Royce Capital Fund-Small-Cap Portfolio Manager Commentary
article 12-31-2017

Royce Capital Fund–Small-Cap Portfolio Manager Commentary

Our hope is that the Fund's outperformance in 2017's final quarter was a sign of a more discerning environment where investors pay more attention to quality.

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Fund Performance

In a challenging year for value stocks, Royce Capital Fund–Small-Cap Portfolio rose 5.4%, trailing the 14.6% advance for its small-cap benchmark, the Russell 2000 Index. This was a disappointing result, even in a year when our contrarian value approach was decidedly out of favor and investors showed a marked preference for growth stocks and companies without earnings. There was, however, a potentially very significant reversal in the year’s fourth quarter: small-cap companies with earnings enjoyed higher returns than those without. It remains an open question, of course, if this was a temporary shift or a sign of a more discerning environment.

What Worked… and What Didn’t

Six of the Fund’s nine equity sectors made positive contributions to performance in 2017. Industrials and Financials made the largest positive impacts, followed by Information Technology, while Consumer Discretionary, Energy, and Consumer Staples detracted.

Four industries made outsized contributions to calendar-year performance—capital markets (Financials), professional services, machinery (both in Industrials), and thrifts & mortgage finance (Financials)—while the biggest detractors were specialty retail (Consumer Discretionary), which led by a wide margin, energy equipment & services (Energy), technology hardware, storage & peripherals (Information Technology), and food & staples retailing (Consumer Staples).

Relative to the benchmark, 2017 performance was hurt most by ineffective stock selection in Consumer Discretionary, where the specialty retail group had the biggest negative impact. Similar issues with stock selection affected Information Technology, where holdings in the electronic equipment, instruments & components underperformed.

In addition, the portfolio’s limited exposure to Health Care had an adverse effect as the Fund had no holdings in growth stalwarts biotechnology, a leading industry in the small-cap index in 2017. Helping relative results most in 2017 was savvy stock selection in Financials, with strength again coming from capital markets and thrifts & mortgage finance, as well as from insurance.

The Fund’s underweight in Real Estate—and a strong result from Marcus & Millichap, which provides investment brokerage and financing services for commercial real estate—were additional positives versus the benchmark, as were our overweight and effective stock picking in Industrials.

The Fund’s top contributor in 2017 was kitchen cabinet and vanity manufacturer American Woodmark. Its stock was doing well before the early December announcement that it was acquiring RSI Home Products, a profitable manufacturer of kitchen and bath cabinetry and home storage products. The market quickly decided that this was an accretive purchase, which sent its shares climbing even higher.

Genworth MI Canada provides private residential mortgage insurance north of the border. Its shares benefited from losses that came in well below expectations and related overall business strength.

Moelis & Company, an investment bank specializing in mergers & acquisitions, had robust business through much of the year. Executive search specialist Korn/Ferry International drew benefits from the acceleration of its recruitment business and the successful integration of its acquisition of Hay Group.

We parted ways with each of the portfolio’s top-five detractors, four of which came from the specialty retail industry. Hibbett Sports, Genesco, The Cato Corporation, and Kirkland’s all face ongoing struggles with the secular shift in consumer spending and shopping habits, along with the ensuing margin contraction, that have been created to a large degree by the omnipresence of Amazon.

Matrix Service is a contractor to the energy, power, and industrial markets that had to deal with ongoing delays in new project awards and starts, depressed maintenance spending, and increased cost estimates on an electrical infrastructure project, a long string of disappointments that exhausted our patience.


Top Contributors to Performance 20171 (%)

American Woodmark1.12
Genworth MI Canada1.08
Moelis & Company Cl. A0.86
Korn/Ferry International0.79
Vishay Intertechnology0.66

1 Includes dividends

Top Detractors from Performance 20172 (%)

Matrix Service-1.22
Hibbett Sports-0.94
Genesco-0.67
Cato Corporation (The) Cl. A-0.60
Kirkland's-0.54

2 Net of dividends

Current Positioning and Outlook

Valuations continue to run higher than we think is healthy. Over the last two years, much has gone right for stocks versus a near-absence of bad news or negative developments. Equities are now enjoying a growing economy, and, while rates are rising, they are rising slowly and remain at the far low end of their historical range. The recent tax bill provides more good news.

As contrarians, we wonder what happens if something goes wrong. What happens if growth stumbles, the yield curve inverts, and/or the deficit balloons? The market has been in a ‘risk-on, can’t lose’ mode for so long, we think investors would have trouble adjusting to new adversities, creating the possibility of a downdraft.

So we remain cautious and have chosen to hold companies where operating risk appears low and fundamentals look strong, which helps to compensate for their high valuations, especially given that most of the stocks that screen for low valuation look cheap for very good reasons and thus do not appeal to us. Some exceptions to this include a few small-cap airlines and furniture makers, as well as individual situations in restaurants and insurance.

Average Annual Total Returns Through 12/31/17 (%)

QTR1 YTD1 1YR 3YR 5YR 10YR 15YR 20YR SINCE INCEPT. DATE
Capital Small-Cap 4.635.385.383.989.367.2810.3310.3510.70 12/27/96

Annual Operating Expenses: Gross 1.11 Net 1.08

1 Not annualized.

Important Performance, Expense, 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 www.roycefunds.com. 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 and other expenses.

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, 2017, 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, 2017 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 12/31/17, the percentage of Fund assets was as follows: American Woodmark was 1.0%, Genworth MI Canada was 2.6%, Moelis & Company Cl. A was 1.5%, Korn/Ferry International was 1.0%, Vishay Intertechnology was 2.3%, Matrix Service was 0.0%, Hibbett Sports was 0.0%, Genesco was 0.0%, Cato Corporation (The) Cl. A was 0.0%, Kirkland's was 0.0%.


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 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 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 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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