Fund Performance

Royce Micro-Cap Fund lost 4.1% in 2014, trailing both its benchmark, the Russell Microcap Index, and the smallcap Russell 2000 Index, which rose 3.6% and 4.9%, respectively, for the same period. The Fund's participation in the more quietly bullish first half was more limited than we would prefer—the Fund was up 1.0% for the six-month period ended June 30, 2014—but things grew worse when a wave of volatility hit the small- and micro-cap markets in the year's second half. Share prices began to fall following a small-cap high on July 3. In the third-quarter downdraft, the Fund fell 10.0% compared to respective declines of 8.2% and 7.4% for the micro-cap and small-cap indexes. We were frustrated that the Fund was unable to hold its value more effectively in a down phase, which has been one of its historical strengths. the Fund's participation in the fourth-quarter rebound was again limited and contributed to its relative performance disadvantage in the calendar year. The Fund was up 5.5% in the fourth quarter versus 11.2% for the Russell Microcap and 9.7% for the Russell 2000.

An examination of longer-term periods showed more attractive results on both an absolute and relative basis. The Fund outperformed the micro-cap benchmark for the 10-year period ended December 31, 2014. (Data for the Russell Microcap only goes back to June 30, 2000.) the Fund also outpaced the Russell 2000 for the 15-, 20-year, and since inception (12/31/91) periods ended December 31, 2014. The Fund's average annual total return since inception was 11.9%. We remain proud of its long-term performance record.

What Worked... And What Didn't

Four of the Fund's 10 equity sectors ended the year in the red, with Energy posting the largest net losses followed by Materials. The negative impact of Industrials and Consumer Staples was far more modest. Energy holdings first gave then took away in 2014, going from the portfolio's top performer in the first half to its worst in the second. The reversal of fortune was keyed by the nearly 50% decline in oil prices during the second half. TGC Industries provides geophysical services to oil and gas companies, such as seismic data acquisition services and gravity data. Its business mirrors that of longtime the Fund holding Dawson Geophysical. In October the two firms announced plans to merge, which should provide wider geographical reach, a stronger balance sheet, and more efficient operations, all of which should prove useful while we wait for commodity prices to recover. Total Energy Services, which was the Fund's twentieth-largest holding at the end of 2014, is a Calgary-based service company that provides contract drilling, equipment rentals, and compression and processing work. Conservatively capitalized, it's a high-return business that we have long regarded as especially well-run. We trimmed our position in 2014. Like many of our energy services holdings, it continued to execute effectively through the painful industry cycle.

Outside of Energy, maternity apparel retailer Destination Maternity continued to labor through a challenging retail market. A new CEO was hired in August with plans to manage inventories more effectively, improve store layouts, and refresh merchandise, all of which inspired our confidence in a turnaround that will require additional patience. Both Olympic Steel and Universal Stainless & Alloy Products grappled with ongoing sluggishness for industrial metals. Companies in the steel business have had no pricing power due to utilization rates being less than optimal. As with Destination Maternity, the turnaround is taking more time than we had initially anticipated. We held shares of all of these stocks at the end of 2014.

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. In October, its stock climbed yet again after beating estimates for third-quarter revenue and earnings. We sold the last of our shares in December. We held a stake in San Jose-based Super Micro Computer, which provides specialized high performance server solutions. Its recent successful forays into cloud computing data storage helped its earnings to soar steadily in 2014.

Current Positioning and Outlook

Sector weightings at year end were relatively unchanged from where they stood at the end of 2013. We continue to emphasize more economically sensitive sectors, such as the Fund's three largest at the end of the period—Industrials, Information Technology, and Consumer Discretionary. Our view is that many portfolio holdings in these (and other) sectors should benefit from a faster-growing economy that also could reward disciplined approaches that focus on fundamentals. So while we were not pleased with the Fund's recent performances, we remain confident about its prospects going forward.

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.

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