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

Royce Capital Fund–Small-Cap Portfolio Manager Commentary

In the context of a down year, we were about as pleased as we could be with the Fund’s performance as it demonstrated better downside protection in 2018, leaving us confident in our holdings for 2019.

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Fund Performance

In the context of a down year, we were about as pleased as we could be with the performance for Royce Capital Fund–Small-Cap Portfolio. Demonstrating better downside protection, the Fund was down 8.3% in 2018 versus a loss of 11.0% for the Russell 2000 Index, its small-cap benchmark, for the same period.

What Worked… And What Didn’t

Six of the Fund’s 10 equity sectors finished 2018 in the red, with the largest negative impact coming from Financials, with Industrials following. These broad and diverse cyclical sectors were also the portfolio’s largest at year-end, along with Information Technology. Modest positive contributions could be found in Health Care, Consumer Staples, Real Estate, and Consumer Discretionary. Banks (Financials) detracted most at the industry level by a wide margin in 2018, followed by semiconductors & semiconductor equipment companies (Information Technology), capital markets, and thrifts & mortgage finance, the latter two also from Financials. We were overweight versus the benchmark in all three of these financial industries at the end of 2018. Our positive stance on banks—our largest exposure among Financials—is based on two factors: First is our belief that the long-term direction of interest rates is upward, with a steepening yield curve. Second, and at least equally important, is that the banks we hold are smaller, generally community-centered businesses that we chose because we saw attributes that go beyond overall improved conditions for the industry which should help them recover. They have some combination of a strong deposit franchise, impressive loan growth, and/or a strong geographic moat.

The electronic equipment, instruments & components (Information Technology) group was home to five of the portfolio’s top 20 contributors, including Electro Scientific Industries, which was acquired by MKS Instruments at a 100% premium, and contract manufacturer Fabrinet. However, this group was also home to the Fund’s biggest detractor at the position level, Methode Electronics, which has a global business in component manufacturing. The costs of an acquisition as well as a slowdown in its automotive end market helped to depress earnings. Wabash National is an industrial company that makes a variety of truck trailers. We like its core business and record of successful execution, but its earnings were adversely affected in 2018 by rising supply and labor costs as well as freight issues that made picking up trailers difficult for many customers. Hawaiian Holdings operates a regional airline in that state as well as on the West Coast and in the South Pacific. Weather-related scares and the prospect of increased competition helped to ground its stock, but we see the first issue as temporary and like the firm’s ability to successfully compete in its core geographic region.


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For the portfolio as a whole in 2018, stock selection was a greater factor in relative outperformance than allocation, though both contributed. Energy was by far the worst-performing sector in the Russell 2000 in 2018. It also provided the Fund with its largest advantage versus the benchmark, driven by a combination of having no exposure to its oil, gas & consumable fuels group and better stock picking in its energy equipment & services industry. Savvy stock selection in Consumer Discretionary provided another significant relative edge, most impactfully in specialty retail where Shoe Carnival and DSW led. Stock selection was also a strength in Industrials, most notably in machinery.

A stock selection disadvantage in Financials hurt relative performance most, the capital markets group disappointing in large part due to poor results for asset managers such as Federated Investors, a position we exited in the fourth quarter. The portfolio’s low exposure to Utilities also dampened relative returns. The sector is often seen as a relatively safe haven during challenging markets, and 2018 was no exception as it was the only Russell 2000 sector to finish the year in the black. Both ineffective stock picking and our lower weighting also led to a modest detraction in Communication Services.


Top Contributors to Performance 20181 (%)

Electro Scientific Industries1.61
Fabrinet1.09
Shoe Carnival0.67
DSW Cl. A0.51
Nutrisystem0.49

1 Includes dividends

Top Detractors from Performance 20182 (%)

Methode Electronics-0.92
Wabash National-0.83
Hawaiian Holdings-0.77
Cooper-Standard Holdings-0.73
Advanced Energy Industries-0.72

2 Net of dividends

Current Positioning And Outlook

Risks can be found throughout the economy and markets. Stocks continue to trade as if investors see an imminent recession; inflation is apparent in supply chains and labor costs, which threatens margin expansion; the anniversary of the tax cuts has arrived, which will slow earnings growth; and the Fed’s subsequent path is unclear, even in light of Chair Powell’s slightly more dovish tone in early January. Our own view is that a recession looks unlikely over the next several months—and may be even further out than that. In our view, growth does not appear ready to contract but rather continue to slow. Given the severity of the market’s decline, we believe this has created interesting valuations within the small-cap marketplace. Within the portfolio, we think the risk/return relationship looks more attractive than it has in some time. We have therefore been adding to those holdings where we see both good value and strong potential while also initiating positions where our analyses have uncovered the same combination among a diverse set of companies involved in aerospace & defense, trucking, investment management, banks, and technology.

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

QTR1 YTD1 1YR 3YR 5YR 10YR 15YR 20YR SINCE INCEPT. DATE
Capital Small-Cap -14.93-8.34-8.345.321.249.787.219.409.76 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. Gross operating expenses reflect the Fund's total gross operating expenses for the Investment Class and include 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 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 1.08% through April 30, 2019.

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: Electro Scientific Industries was 0.0%, Fabrinet was 0.5%, Shoe Carnival was 0.9%, DSW Cl. A was 1.0%, Nutrisystem was 0.0%, Methode Electronics was 0.8%, Wabash National was 1.5%, Hawaiian Holdings was 2.0%, Cooper-Standard Holdings was 1.6%, Advanced Energy Industries was 2.1%, Federated Investors 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 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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