article 06-30-2014

Royce Micro-Cap Fund Manager Commentary

Royce Micro-Cap Fund finished the year-to-date period ended June 30, 2014 with an advance of 1.0% versus respective gains of 1.6% for its benchmark, the Russell Microcap Index, and 3.2% for the small-cap Russell 2000 Index for the same period. Following a wonderfully bullish 2013, stocks as a group cooled down in the opening months of 2014, though returns for the most part remained solidly in the black. The Fund’s participation was more limited than we would prefer.

The year began with many share prices accelerating at a slower pace than they did in the torrid second half of 2013. The Fund, however, fell out of step with the market as a whole—and micro-caps more specifically—during both that highly bullish phase and the more moderate market that ushered in 2014. The Fund was down 0.8% in the first quarter versus a gain of 3.0% for the Russell Microcap and 1.1% for the Russell 2000. The Fund’s results improved in the second quarter, which saw the year’s only correction so far. In fact, its performance from the interim small-cap high on March 4 through the end of June was better than both the micro-cap and small-cap indexes. This relative edge over the indexes played a major role in giving a boost to quarterly results. For the second quarter, the Fund advanced 1.8% compared to a decline of 1.4% for the Russell Microcap and an increase of 2.0% for the Russell 2000.

A look at longer-term periods showed a healthier advantage. The Fund outpaced the Russell Microcap for the 10-year period ended June 30, 2014. (Data for this index only goes back to June 30, 2000.) Micro-Cap also beat the Russell 2000 for the 15-, 20-year, and since inception (12/31/91) periods ended June 30, 2014. The Fund’s average annual total return since inception was 12.4%. We remain proud of Micro-Cap’s long-term performance record.

The Fund’s overweight in Energy was a factor as 2014 wore on—the sector’s strong second-quarter results made it the portfolio’s top-performing sector for the year-to-date period ended June 30, 2014. In the micro-cap space we have invested in a larger number of E&P (exploration & production) companies and energy services businesses. While the former are often more volatile, we have found a number of conservatively capitalized services companies that we think are well-managed businesses. We believe that Triangle Petroleum offers an interesting high risk/high reward example in the E&P space. A Denver-based E&P business, its share price was volatile through much of the first half, though its overall direction was up. Moving quickly, in just two years, from exploration to production helped attract interest in the stock. We liked its prospects going forward, modestly trimming our shares in the first half.

The Fund’s top performer was Furiex Pharmaceuticals, which was acquired by Forest Laboratories at a healthy premium. The announcement came in April, when we sold our position. We were drawn first to its royalty and revenues on two approved drugs and to promising results for an IBS (irritable bowel syndrome) drug. VASCO Data Security International specializes in bank security and develops security systems to secure and manage access to user digital assets. Its stock made two significant upticks in the first half. In February, its shares rose on better-than-expected fourth quarter of 2013 earnings and a strong outlook for fiscal 2014. Increased revenues and ongoing earnings strength saw the shares getting another major boost late in April, especially with HSBC, USA, its customer, offering VASCO authentication solutions to its retail customers.

A disappointing holiday season and a miserably cold winter spelled tough times for many consumer stocks in both the Discretionary and Staples sectors. Seeing better times ahead, we held onto our shares of Shoe Carnival, a family footwear retailer based in Indiana. The company has a history of strong top-line growth and what we think are reasonable and intelligent plans to both grow and improve its business. It was the Fund’s eleventh-largest holding at the end of June. After a very successful 2013, we were not shocked to see some pullback for transportation and real estate business Patriot Transportation Holding. The stock is thinly traded and tightly held, so transactions tend to have an outsized effect on its shares. Earnings cooled down a bit during the first half, but we think its core strategic business realignment remains on track.

Over the past several years, we have been finding some of the most attractive micro-cap valuations in more economically sensitive sectors. Two of the Fund’s three largest sector weightings at the end of the period reflected this, with Industrials at 25.5% and Information Technology at 14.4%. The portfolio also remained overweight versus the Russell Microcap in other cyclical sectors, most notably Energy and Materials. Our view is that many portfolio holdings in these (and other) sectors can benefit from a faster-growing economy in which the Fed’s quantitative easing program comes to a close and interest rates are rising. Such an environment is likely to reward disciplined active approaches that focus on fundamentals such as strong balance sheets and high returns on invested capital. So while we remain frustrated by the Fund’s recent performance record, we are confident in its prospects going forward.

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

Furiex Pharmaceuticals 0.43
VASCO Data Security International 0.40
Super Micro Computer 0.33
Triangle Petroleum 0.32
Kennedy-Wilson Holdings 0.27
1 Includes dividends

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

Shoe Carnival -0.39
Patriot Transportation Holding -0.25
Destination Maternity -0.24
TGC Industries -0.24
Global Power Equipment Group -0.23
1 Net of dividends

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

Micro-Cap 1.81 1.02 18.91 4.17 14.13 8.24 11.23 11.49 12.43 12/31/1991
Russell Microcap -1.41 1.56 24.98 15.94 20.03 6.67 N/A N/A N/A N/A
Russell 2000 2.05 3.19 23.64 14.57 20.21 8.70 8.01 9.81 10.01 N/A
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Annual Operating Expenses: 1.56%

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 year-to-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 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 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.) 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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