Royce Capital Fund-Micro-Cap Portfolio Manager Commentary
article 02-14-2019

Royce Capital Fund–Micro-Cap Portfolio Manager Commentary

Our micro-cap fund held an advantage over its benchmark in 2018 thanks to losing less during the downturn that hit the markets from September through the end of the year.


Fund Performance

Royce Micro-Cap Fund held an advantage over its benchmarks for the calendar-year period, in large part due to losing less during the downturn that hit the markets from September through the end of the year. The Fund fell 9.0% in 2018 compared to the Russell Microcap and Russell 2000 Indexes, which fell 13.1% and 11.0%, respectively, for the same period.

What Worked… And What Didn’t

Six of the portfolio’s 10 equity sectors detracted from performance in 2018. Financials, Industrials, and Energy made the largest negative impacts while Health Care made the biggest positive contribution, followed by Information Technology, historically one of our heaviest weightings. We were pleased to see these contributions because accruing positive performance was no small feat during such a difficult year. In fact, most of the cyclical areas where we focus struggled in 2018, including machinery (Industrials), which was the portfolio’s top detractor at the industry level. This group was followed by energy equipment & services holdings (Energy), which were mostly hurt by plummeting oil prices, while holdings in capital markets (Financials) slumped because most of our positions are asset management companies, an industry that is often sensitive to market pullbacks.

Lydall, the Fund’s top-detracting position in 2018, is a machinery company that manufactures an assortment of specialized products with automotive and industrial applications. A multi-year restructuring effort in the company’s Thermal/Acoustical Solutions segment has been slow to generate positive returns, a problem exacerbated by slowing light vehicle sales. We built our position as we believe recent data points to a bottom for its margins while we remain cognizant of the risks inherent in its end market exposure. Ultra Clean Holdings provides gas panel subsystems to semiconductor equipment manufacturers. Its shares were hurt by the global slowdown in semiconductor equipment production. We added to our position as we believe the recent acquisition of Quantum Global, which provides ultra-purity cleaning solutions to the semiconductor equipment industry, can strengthen Ultra Clean’s already formidable competitive position.

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Health care equipment & supplies (Health Care) was the Fund’s top-contributing industry, with results driven by positive performance for five of our six holdings, including AtriCure, Tactile Systems Technology, and CryoLife. Positive results also came from electronic equipment, instruments & components (Information Technology), where Fabrinet and laser solutions company Electro Scientific Industries, which was acquired at a 100% premium, boosted performance. The Fund’s top contributor at the position level was Attunity, which makes database management software that addresses the increasing need for rapid access to data. Its shares benefited from the accelerating adoption of its products, which lifted enterprise sales. We trimmed our stake but maintained a position as we see its opportunity as relatively open ended in the intermediate term.

Relative to the Russell Microcap, stock selection drove calendar-year results while sector allocation detracted somewhat. The largest stock selection advantage came from Information Technology, where our holdings in electronic equipment, instruments & components, specifically Fabrinet and Electro Scientific Industries, did most to drive results. Stock picking in Health Care, Consumer Discretionary, and Industrials also boosted relative performance. In the first sector, health care equipment & supplies dominated. In Industrials, electrical equipment did best while auto components and household durables stood out in Consumer Discretionary. Financials was the largest detractor for the calendar-year period, mostly due to stock picking issues in the aforementioned capital markets group, where Westwood Holdings Group detracted most. Energy also had a negative relative effect, mostly due to poor stock selection in energy equipment & services. Smaller detractions came from Consumer Staples and Utilities.

Top Contributors to Performance 20181 (%)

American Superconducter0.68
Electro Scientific Industries0.54

1 Includes dividends

Top Detractors from Performance 20182 (%)

Ultra Clean Holdings-0.55
Paratek Pharmaceuticals-0.51
FreightCar America-0.47
Francesca's Holdings-0.43

