article 12-31-2013

Royce Micro-Cap Fund Manager Commentary

Royce Micro-Cap Fund enjoyed a solid year on an absolute basis, though it remained behind its micro-cap benchmark and the small-cap Russell 2000 Index. The Fund rose 21.3% in 2013, trailing its benchmark, the Russell Microcap Index, and the Russell 2000 Index, which had respective gains of 45.6% and 38.8% for the same period. A stronger, highly encouraging second half on both an absolute and relative basis was not enough to close the gap between the Fund and these two indexes. We were pleased, though, to see a narrowing of the spread.

As was the case in 2010, 2011, and 2012, the equity markets kicked the year off in bullish fashion. Micro-Cap, however, failed to participate, gaining 2.4% in the first quarter versus 12.6% for its benchmark and 12.4% for the small-cap index. Indeed, the first quarter accounted for most of the Fund’s relative underperformance for the year. Data from FactSet showed that within the Russell 2000 REITs, commercial banks, and biotech were the small-cap index’s top contributing industries in the first quarter. None of these are areas that draw a significant amount of our attention because they typically fail to meet the portfolio’s balance sheet criteria and our general preference for high returns on invested capital.

Volatility was a more forceful presence in the second quarter than it was in any other part of the year, though the month of December was close. From the beginning of April through the end of June, the Fund picked up 0.6% versus 5.1% for the micro-cap index and 3.1% for the small-cap index. The second quarter saw the first round of tapering talk from the Fed, which initially panicked many investors. Discouraging news out of China, Brazil, Turkey, and Europe also contributed to falling share prices, which did not begin climbing again until early July.

The resurgent third quarter was the Fund’s strongest on both an absolute and relative basis. The Fund gained 10.0% for the quarter, while the Russell Microcap was up 11.6% and the Russell 2000 rose 10.2%. The Fed talked more about tapering through the summer and early fall, comments that included reassurances that it would begin slowing the pace of its bond-buying program only if it saw solid evidence of a sturdy economy. Along with an economy that kept growing and a federal deficit and unemployment rate that kept declining, investors seemed reassured, even if the rate of change seemed painfully slow. Following a short wave of volatility, which cooled the pace of returns in mid-December, stocks rallied later in the month. For the fourth quarter the Fund was up 7.0%, again trailing its benchmark (+10.3%) and the small-cap index (+8.7%).

­For the periods ended December 31, 2013, the Fund was behind both indexes for one-, three-, and five-year spans, as well as in recent market cycle periods. However, the Fund outpaced the Russell Microcap for the 10-year period and beat the Russell 2000 for the 15-, 20-year, and since inception (12/31/91) periods ended December 31, 2013. (Data for the Russell Microcap Index only goes back to June 30, 2000.) Micro-Cap’s average annual total return since inception was 12.7%. We are quite proud of the Fund’s long-term record.

PDI provides outsourced sales and other commercial services to pharmaceutical, biotechnology, and healthcare companies in the U.S. Its contract sales business did not grow as we had anticipated, which hurt results and led us to reduce our position between April and July. As a group, investments in the Materials sector, particularly those in the metals & mining category, detracted most from the portfolio’s calendar-year results. Three of the portfolio’s five largest detractors were precious metals miners. We reduced the Fund’s exposure to this industry, holding positions only in those companies that are well funded or, in the case of Pilot Gold, particularly well managed. Each in our view is capable of weathering a very challenging period for mining businesses—challenges that include rising operating costs and declining commodity prices—and benefiting from a recovery of commodity prices. We added a small number of shares of Endeavour Silver in March and April, trimmed our position in Pilot Gold in March, and bought shares of McEwen Mining in late summer. We also reduced our stake in Sprott Resource, a Toronto-based firm that invests and operates in oil and gas, energy, agriculture, precious metals, and other natural resources. (Four of the Fund’s top five detractors were holdovers from the year’s first half.)

A rising stock price led us to reduce our position in Kirkland’s, which profited from the resurgence in the housing industry as well as from analytical tools that allowed it to better understand and respond to sales activity at its stores. This created greater efficiency and better inventory management that in turn helped margins. Graham Corporation manufactures custom vacuum and heat transfer equipment. We bought shares when its niche business was slow and its valuation looked particularly attractive to us. Growing sales and record revenue in its fiscal fourth quarter drove its stock price upward, especially in the first half. We trimmed our position throughout the year, with the largest trims in July and October. A retailer specializing in consumer electronics, home appliances, and other items, hhgregg benefited from growing home sales and improving consumer confidence. We began to take gains in April.


GOOD IDEAS THAT WORKED
Top Contributors to 2013 Performance
1

Kirkland's 1.02%
Graham Corporation 0.95
hhgregg 0.77
Marten Transport 0.77
Stein Mart 0.76
1 Includes dividends

GOOD IDEAS AT THE TIME
Top Detractors from 2013 Performance1

Endeavour Silver -0.52%
Pilot Gold -0.51
Sprott Resource -0.43
PDI -0.36
McEwen Mining -0.36
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR 20YR Since
Inception
Inception
Date
Micro-Cap 6.96 21.29 21.29 4.82 18.45 8.82 11.36 11.38 12.67 12/31/1991
Russell Microcap 10.26 45.62 45.62 16.52 21.05 6.99 N/A N/A N/A N/A
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 8.42 9.27 10.09 N/A

Annual Operating Expenses: 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. All performance and risk information reflects results of the Investment Class (its oldest class). 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 Fund at 12/30/11 for financial reporting purposes, and as a result the net asset values for shareholder transactions on that date and the 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. 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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of RMC’s Service and Consultant Classes bear an annual distribution expense that is not borne by the Investment Class. 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’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 35% 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 Russell 2000 Index 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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