article 12-31-2014

Royce Capital Fund — Small-Cap Portfolio Manager Commentary

Fund Performance

Royce Capital Fund – Small-Cap Portfolio did all right on an absolute basis in 2014 but came up short versus its benchmark. The Fund gained 3.2% for the calendar year compared to a 4.9% increase for the small-cap Russell 2000 Index for the same period. The Fund narrowly underperformed the small-cap index in four of the last five calendar years, periods that include three years with strong absolute returns. While satisfied with these absolute results, we would prefer not to play catch-up with the benchmark over an extended period.

The first half of the year was quietly bullish. Capital Small-Cap gained 1.9% in the year's first six months before small-cap prices quickly headed south after the third quarter began. For the quarter as a whole, the Fund held its value comparatively well, falling 6.4% versus a decline of 7.4% for the Russell 2000. Capital Small-Cap was unable to maintain this advantage, however, when small-cap stock prices began to recover in October. Although a volatile period like the preceding one, the fourth quarter was also markedly bullish. The Fund climbed 8.2% during the year's final three months versus a 9.7% gain for the benchmark. Over longer-term spans, Capital Small-Cap's relative results were better. The Fund outpaced the Russell 2000 for the 10-, 15-year, and since inception (12/27/96) periods ended December 31, 2014. Capital Small-Cap's average annual total return since inception was 11.9%. We are very proud of the Fund's long-term performance record.

What Worked... And What Didn't

Information Technology led all of the Fund's sectors, followed by solid net gains for Financials, Consumer Discretionary, Health Care, and, to a lesser degree, Industrials. Chemed Corporation operates two very different businesses—hospice care provider Vitas and plumbing and drain cleaning service company Roto-Rooter—and is slotted in Health Care. Each is a solid cash flow business, but its shares appeared to benefit most from a "no news is good news" scenario regarding Vitas. In 2013 this business became the target of a Justice Department investigation concerning Medicare enrollments and billing rates. Vitas offers more critical care than is typical in the hospice industry, which might have helped to trigger the inquiry. However, margins for critical care are not much higher than for other elements of hospice care, and the firm is one of the few able to deliver it on a nationwide basis. The lack of any additional news seemed to quell concerns about the investigation, and reassured investors flocked to the stock. We like the consistency and brand value of Roto-Rooter and Vitas's status as one of the few hospice providers with coast-to-coast reach.

Two retailers rebounded in 2014. The Cato Corporation is a discount fashion retailer. Its improved sales may have been partly the result of the better employment picture and lower energy prices. It was a top-10 position at the end of the year. DSW sells footwear and accessories. The company's important women's shoe lines were doing poorly until DSW began to manage its inventories more effectively and some new trends helped spark sales. It was a top 20 position at the end of 2014. We had less luck with two other consumer-related holdings. Tween girl retailer Justice and plussize women's retailer Lane Bryant continued to struggle in 2014, which drove down the stock price of multiline fashion business Ascena Retail Group. Nu Skin Enterprises settled some issues with the Chinese government by paying fines and improving training, restructuring its debt covenants, and reversing a cash flow problem. This was all good news, but we think the firm also needs improved sales in China to engineer a comeback.

Energy was the leading detractor by a wide margin while net losses in Consumer Staples and Materials were more modest. Unit Corporation is a long-held position and was Capital Small-Cap's twenty-fifth largest at year end. Operating primarily as a contract drilling company, 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. The Fund's top performer in the first half, Unit was experiencing double-digit production growth, introducing a new advanced drilling rig, and showing strength in its midstream operations. Then oil prices collapsed by almost 50% in the second half of the year. While there is still much to like about this distinctive business, its short- and intermediate-term prospects are very tough to read in what is almost guaranteed to be a highly challenging environment for the energy industry in 2015.

Top Contributors to Performance
For 2014 (%)

Chemed Corporation 0.84
Cato Corporation (The) Cl. A 0.76
DSW Cl. A 0.66
World Wrestling Entertainment Cl. A 0.60
Knight Transportation 0.52
1 Includes dividends

Top Detractors from Performance
For 2014 (%)

Unit Corporation -0.94
Ascena Retail Group -0.77
Nu Skin Enterprises Cl. A -0.60
Alamo Group -0.42
TESSCO Technologies


1 Net of dividends

Current Positioning and Outlook

The portfolio remained heavily overweight in the Consumer Discretionary and Information Technology sectors, which together comprised more than half of net assets at year end and reflected our confidence for strong growth potential in these areas. Nine of the Fund's top-10 positions at the end of 2014 came from one of these two sectors. We expect interest rates to remain low and for the economy to keep growing. In our view stocks should benefit from earnings growth, and we have positioned the portfolio for this kind of environment.

Average Annual Total Returns as of Quarter-End 12/31/14 (%)

Capital Small-Cap 8.21 3.24 16.10 12.78 8.23 11.91 11.87 12/27/1996
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 8.36 N/A
Annual Operating Expenses: 1.05%

* Not Annualized

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

Important Performance, Expense, and Disclosure Information

All performance information in this piece 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 Capital Small-Cap'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 "Top Contributors" and "Top Detractors" 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 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 December 31, 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 December 31, 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 small-cap stocks, which may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) As of 12/31/14 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than more broadly diversified 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 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.



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