Royce International Micro-Cap Fund Manager Commentary
article 02-24-2016

Royce International Micro-Cap Fund Manager Commentary

Europe and Japan have seen underlying improvements in their respective economies, though growth has so far been modest. While these markets rallied in 2015, we still see a large number of mispriced opportunities in the micro-cap space.


Fund Performance

Royce International Micro-Cap Fund was down 1.0% in 2015, trailing its benchmark, the Russell ex-U.S. Global Small Cap Index, which was up 0.5% for the same period. For the year-to-date period ended June 30, 2015, the Fund advanced 7.5% while its benchmark gained 7.7%.

Stocks across the globe were then sent reeling in the sweeping correction during the third quarter, in which the Fund lost 10.7% versus a decline of 11.2% for the Russell ex-U.S. Global Small Cap. The Fund then gained 3.2% compared to a 5.1% increase for the non-U.S. small-cap index in the fourth quarter. We were pleased that the Fund outperformed its benchmark for the three-year period ended December 31, 2015. International Micro-Cap also celebrated five years of performance history at year-end.

What Worked... And What Didn't

On a sector basis, net gains and losses were split down the middle, with four making contributions and four detracting from calendar-year results. The most significant net gains came from Industrials and Financials while the largest net losses by far could be found in Information Technology.

There was a similar pattern on an industry group basis. Three posted notable contributions—textile, apparel & luxury goods, road & rail, and capital markets, while three areas showed good-sized net losses—electronic equipment, instruments & components, multiline retail, and metals & mining.

Two of the portfolio's top four detractors came from the Consumer Discretionary sector. Malaysia's Parkson Retail Asia has been hit by a slowdown in consumer spending in Southeast Asia and an expansion into Vietnam that encountered setbacks with local partners. Its shares were also hampered by political scandal and a slowdown in the Malaysian economy that further reduced consumer demand. Confident that the firm can bounce back, we continued to hold shares at year-end.

Brazil's T4F Entretenimento operates at all levels of the global entertainment industry, including venue operation, ticketing, food & beverage, merchandise sales, and corporate sponsorships. Its business continued to perform well in 2015, but as U.S. investors our position was compromised by ongoing weakness in the Brazilian real. It was the Fund's fourteenth-largest position at year-end.

Imdex is an Australian business that provides drilling fluids and down hole instrumentation to the mining, oil & gas, water well, and civil engineering industries worldwide. Continued weakness in the mining and oil industries has slowed demand for its equipment. Liking the way in which the company has worked on deleveraging its balance sheet, we think it's well positioned for any recovery and held a stake at the end of 2015.

We thought otherwise about SuperCom, which we exited in November as mounting skepticism about the company's growth prospects seemed to come to a head when the CFO departed, leading to a steep decline in its stock. Based in Israel, the company makes electronic identity solutions including electronic monitoring, identification, and security products.

"Europe and Japan have seen underlying improvements in their respective economies, though growth has so far been modest. While these markets rallied in 2015, we still see a large number of mispriced opportunities in the micro-cap space."

Ireland's Trinity Biotech was caught up in the sell-off with the rest of the biotech sector in the third quarter. However, we like its product pipeline, so we held a large stake in the company, which provides products for the point-of-care, self-testing, and clinical laboratory segments of the diagnostic market.

There were notable successes as well. Headquartered in Japan, TRANCOM offers distribution information, logistic management service, freight transportation, and system development services. The company continues to gain market share as a growing number of customers are outsourcing their transportation needs. Taiwan PAIHO saw strong growth in demand for sports apparel and shoes translate into strong demand for its fasteners.

On a relative basis, the Fund suffered from ineffective stock selection in the Information Technology and, to a lesser degree, Consumer Discretionary sectors. Conversely, we benefited from successful stock selection in Financials and Industrials.

Top Contributors to Performance
For 2015 (%)1

Trancom 0.87
Taiwan Paiho 0.81
GFT Technologies 0.62
Pantheon Resources plc 0.53
Relo Holdings 0.51
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Parkson Retail Asia -0.75
Imdex -0.69
SuperCom -0.46
T4F Entretenimento -0.39
Trinity Biotech ADR Cl. A -0.34
2 Net of dividends

Current Positioning and Outlook

Europe and Japan have seen underlying improvements in their respective economies, though growth has so far been modest. While these markets rallied in 2015, we still see a large number of mispriced opportunities in the micro-cap space. Canadian stocks sold off dramatically in 2015, which was largely the result of the steep decline in oil prices, though it did not spare our related holdings in technology, manufacturing, and services.

Along with plummeting share prices, the greatly weakened Canadian dollar has presented what we see as a large number of opportunities. The overall environment in developing markets remains challenging as growth rates in these countries have cooled considerably. While there may be a little bit more downside in these markets, we think they should recover nicely once they bottom, as they have done historically.

Canada, Germany, and Hong Kong were the portfolio's largest overweights by country at year-end, though Japan accounted for the largest percentage of net assets. On a sector basis, we had greater exposure to Consumer Discretionary and Information Technology (the Fund's two largest sectors) with comparable exposure to Industrials. We were also underweight Financials, Health Care, Materials, Consumer Staples, and Energy at year-end.

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

International Micro-Cap 3.17 -0.99 4.76 0.50 12/31/2010
Russell Global ex-U.S. Small Cap 5.11 0.50 4.32 1.87 N/A
Annual Operating Expenses: Gross 3.47% Net 1.65%

* 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. Shares redeemed within 30 days of purchase may be subject to a 2% redemption fee payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Gross operating expenses reflect total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund's most current prospectus. Royce & Associates has contractually agreed to waive its fees and/or reimburse operating expenses, to the extent necessary to maintain the Fund’s net annual operating expenses, (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business), at or below 1.64% through April 30, 2016 and at or below 1.99% through April 30, 2025. 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, Parkson Retail Asia was 0.4% of the Fund's net assets, T4F Entretenimento was 1.0%, Imdex was 0.3%, SuperCom was 0.0%, Trinity Biotech was 1.0%, TRANCOM was 1.4%, and Taiwan PAIHO was 0.8%.

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 may invest a significant portion of its assets in foreign companies which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also generally invests 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 one 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.) 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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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