2 Net of dividends

Current Positioning And Outlook

We used the sharp pullback to allocate capital from lower-conviction names into those in which we had greater confidence, including several in Information Technology, which saw several stocks particularly hard hit on concerns over slowing global growth, a trade war with China, tariff-related supply chain issues, and short-term oversupply in memory semiconductors. We believe all of the longer-term positive demand drivers in the technology sector, a long list that includes growing storage demand, increasing mobility, and connectedness encompassing the “Internet of Things,” remain intact and should benefit the industry’s high-quality micro-cap companies. We also maintained a sizable exposure to Consumer Discretionary. Health Care was one of our most underweighted sectors, although we began to add a few new ideas in the fourth quarter when valuations looked particularly attractive to us. These weightings are consistent with the portfolio’s historical emphasis on cyclical areas while also reflecting our confidence in the ongoing growth of the U.S. economy. We remain optimistic about the prospects for micro-cap stocks in this still-vibrant environment. Anticipating more robust growth in the U.S. relative to the rest of the globe, we stayed primarily focused on companies that derive most of their revenues from the U.S. economy.

Average Annual Total Returns Through 12/31/18 (%)

Capital Micro-Cap -19.72-9.04-9.044.63-0.678.554.948.689.01 12/27/96
Russell Microcap -22.14-13.08-13.085.793.0811.715.67N/AN/A N/A

Annual Operating Expenses: Gross 1.39 Net 1.33

1 Not annualized.

Important Performance and Disclosure Information

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. Gross operating expenses reflect the Fund's total gross operating expenses for the Investment Class and include include management 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, without right of termination, to waive fees and/or reimburse expenses to the extent necessary to maintain the Investment Class'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 1.33% through April 30, 2019. 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.

Notes to Performance and Other Important Information

The thoughts expressed in this report concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2018, 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, 2018 and are subject to change at any time without notice. There can be no assurance that securities mentioned in this report will be included in any Royce-managed portfolio in the future.

As of 12/31/18, the percentage of Fund assets was as follows: Attunity was 1.1%, American Superconducter was 1.1%, QuinStreet was 1.1%, Electro Scientific Industries was 0.0%, AtriCure was 1.1%, Lydall was 0.5%, Ultra Clean Holdings was 0.6%, Paratek Pharmaceuticals was 0.3%, FreightCar America was 0.4%, Francesca's Holdings was 0.0%, CryoLife was 1.0%, Fabrinet was 0.9%, Westwood Holdings Group was 0.6%

Sector weightings are determined using the Global Industry Classification Standard (“GICS”). GICS was developed by, and is the exclusive property of, Standard & Poor’s Financial Services LLC (“S&P”) and MSCI Inc. (“MSCI”). GICS is the trademark of S&P and MSCI. “Global Industry Classification Standard (GICS)” and “GICS Direct” are service marks of S&P and MSCI. 

All indexes referred to are unmanaged and capitalization weighted. Each index’s returns include net reinvested dividends and/or interest income. Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 Index is an 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 Russell 2000 Value and Growth Indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 1000 Index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. The Russell Microcap Index includes 1,000 of the smallest securities in the Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes approximately 800 of the smallest securities in the Russell 1000 Index. The Russell Global ex-U.S. Small Cap Index is an index of global small-cap stocks, excluding the United States. The Russell Global ex-U.S. Large Cap Index is an index of global large-cap stocks, excluding the United States. The Russell 2500 is an unmanaged, capitalization-weighted index of the 2,500 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. Returns for the market indexes used in this report were based on information supplied to Royce by Russell Investments. Royce has not independently verified the above described information.

This material contains forward-looking statements within the meaning of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve risks and uncertainties, including, among others, statements as to: 

-the Funds’ future operating results,

-the prospects of the Funds’ portfolio companies,

-the impact of investments that the Funds have made or may make, the dependence of the Funds’ future success on the general economy and its impact on the companies and industries in which the Funds invest, and

-the ability of the Funds’ portfolio companies to achieve their objectives.

This discussion uses words such as “anticipates,” “believes,” “expects,” “future,” “intends,” and similar expressions to identify forward-looking statements. Actual results may differ materially from those projected in the forward-looking statements for any reason.

The Royce Funds have based the forward-looking statements included in this commentary on information available to us on the date of the commentary, and we assume no obligation to update any such forward-looking statements. Although The Royce Funds undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events, or otherwise, you are advised to consult any additional disclosures that we may make through future shareholder communications or reports.

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.)



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