article 02-22-2016

Royce Capital Fund—Small-Cap Portfolio Manager Commentary

Strong runs for biotech and other high flyers combined with tough times for retail, energy, and other industries to create challenges for managers like Jay Kaplan, whose approach emphasizes out-of-favor companies with attractively low valuations and histories of profitability and effective execution.                                       

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Fund Performance

Royce Capital Fund–Small-Cap Portfolio lost 11.8% in 2015 while its small-cap benchmark, the Russell 2000 Index, declined 4.4% for the same period. For the year-to-date period ended June 30, 2015, the Fund fell 0.3% compared to an advance of 4.8% for the benchmark. In the third quarter’s sweeping correction, the portfolio lost 10.3% while the Russell 2000 was down 11.9%. Small-cap growth companies outpaced their value counterparts in the fourth quarter, when the Fund was down 1.4% compared to a 3.6% gain for the Russell 2000.

The year proved challenging for strategies focused on valuation, profitability, and out-of-favor companies. Our large weightings in Consumer and Energy stocks and slight exposure to the bio-pharma complex were major factors in underperformance. We are, however, guardedly optimistic looking ahead and were pleased that the Fund beat the Russell 2000 for the 15-year and since inception (12/27/96) periods ended December 31, 2015. Royce Capital Small-Cap’s average annual total return since inception was 10.5%.

What Worked... And What Didn't

Six of the Fund's eight equity sectors finished 2015 in the red. The most significant net losses came from holdings in Consumer Discretionary, which also detracted most from relative results by a sizable margin. Both absolute and relative results were hurt by our substantial overweight in this sector's specialty retail group.

A longstanding area of focus for this portfolio, the prospects for many retailers began to look even more attractive in 2014 when oil prices began to decline because consumers often spend more on discretionary purchases when energy prices are low. On the heels of a very difficult holiday season for retailers, we are being patient, confident in the financial strength, management expertise, and previous operational success of our holdings.

Casual clothing retailer The Buckle, a long-term core holding, detracted most in the specialty retail group and second-most in the portfolio as a whole in 2015. Its shares suffered most from the sorry state of mall traffic, which extended into the normally robust holiday shopping season. Our confidence in its capable management team, long history of success, and ability to execute effectively during a very trying period for its industry helped make it a top-10 position at the end of the year.

We had a comparably high conviction level for specialty footwear retailer DSW and retail department store operator Dillard's, as well as other large positions in the sector such as Deckers Outdoors, best known as the makers of UGGs.

"The recent contractions in share values, however, have created some potentially promising opportunities. It also appears that the "leverage is good" era has come to a close, which we believe should benefit the kind of conservatively capitalized, free-cash-flow-generating companies that we seek for the portfolio."

Energy was another sector in which losses tested our patience and conviction. The energy equipment & services group posted the portfolio's second-largest net losses at the industry level. And while our overweight in this group also hampered relative results, our stock selection was a strength vis-à-vis the benchmark.

Unit Corporation is a long-time holding that explores for and produces oil and natural gas, is a contract driller, and engages in midstream activities. It has been executing effectively through a painful period for its industry and with access to capital becoming an issue for leveraged energy businesses, the company is operating within its own internal cash flow generation.

Shares of residential mortgage insurer Genworth MI Canada often move with the direction of energy prices, and ongoing concerns about mortgage losses in energy-dominated western Canada continued to push its price down. Ever contrarian, we suspect the bulk of those losses have already been reflected in the stock price. It was our eleventh-largest holding at year-end.

In addition to those factors already mentioned, stock selection in Information Technology and Financials, as well as a substantial underweight in banks, hurt relative performance in 2015. Health Care was the top-performing small-cap sector in 2015, but with many health-related companies having no earnings, the sector was not a significant area of investment for the portfolio.

Materials was a strength relative to the benchmark—mostly due to effective stock selection—as was Consumer Staples, though its advantage was far more modest.


Top Contributors to Performance
For 2015 (%)1

Fabrinet 0.84
Steven Madden 0.50
Convergys Corporation 0.36
Miller Industries 0.26
Synaptics 0.26
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Unit Corporation -1.26
The Buckle -1.18
Genworth MI Canada -1.11
Saia -1.00
Deckers Outdoor 

-0.90

2 Net of dividends

Current Positioning and Outlook

Early in 2016, both the economic and equity fronts looked even more uncertain than usual, especially when the increasingly troubled junk bond market and geopolitical risks were factored in. However, this pessimism about the near term makes us more confident in the long term. Until recently (as well as during the fall of 2015) the general state of small-cap valuations did not look very attractive. The recent contractions in share values, however, have created some potentially promising opportunities.

It also appears that the “leverage is good” era has come to a close, which we believe should benefit the kind of conservatively capitalized, free-cash-flow-generating companies that we seek for the portfolio. As we wait for many underperforming holdings to turn around, we maintained a significant overweight in Consumer Discretionary at the end of 2015, as we did in Information Technology and Industrials—two sectors where the portfolio was diversified across a number of industries at the end of the year.

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

QTR* 1 YR 3 YR 5 YR 10 YR 15 YR SINCE INCEPT. DATE
Capital Small-Cap -3.22 0.95 14.05 12.73 7.75 10.89 11.51 12/27/96
Russell 2000 0.42 6.49 17.81 17.08 8.40 7.50 8.40 N/A
Annual Operating Expenses: 1.05%

* 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 RCS'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 and other expenses. 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, The Buckle was 2.9% of the Fund’s net assets, DSW was 3.0%, Dillard’s was 1.8%, Deckers Outdoor was 2.1%, Unit Corporation 1.2%, and Genworth MI Canada was 2.8%.

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 small- cap and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. In addition, as of 6/30/15 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund’s overall value to decline to a greater degree.(Please see "Primary Risks for Fund Investors" in the prospectus.) 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 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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