


GOOD IDEAS THAT WORKED
Top Contributors to 2013 Performance
1

Nu Skin Enterprises Cl. A 3.79%
G-III Apparel Group 2.41
Deckers Outdoor 1.82
Matrix Service 1.45
Fabrinet 1.37
1 Includes dividends

GOOD IDEAS AT THE TIME
Top Detractors from 2013 Performance
1

NETGEAR -0.61%
American Eagle Outfitters -0.50
Orthofix International -0.20
Multi-Fineline Electronix -0.18
Intrepid Potash -0.13
1 Net of dividends

Average Annual Total Returns as of Quarter-End 12/31/13 (%)

  QTR YTD 1YR 3YR 5YR 10YR 15YR Since
Inception
Date
Capital Small-Cap 9.85 34.75 34.75 13.61 19.03 10.32 12.26 12.39 12/27/1996
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 8.42 8.57 N/A

Annual Operating Expenses: 1.06%

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

Important Disclosure Information

All performance information in this Report reflects past performance, is presented on a total return basis, and reflects the reinvestment of distributions. 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. Current performance may be higher or lower than performance quoted. The Fund’s total returns do not reflect any deduction for charges or expenses of the variable contracts investing in the Fund. Returns as of the most recent month-end may be obtained here. All performance and risk information reflects the result of the Investment Class (its oldest class). Shares of RCS’s Service Class bear an annual distribution expense that is not borne by the Investment Class. Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management fees and other expenses. Regarding the two “Good Ideas” tables shown above, the sum of all contributors to, and all detractors from, performance for all securities in the portfolio would approximate the Fund’s performance for 2013.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2013, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds' portfolios and Royce's investment intentions with respect to those securities reflect Royce's opinions as of December 31, 2013 and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Royce-managed portfolio in the future.

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 Fund invests primarily in securities of small-cap companies, which may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund also invests primarily in a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one 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, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please the "Investing in Foreign Securities" 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. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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