article 12-31-2014

Royce Micro-Cap Discovery Fund Manager Commentary

Fund Performance

Royce Micro-Cap Discovery Fund rose 1.0% in 2014, lagging its benchmark, the Russell Microcap Index, which gained 3.6% for the same period. Micro-cap stocks have been among the equity market's best-performing asset classes over the last several years. In addition, 2013 was the second-best calendar-year result for the Russell Microcap since its inception on June 30, 2000. A slackening of the pace of returns was therefore not unexpected, and this is what took place in 2014, beginning with the year's first half in which the Fund was essentially flat and its benchmark was up 1.6%.

The third quarter saw both an increase in volatility and a downdraft for small-cap and micro-cap stocks. Micro-Cap Discovery was down 7.9% for the quarter, losing less than the Russell Microcap, which declined 8.2% for the same period. We were pleased to see the portfolio hold its value a bit better than the index, though the Fund was still behind its benchmark for the nine-month period ended September 30, 2014. Micro-Cap Discovery then outpaced its benchmark in October and December but underperformed in November. The end result was that the Fund trailed the Russell Microcap in the fourth quarter, up 9.6% versus 11.2%. Micro-Cap Discovery underperformed its benchmark for the three-, five-, 10-year, and since inception (10/3/03) periods ended December 31, 2014, though the Fund's average annual total returns for the three- and five-year periods were solid on an absolute basis.

What Worked... And What Didn't

The Consumer Discretionary and Energy sectors posted net losses in 2014 while seven of Micro-Cap Discovery's nine equity sectors finished the year in the black. Industrials led by a wide margin, boosted by net gains in the machinery industry and, to a lesser degree, professional services companies. Two of the Fund's top-five contributing stocks came from the machinery group. Two industries from the Information Technology sector also made strong net contributions. Software was the Fund's top industry in 2014 while the semiconductors & semiconductor equipment group finished third behind it and machinery stocks. Two other industry groups within Information Technology, however, were Micro-Cap Discovery's two biggest detractors in 2014—IT services and internet software & services. Net losses in the first of these groups were entirely attributable to Computer Task Group, an IT services and staffing company and the Fund's largest-detracting position for the year. Its stock price began to decline steeply in early July after the firm reported lower-than-expected earnings largely due to higher costs and lower revenues from its healthcare business. While the company claimed these higher expenses were likely anomalous, it also boosted its projected medical costs for the rest of 2014, thus revising guidance downward. The Internet software & services industry was home to Liquidity Services, which runs online auction marketplaces for sellers and buyers of surplus, salvage, and scrap assets. Its stock endured its worst declines earlier in the year after the company missed earnings and revised guidance. We scrapped our position in the first half before reinitiating a position in July.

VASCO Data Security International was Micro-Cap Discovery's best-performing position in 2014. The company 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 as earnings improved. Its stock climbed yet again in October after the company again beat estimates, this time for third-quarter revenue and earnings. We took gains as its shares moved up, selling the last of our stake in December.


Top Contributors to Performance
For 2014 (%)
1

VASCO Data Security International 1.65
John B. Sanfilippo & Son 0.95
Symmetry Medical 0.92
Lydall 0.61
Standex International 0.61
1 Includes dividends

Top Detractors from Performance
For 2014 (%)
1

Computer Task Group -1.40
Liquidity Services -0.93
PhotoMedex -0.76
Big 5 Sporting Goods -0.52
Nam Tai Property -0.51
1 Net of dividends

Current Positioning and Outlook

To enhance the detection of potential portfolio candidates, Micro-Cap Discovery's portfolio managers combine a proprietary quantitative screening model with traditional fundamental analysis to aid them in their effort to find companies that exhibit certain value-based characteristics. There are several key pieces to the Fund's proprietary model: First, relative sector valuations are an important element in understanding outperformance patterns. The model's output is sector adjusted so that companies are evaluated relative to their sector peers. Second, the model has historically been more effective in discriminating between over and undervalued companies as one moves down the market cap scale, which explains Micro-Cap Discovery's emphasis on micro-cap stocks. Finally, the efficacy of each of these attributes can vary depending on what stage we are in within a particular economic cycle. While we believe the model is effective at generating a list of micro-cap investment candidates, fundamental scrutiny adds a level of refinement that does not exist in purely quantitative approaches.

At the end of 2014 the Fund was substantially overweight the Industrials, Materials, and Consumer Staples sectors, the portfolio's modest exposure to the last two sectors notwithstanding. Micro-Cap Discovery was also overweight Energy, Information Technology, and Consumer Discretionary while it was significantly underweight Financials and Health Care and had no exposure to Telecommunication Services at the end of 2014.

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

  QTR* 1 YR 3 YR 5 YR 10 YR SINCE INCEPT. DATE
Micro-Cap Discovery 9.58 0.97 12.09 10.50 4.59 6.47 10/3/2003
Russell Microcap 11.19 3.65 21.81 16.14 5.96 7.57 N/A
Annual Operating Expenses: Gross 2.5% Net 1.49%

* 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. Shares redeemed within 30 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. 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 expenses, (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business), at or below 1.49% through April 30, 2015 and at or below 1.99% through April 30, 2024. 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 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 (measured at the time of investment) in securities of companies headquartered in foreign countries, 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 1000 of the smallest securities in the small-cap Russell 2000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an 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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