article 06-30-2014

Royce Capital Fund — Small-Cap Portfolio Manager Commentary

Royce Capital Fund–Small-Cap Portfolio was up 1.9% for the year-to-date period ended June 30, 2014 versus a 3.2% gain for its small-cap benchmark, the Russell 2000 Index, for the same period.

The first quarter saw a widespread slowdown in the speed of smallcap returns following the dynamic second half of 2013, which was not entirely unexpected considering last year’s blistering pace. Capital Small-Cap rose 0.7% for the first quarter of 2014, trailing its benchmark’s 1.1% advance. A slight downturn that lasted from early March through mid-May made for a rockier second quarter, though June was in general a positive month that did much to bring small-cap results back into the black. For the second quarter, the Fund rose 1.2% compared to 2.0% for the small-cap index. Capital Small-Cap did, however, beat the Russell 2000 from the index’s early March high through the end of June. Although we always like to see the Fund hold a down-market advantage, in light of the last few years of relative underperformance, this edge during a brief bearish phase offered mostly cold comfort. The Fund did outpace the benchmark for much longer-term periods. Capital Small-Cap beat the Russell 2000 for the 10-, 15-year, and since inception (12/27/96) periods ended June 30, 2014. The Fund’s average annual total return since inception was 12.1%. We are very proud of the Fund’s long-term performance record.

When selecting stocks for the Fund's portfolio, we focus first on balance sheets, looking for businesses with low debt, which is frequently a sign of financial strength. We next look for high returns on invested capital (ROIC). Like a strong balance sheet, high ROICs are in our view a proxy for quality. We also want the company to be trading for what we believe is an attractively low share price vis-à-vis its worth as a business. In order to evaluate this, we typically use capitalization rates, which we define as operating income divided by enterprise value. We want to understand the return on our investment as if we were buying the whole company.

Our challenge through the most recent cycle has been the unfashionable status of this disciplined, value-oriented approach. With a still highly accommodative Federal Reserve pouring money into the economy while keeping interest rates essentially at zero, the cost of debt is historically low and access to cash is extremely easy. This has the effect of reducing the appeal of conservatively capitalized, steadily growing businesses while increasing the demand for both fast growth (often regardless of profitability) and high yield (often regardless of underlying quality). While there have been some signs that this is changing, a large-scale flight to quality has not yet occurred, certainly not in the small-cap space. We remain, however, squarely focused on both long-term and absolute results and are hopeful for a shift in sentiment in which fundamentals will matter more than momentum and yield.

Five of the Fund's eight equity sectors contributed to first-half returns, with Energy holding a considerable edge, followed by notable net gains for Information Technology. The Fund’s two top performers both came from the energy equipment & services industry. Unit Corporation is a long-time position—and the Fund’s third largest at the end of June— that we have owned continuously since 2002. It operates primarily as a contract drilling company, though it also explores for and produces oil and natural gas, and engages in midstream activities. These related businesses make it an outlier in an otherwise rigidly specialized industry. Unit reported double-digit production growth, introduced a new advanced drilling rig, and enjoyed continued strength from its midstream operations. Matrix Service builds natural gas storage tanks and provides construction and maintenance services to the oil, gas, power, petrochemical, industrial, and metals industries. Increased demand for its services, a complementary acquisition, and ongoing strength for natural gas helped both operating results and its stock price. We reduced our position as its price soared.

Shoe Carnival is a family footwear retailer that endured the same dismal results that most other retailers did in the first half, including The Buckle and Ascena Retail Group. We held our position in Shoe Carnival and added shares of The Buckle as its stock price declined. In the case of the former, we like its plan to expand the number of stores and raise the quality of the women’s shoes it sells. After a turn as the portfolio’s top contributor in 2013, Nu Skin Enterprises earned a less esteemed status for the semiannual period. The company develops and distributes personal skin care products worldwide. Its share price suffered mightily after an article in a Chinese newspaper accused the firm in January of running a pyramid scheme, and an investigation by the Chinese government followed. The firm paid modest fines in March and began to tighten up its training procedures. We were hopeful that Nu Skin could right itself at the end of June.

Top Contributors to Performance
Year-to-Date through 6/30/14

Unit Corporation 0.91
Matrix Service 0.68
Synaptics 0.61
World Wrestling Entertainment Cl. A 0.59
Vishay Intertechnology 0.53
1 Includes dividends

Top Detractors from Performance
Year-to-Date through 6/30/14

Shoe Carnival -0.68
Nu Skin Enterprises Cl. A -0.54
Buckle (The) -0.41
Ascena Retail Group -0.34
TESSCO Technologies -0.30
1 Net of dividends

Average Annual Total Returns as of Quarter-End 6/30/14 (%)

Capital Small-Cap 1.21 1.94 22.19 12.40 17.81 9.44 12.02 12.15 12/27/1996
Russell 2000 2.05 3.19 23.64 14.57 20.21 8.70 8.01 8.51 N/A
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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. 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 yearto- date performance for 2014.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at June 30, 2014, 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 June 30, 2014 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 (measured at the time of investment), 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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