Royce Capital Fund-Micro-Cap Portfolio Manager Commentary
article 02-22-2016

Royce Capital FundMicro-Cap Portfolio Manager Commentary

Small- and micro-cap returns were dominated by growth stocks through much of the year, which created challenges for our more valuation-centric approach—but also presented promising long-term opportunities. We entered the new year with renewed, though cautious, optimism.


Fund Performance

Royce Capital Fund–Micro-Cap Portfolio was down 12.5% in 2015, lagging its benchmark, the Russell Microcap Index, which fell 5.2%, and the small-cap Russell 2000 Index, which declined 4.4% for the same period.

Small- and micro-cap returns were dominated by growth stocks through much of the year, which created challenges for our more valuation-centric approach—but also presented promising long-term opportunities. Indeed, following a strong fourth quarter, we entered the new year with renewed, though cautious, optimism.

Micro-Cap fell 1.1% for the year-to-date period ended June 30, 2015, while the Russell Microcap and Russell 2000 advanced 6.0% and 4.8%, respectively. In the third quarter stocks experienced a sweeping correction, and the Fund slid 15.2% versus respective losses of 13.8% and 11.9% for the micro-cap and small-cap indexed.

Micro-Cap did better on both an absolute and relative basis in the fourth quarter, outpacing both indexes with a 4.3% advance compared to 3.7% for the Russell Microcap and 3.6% for the Russell 2000.

Longer-term relative results were better versus the small-cap index. Royce Micro-Cap Portfolio outperformed the Russell 2000 for the 15-year and since inception (12/27/96) periods ended December 31, 2015. (Data for the Russell Microcap only goes back to June 30, 2000.) The Fund’s average annual total return since inception was 9.7%.

What Worked... And What Didn't

Seven of the portfolio’s nine equity sectors finished 2015 in the red. Four areas detracted significantly—Industrials, Consumer Discretionary, Materials, and Energy. On the industry level, five groups posted sizable net losses: metals & mining, specialty retail, energy equipment & services, diversified consumer services, and machinery.

The first of these groups was home to two of the Fund’s three largest detractors. Horsehead Holding produces zinc. Among other challenges, its management struggled to boost production in a newly commissioned processing facility to a level that would generate sustainable returns for shareholders. The combination of falling zinc prices, low utilization, and relatively high levels of project financing led us to sell our position.

Universal Stainless & Alloy Products, which manufactures semi-finished and finished specialty steel products, underwent significant pressure on its business as steel prices continued to decline. As part of an ongoing effort to reduce the portfolio’s exposure to the commodity complex, we sold our position.

"Small- and micro-cap returns were dominated by growth stocks through much of the year, which created challenges for our more valuation-centric approach—but also presented promising long-term opportunities. Indeed, following a strong fourth quarter, we entered the new year with renewed, though cautious, optimism."

Gulf Island Fabrication suffered along with most energy businesses in what’s shaping up to be the worst market for its industry in 30 years. The company makes offshore drilling platforms and other structures for use in offshore energy production. We held the bulk of our shares, which were trading at a significant discount to book value at the end of 2015. Liking its efforts to diversify its customer base, we see it as part of an effort to high-grade our holdings with commodity exposure.

Two stocks in the for-profit education business (part of Consumer Discretionary) endured losses for the year, mostly due to intense regulatory scrutiny from the current Administration, which has created significant headwinds to enrollment growth. American Public Education focuses on postsecondary school needs for the military and public services sectors. We like its valuation and differentiated focus and thus kept a small position at the end of 2015. We chose to exit our position in Lincoln Educational Services as we did not think its offerings were diverse enough.

Net losses for Industrials were spread out across a number of industry groups, including machinery and construction & engineering and companies.

On the positive side, two holdings stood out. Firearms manufacturer Smith & Wesson Holding continued to gain market share while recent heavy investments in R&D led to major product innovation. We took gains as its shares climbed. LSI Industries was the portfolio’s largest position at year-end. A leading provider of lighting and graphics products, it’s continued to benefit from its strong position in light-emitting diode (LED) technology.

All but one of the Fund’s sectors came up short versus the Russell Microcap in 2015. Our significant underweight in Financials played the primary role, keyed by our very low exposure to banks. Stock selection was also a factor. The portfolio’s overweight in Materials hampered relative results as did exposure to metals & mining stocks. Stock selection in Consumer Discretionary also contributed to underperformance.

In Energy and Industrials, however, stock selection was a positive.

Top Contributors to Performance
For 2015 (%)1

Smith & Wesson Holding Corporation 0.73
LSI Industries 0.61
INTL FCStone 0.42
Photronics  0.40
Relypsa  0.28
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Horsehead Holding Corporation -0.68
Gulf Island Fabrication -0.52
American Public Education -0.48
Universal Stainless & Alloy Products -0.47
Lincoln Educational Services


2 Net of dividends

Current Positioning and Outlook

We made only modest changes to the portfolio in the second half of 2015. We used proceeds from trims to commodity-based holdings to add to Financials as we believe the first steps toward a more normalized interest rate environment should benefit many companies in the sector. At the end of the year, however, we remained underweight.

Our largest weightings remained Industrials, Information Technology, and Consumer Discretionary. We continue to find value in these sectors and view select areas as having the potential to benefit from the relative strength of the U.S. economy. Health Care was a large underweight, with significantly less exposure to biotech where multiples continued to look too stretched for our valuation-based discipline.

Average Annual Total Returns Through 12/31/15 (%)

Capital Micro-Cap 4.34 -12.46 0.70 -0.69 3.55 7.68 9.71 12/27/96
Russell Microcap 3.74 -5.16 12.70 9.23 5.13 7.99 N/A N/A
Russell 2000 3.59 -4.41 11.65 9.19 6.80 7.28 7.65 N/A
Annual Operating Expenses: 1.31%

* 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 RCM’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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. 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 year-to-date performance for 2015.

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, 2015, 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, 2015 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.

As of 12/31/15, Horsehead Holding Corporation was 0.0% of the Fund’s net assets, Universal Stainless & Alloy Products was 0.0%, Gulf Island Fabrication was 0.8%, American Public Education was 0.4%, Lincoln Educational Services was 0.0%, Smith & Wesson Holding Corporation was 0.5%, and LSI Industries was 1.0%.

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’s broadly diversified portfolio does not ensure a profit or guarantee against loss. 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 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 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 Russell 2000 Index 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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