article 12-31-2013

Royce Micro-Cap Discovery Fund Manager Commentary

Royce Micro-Cap Discovery Fund gained 35.3% in 2013, trailing both its benchmark, the Russell Microcap Index, which was up 45.6%, and the small-cap Russell 2000 Index, which advanced 38.8% for the same period. So while the Fund’s results were more than respectable on an absolute basis, its relative results were disappointing. The bulk of the Fund’s relative disadvantage for the calendar year was solidified during the highly bullish first quarter. This dynamic upswing followed a solid third quarter and more volatile fourth quarter in 2012. The Fund posted a solid result on an absolute basis even as its relative performance fell short. For the first quarter, the Fund gained 8.2% versus 12.6% for its benchmark and 12.4% for the small-cap index.

The second quarter brought more volatility and lower returns for equities across the board. Markets all over the world convulsed late in June following the announcement by Fed Chairman Bernanke that the central bank would consider tapering the pace of monthly bond purchases later in the year—a promise made good on in December. Along with less-than-stellar news out of China, Brazil, Turkey, and Europe, stocks fell precipitously for several sessions before beginning to find their feet again. The upshot was a rougher quarter for stocks, though the U.S. fared better on the whole than foreign markets. Micro-Cap Discovery was up 3.7% for the second quarter, which was a mixed performance on a relative basis—the Russell Microcap rose 5.1% while the small-cap index advanced 3.1% for the same period.

The third quarter saw investors shaking off these potentially worrisome developments, and the market quickly resumed the feverish pace established earlier in the year. The Fund participated, advancing 8.4% while the micro-cap index climbed 11.6% and the small-cap index increased 10.2%. Although December brought a small wave of volatility, the fourth quarter also saw strong results for equities as a whole, and micro-caps in particular. The Fund outpaced both indexes in the year’s final frame, rising 11.3% in the fourth quarter compared to respective gains of 10.3% and 8.7% for the Russell Microcap and Russell 2000 Indexes. Longer-term results were less encouraging as the Fund lagged both indexes for the three-, five-, 10-year, and since inception (10/3/03) periods ended December 31, 2013.

During the Fund’s stock selection process, we seek micro-cap companies with the same highquality features found in most other Royce-run portfolios—strong balance sheets, high returns on invested capital, and positive cash flow. However, what differentiates the Fund is the use of a proprietary quantitative screening model, which has been in place for more than a decade, that attempts to enhance the discovery of micro-cap companies exhibiting certain key characteristics. We believe that this complementary tool provides us with an invaluable starting point to perform traditional fundamental analysis. It identifies micro-cap companies with certain qualities that we find attractive in a business, particularly those characteristics that Royce has enjoyed success with throughout our more than 40-year history of applying bottom up, fundamental analysis to small-cap stocks. The model combs through an extensive amount of data in an effort to capture three key attributes—valuation, profitability, and earnings yield. The managers then evaluate the effectiveness and appropriate weightings for each of these three attributes.

Information Technology and Industrials led all of the Fund’s sectors, each of which finished 2013 in the black. Consumer Discretionary, Health Care, Materials, and Financials also posted notable net gains. Net losses at the industry level were few and minimal while strong contributions came from machinery stocks, health care equipment & supplies businesses, and insurance companies. At the individual position level, net losses were comparatively modest. We sold our shares in Canadian silver producer Endeavour Silver in August. Precious metals miners endured an awful year in 2013, faced with commodity price weakness and increased mine operating costs. Texas-based energy producer and explorer VAALCO Energy stumbled with a fiscal fourth-quarter earnings miss, rising costs, lower energy prices, and a stalled project in Angola, all of which affected margins and kept its stock price slumping. Still confident in its long-term potential, we increased our position with small buys in February and March.

Four of the Fund’s top contributors for the year were also top positions at the end of December. (The exception was Obagi Medical Products, which was acquired in April by Valeant Pharmaceuticals.) We took gains in PC Connection at various points during the year. The company provides a full range of information technology (IT) solutions to business, government, and educational customers. Its growing business, solid earnings, and steady dividends, as well as a tech-friendlier market, appeared to give a boost to its share price. It was Micro-Cap Discovery’s twelfth-largest holding at year-end. Capella Education benefited from a rebound in the for-profit education business as well as its own revenue and enrollment growth. Automotive parts maker Standard Motor Products enjoyed revenue growth (primarily via acquisitions) and strong cash flows while also experiencing ongoing growth in the auto aftermarket business. Alamo Group manufactures and distributes heavy duty, tractor-mounted mowing and vegetation maintenance equipment and replacement parts. Increased demand for industrial infrastructure companies helped it to achieve record revenues for its fiscal third quarter.

Top Contributors to 2013 Performance

PC Connection 1.42%
Capella Education 1.31
Alamo Group 1.23
Standard Motor Products 1.13
Obagi Medical Products 1.01
1 Includes dividends

Top Detractors from 2013 Performance1

Endeavor Silver -0.43%
VAALCO Energy -0.36
TransGlobe Energy -0.35
PhotoMedex -0.34
Nevsun Resources -0.26
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR Since
Micro-Cap Discovery 11.25 35.29 35.29 10.89 15.48 5.81 7.02 10/3/2003
Russell Microcap 10.26 45.62 45.62 16.52 21.05 6.99 7.96 N/A

Annual Operating Expenses: Gross 2.94 Net 1.49%

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, 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 180 days of purchase may be subject to a 1% redemption fee payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Price and total return information is based on net asset values calculated for shareholder transactions. Certain immaterial adjustments were made to the net assets of Royce Micro-Cap Discovery Fund at 6/29/12 for financial reporting purposes, and as a result the net asset values for shareholder transactions on that date and calendar-year total returns based on those net asset values differ from the adjusted net asset values and calendar-year total returns reported in the Financial Highlights. Gross operating expenses reflect the Fund’s gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service fees, and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Service Class’s net annual operating expense ratio at or below 1.49% through April 30, 2014 and at or below 1.99% through April 30, 2023. 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 micro-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 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 see "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 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Insights & News



Sign Up