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.

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 (%)

* Not Annualized

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

Important Performance, Expense, and Disclosure Information