Royce Micro-Cap Opportunity Fund Manager Commentary
article 02-22-2016

Royce Micro-Cap Opportunity Fund Manager Commentary

It was a rough year for micro-cap stocks, but by the end of 2015 Portfolio Manager Bill Hench thought that valuations for the majority of his holdings looked attractive and seemed poised for recovery.


Fund Performance

Royce Micro-Cap Opportunity Fund was down 16.0%, lagging both its new benchmark, the Russell Microcap Index, which lost 5.2%, and its former yardstick, the small-cap Russell 2000 Index, which was down 4.4% for the same period. (We are using the Russell Microcap as the Fund's new benchmark because it better reflects the Fund’s selection universe, part of changes that became effective on May 1, 2015.)

For the year-to-date period ended June 30, 2015, the Fund gained 4.3% versus respective increases of 6.0% and 4.8% for the micro-cap and small-cap indexes. Returns for most equities reversed dramatically in the year’s third quarter, when Micro-Cap Opportunity fell 19.8% versus a loss of 13.8% for the Russell Microcap and a decline of 11.9% for the Russell 2000. For the fourth quarter the Fund was up 0.5% versus respective gains of 3.7% and 3.6% for the portfolio’s new and former benchmarks.

So while it was a difficult year, it was also a year in which we built a portfolio that we believed looked attractively cheap and poised for growth at the end of 2015. Measured by P/B and price-to-sales, valuations for companies in several industries looked good to us, and we remained bullish even in the midst of January 2016’s painful declines. For the period ended December 31, 2015, Micro-Cap Opportunity Fund's average annual total return since inception (8/31/10) was 10.2%.

The Fund's name change became effective on May 1, 2015 when it also began to operate under a new non-fundamental investment policy requiring 80% of its assets to be invested in stocks with market caps up to $1 billion. The Fund is being run closely to the way in which it has been since its inception, investing primarily in a limited number (generally less than 100) of mostly micro-cap stocks.

What Worked... And What Didn't

Eight of the Fund's nine equity sectors finished the year in negative territory. Consumer Discretionary was the clear loss leader, though Industrials and Energy also posted detracted notably. At the industry level, three groups were significantly in the red—electrical equipment (from Industrials), health care equipment & supplies, and specialty retail.

The Fund's largest net loss at the position level came from Power Solutions International, which makes environmentally friendly natural gas engines. Exposure to the energy markets was the major factor in its share-price slump, which was also affected by reduced full year guidance announced in November. Confident in its growth prospects, we built our position through much of the year.

Earnings growth for surf-and-skate apparel retailer Zumiez trended in the wrong direction in 2015, which led us to begin selling our shares. Exar Corporation, with which we've enjoyed success in the past, saw its stock price fall when a rumored acquisition did not happen. Shares fell further when its CEO departed. We chose to sell our stake in the fourth quarter.

Century Aluminum, which produces the metal, had to contend with significant commodity price weakness, exacerbated by China's decision to export its excess capacity. We sold our position in October.

"We expect the increased federal spending and business tax credit plans passed in anticipation of the 2016 elections to boost the pace of growth in the U.S., which should help areas such as nonresidential construction, defense, consumer, and technology."

Tangoe makes software that helps companies manage their fixed and mobile communications assets and costs, which in our view makes it a unique business that offers considerable value. We built a position throughout 2015.

We still liked the ongoing prospects for U.S. Concrete, which supplies concrete and related products to the construction industry throughout the country. We remain bullish on nonresidential construction, particularly in the Northeast. Although its rising stock price led us to take gains in 2015, it was the portfolio's fifteenth-largest holding at year-end.

We acted in a similar fashion with EarthLink Holdings. We like how the company has moved from providing general Internet services to focusing on more business-oriented activities. Initially seeing it as an asset play, we also liked its new management's plans to better focus the business and their ability to cut costs in a flat-growth environment. The company's steady march toward profitability attracted investors in 2015. We held shares in part because we think it possesses valuable assets that are likely to attract premium prices.

Builders FirstSource, which makes building products for homebuilders, acquired a private competitor and saw its shares rise, prompting us to take gains.

Relative to the Russell Microcap, the Fund suffered most from ineffective stock selection in Consumer Discretionary, a combination of our large underweight and ineffective stock selection in Health Care, and an underweight in Financials.

Conversely, we had relative advantages in Information Technology and, less impactfully, Materials. In each case, stock selection provided the edge.

Top Contributors to Performance
For 2015 (%)1

U.S. Concrete 1.33
EarthLink Holdings 1.20
Builders FirstSource 1.06
RTI International Metals 0.85
Applied Optoelectronics  0.60
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Power Solutions International  -2.26
Zumiez -1.19
Exar Corporation -0.98
Century Aluminum -0.87
Tangoe -0.85
2 Net of dividends

Current Positioning and Outlook

We remained significantly overweight in Information Technology, Industrials, and Consumer Discretionary at the end of 2015. This positioning is consistent with our view that valuations for the majority of our portfolio holdings look attractive to us and are poised to benefit from ongoing U.S. economic growth. We expect the increased federal spending and business tax credit plans passed in anticipation of the 2016 elections to boost the pace of growth in the U.S., which should help areas such as nonresidential construction, defense, consumer, and technology.

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

Micro-Cap Opportunity 0.51 -15.98 4.91 5.27 10.21 08/31/10
Russell Microcap 3.74 -5.16 12.70 9.23 14.70 N/A
Russell 2000 3.59 -4.41 11.65 9.19 14.18 N/A
Annual Operating Expenses: Gross 1.56% Net 1.28

* 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 1% 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 the Fund’s total gross annual operating expenses and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Funds most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, (excluding dividend and interest expenses relating to short sale activities, 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 1.24% through April 30, 2016 and at or below 1.99% through April 30, 2025. 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, Power Solutions International was 1.9% of the Fund’s net assets, Zumiez was 0.2%, Exar Corporation was 0.0%, Century Aluminum was 0.0%, Tangoe was 1.0%, U.S. Concrete was 1.6%, EarthLink Holdings was 0.9%, and Builders FirstSource was 0.3%.

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. The Fund 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 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 Microcap Index includes 1000 of the smallest securities in the small-cap Russell 2000 Index. The Russell 2000 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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