Fund Performance

It was a difficult first half for Royce Capital Fund–Small-Cap Portfolio. The Fund was down 0.3% for the year-to-date period ended June 30, 2015, well behind its small-cap benchmark, the Russell 2000 Index, which advanced 4.8% for the same period. This was particularly frustrating in light of the fact that the Fund, while behind, had been much closer to the small-cap index in four of the last five calendar years while also posting strong absolute returns during a market cycle that has been largely inhospitable to our valuation-focused, quality-centric, and highly disciplined approach.

As was the case in 2014, the first half of the year looked quietly bullish. The key differences were both more volatility and narrower market leadership through the first six months of 2015. The second of these developments played a large role in the Fund's first-half underperformance. The year began with most stocks trending down, though small-cap growth stocks generally—and uncharacteristically—fared better than their value counterparts. This short-term anomaly can be added to a growing list of the historical deviations that have marked the current small-cap cycle.

For the first quarter Royce Small-Cap Portfolio rose 3.0% versus a 4.3% gain for its benchmark. The second quarter was less bullish and, at least through the fourth week of June, somewhat less volatile. Small-cap shares stumbled in April. They were recovering nicely through May and into the last days of June before the second-tolast trading day of the quarter brought a wave of volatility from the Greek default that washed over the market and plunged many stock prices into the red for the quarter. The Fund fell 3.2% for the second quarter versus a gain of 0.4% for the Russell 2000. Longer time spans saw better relative results for the Fund. Royce Small-Cap Portfolio outpaced the Russell 2000 for the 15-year and since inception (12/27/96) periods ended June 30, 2015. The Fund's average annual total return since inception was 11.5%, a long-term record that gives us great pride.

What Worked... And What Didn't

The Fund's worst-performing sector in the first half was Energy, just as it was in 2014 when the price of oil collapsed. The lion's share of the sector's net losses in the first half of this year occurred in the first quarter as the arrival of spring saw some recovery in commodity prices. Our own long-term outlook for the sector remains positive. One of the portfolio's larger detractors was long-time holding Unit Corporation, which operates several energy businesses. Primarily a contract driller, Unit also explores for and produces oil and natural gas while engaging in midstream activities. The decline in energy prices badly hurt its stock, which was beginning to show signs of life early in 2015's second quarter until May, when the company announced a first-quarter loss that depressed its shares. We were more focused on its record oil production, improved dayrates, and other positive developments.

Two technology companies were the Fund's two largest detractors in the first half. Top-five position Vishay Intertechnology makes semiconductors and components. It's a conservatively capitalized, cashrich business with a long history of successful and profitable execution. Its stock began to slip in March in the context of an uncertain and more volatile market for many tech issues. The firm's good-sized exposure to an equally uncertain Europe appears to have been a factor. TESSCO Technologies distributes specialized equipment for cell phone towers. The decision of one of its major customers to curtail spending had a chilling effect on its shares, which plummeted further in early May when the firm announced fiscal fourth-quarter and 2015 earnings that were not to Wall Street's liking.

Top-ten position Genesco, another detractor, is a specialty footwear retailer that also sells licensed and branded headwear and licensed sports apparel. The company lowered its fiscal year earnings outlook late in May, leading its stock to slump. The firm has a number of attractive businesses but has recently struggled to turn around business at its Lids hat and Locker Room stores. Shares of Genworth MI Canada bottomed out in April though its subsequent secondquarter recovery was not robust enough to lift it out of the red for the first half. This Canadian mortgage insurer was a top-10 holding at the end of June.

The Fund's best performer in the first half was Steven Madden, which designs and sells name brand and private label shoes for women, men, and children. The rising price of its shares seems to have been influenced by the perception that consumers were turning toward more fashionable footwear. Call-center specialist Convergys Corporation benefited from steadily improving execution, which spurred earnings improvement. Long-time holding Nu Skin Enterprises, which makes and markets personal care products, saw its shares rise through much of the first half as the firm won back investor confidence after it settled issues with the Chinese government—Asia is its largest market—and restructured its debt covenants. Its stock pulled back in the second quarter on an earnings miss and concerns over currency headwinds.

Current Positioning and Outlook

At the end of June, the portfolio remained heavily overweight in the Consumer Discretionary, Information Technology, and Energy sectors, though its exposure to the latter in the portfolio was relatively low. These weightings reflected our expectation for slow but mostly steady economic growth. We also anticipate a possible increase in interest rates. However, even in the event of an increase rates will remain historically low. The portfolio is positioned for a market that more consistently rewards quality companies with low leverage and high returns on invested capital.

Average Annual Total Returns as of Quarter-End 6/30/15 (%)

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

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