article 12-31-2016

Royce Capital Fund–Micro-Cap Portfolio Manager Commentary

Lead Portfolio Manager Jim Stoeffel and Portfolio Manager Brendan Hartman see pockets of value in Health Care, and continue to find some pockets of value in Information Technology and Industrials. They view them as areas that have selective potential to benefit from the relative strength of the U.S. economy. 


Fund Performance

Royce Capital Fund–Micro-Cap Portfolio gained 19.7% in 2016, a strong absolute result that nonetheless fell short of both its benchmark, the Russell Microcap Index, which was up 20.4%, and the small-cap Russell 2000 Index, which advanced 21.3% for the same period.

This disappointing relative result notwithstanding, we were encouraged by other developments in 2016. In particular, there were three reversals that we think should continue to bode well for micro-cap stocks and active management in that space: Both the Russell Microcap and Russell 2000 turned around 2015's negative results, value outperformed growth, and cyclicals beat defensives.

During the first half of 2016, the Fund was up 0.1%, outperforming its micro-cap benchmark, the Russell Microcap, which was down 1.7%, while trailing the small-cap index, which rose 2.2% for the same period. The Fund advanced 8.1% in the third quarter compared to respective gains of 11.2% and 9.0% for the micro-cap and small-cap indexes. The fourth quarter saw a robust, post-election rally and the Fund rose 10.6% versus 10.0% for the Russell Microcap and 8.8% for the Russell 2000. The Fund's average annual total return since inception was 10.2%.

What Worked... And What Didn't

Of the Fund's 11 equity sectors, 10 made contributions to performance in 2016. Industrials and Information Technology, its two largest sectors at year-end, also made by far the biggest positive impact.

Financials and Consumer Discretionary made smaller but still notable contributions while Health Care detracted. Three industries made substantial contributions: electronic equipment, instruments & components, semiconductors & semiconductor equipment (both from Information Technology), and machinery (Industrials). Software (Information Technology), pharmaceuticals (Health Care), and distributors (Consumer Discretionary) detracted most, though far less meaningfully, on the industry level.

We were net sellers across the board in the face of the strong postelection rally, as we believe valuations have become extended on our 2017 estimates. We continue to find some pockets of value in Health Care, as well as in Information Technology and Industrials, viewing them as areas that have selective potential to benefit from the relative strength of the U.S. economy.

The Fund's top-contributing holding was PDF Solutions, which provides test chips that allow semiconductor companies to rapidly improve initial yields on new designs. Yield improvements are critical drivers of financial results for integrated circuit companies, so a unique gain-sharing model shows PDF's importance to its customers. While we reduced our stake in 2016, we held some shares as the increasing complexity of semiconductor design makes PDF's opportunity look somewhat open ended.

Direxion Small Cap Bull 3X Shares is a micro-cap ETF that we utilized on a temporary basis to manage a larger-than-normal cash flow during the second half of the year. DTS specializes in digital surround sound formats used for both commercial/theatrical and consumer grade applications. Its acquisition at an attractive premium was announced in September.

As for detractors, our view of SeaChange International remained intact, though we trimmed our stake in the second half. The company provides video-on-demand software to cable television and telecommunications operators. Its efforts to offer a similar turnkey video solution to over the- top video providers such as Netflix are proving to be a longer-term project than we had originally anticipated and which also resulted in an unexpected CEO change. However, we like its inexpensive valuation and long-term prospects for success.

Dynavax Technologies is a specialty pharmaceutical company whose lead product is a Hepatitis-B vaccine that has been shown to be more effective than currently marketed versions. FDA approval remains uncertain, however, so we have been selling our position, unsure about how long the company's strong balance sheet can sustain operating losses as it develops other drugs.

On a relative basis in 2016, the Fund was hurt most by both its underweight and poor stock selection in Financials, a source of strength for micro-caps in 2016, especially for banks. Stock picking and, to a lesser extent, our underweight detracted in Real Estate while the Fund's cash position was also a drag on results. Conversely, our underweight in the underperforming Health Care sector provided a sizable relative advantage, as did savvy stock picking in Information Technology and, to a lesser degree, our overweight in Industrials.

Top Contributors to Performance
For 2016 (%)1

PDF Solutions 0.74
Direxion Daily Small Cap Bull 3X Shares 0.68
DTS 0.67
Capella Education 0.62
Olympic Steel 0.55
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

SeaChange International  -0.66
Dynavax Technologies -0.50
Avinger -0.45
Rubicon Project -0.45
BioDelivery Sciences International


2 Net of dividends

Current Positioning and Outlook

We were net sellers across the board in the face of the strong postelection rally, as we believe valuations have become extended on our 2017 estimates. While the reduction in position sizes was generally broad based, Health Care, saw the biggest weighting decline in the portfolio.

We continue to find some pockets of value in that sector, as well as in Information Technology and Industrials. We view them as areas that have selective potential to benefit from the relative strength of the U.S. economy. Consumer companies remain among the most intriguing from a valuation perspective, but fundamentals continue to surprise on the downside, so we are proceeding even more cautiously than usual. Health Care remains a large underweight, mostly rooted in our significantly lower exposure to biotechnology stocks, where valuations look stretched relative to our price-sensitive discipline.

However, the sector failed to participate in the year-end rally and so we are beginning to see some areas in medical technology where valuations are becoming more reasonable to us. This could provide a source of new ideas in 2017.

Average Annual Total Returns (%) as of 12/31/16

Capital Micro-Cap 10.59 19.71 0.35 5.64 3.43 10.19 10.19 12/27/96
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 8.29 N/A
Russell Microcap 10.05 20.37 5.77 15.59 5.47 N/A N/A N/A
Annual Operating Expenses: 1.33%

* Not Annualized

Important Performance and Expense Information

All performance information 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 month-end performance may be higher or lower than performance quoted and may be obtained at The Fund's total returns do not reflect any deduction for charges or expenses of the variable contracts investing in the Fund. 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.

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

Important Performance and Disclosure Information

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, 2016, 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, 2016 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. 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 2016.

As of 12/31/16, PDF Solutions was 0.6% of the Fund's net assets, Direxion Small Cap Bull 3X Shares was 0.0%, DTS was 0.0%, Capella Education was 0.7%, Olympic Steel was 0.0%, SeaChange International was 0.3%, Dynavax Technologies was 0.1%, Avinger was 0.0%, Rubicon Project was 0.5%, and BioDelivery Sciences International was 0.1%.

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. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (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 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 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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