Royce Micro-Cap Fund Manager Commentary
article 12-31-2016

Royce Micro-Cap Fund Manager Commentary

Lead Portfolio Manager Jim Stoeffel and Portfolio Manager Brendan Hartman were net sellers across the board in the face of the strong postelection rally, as they believe valuations have become extended based on their 2017 estimates. They 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.

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Fund Performance

Royce Micro-Cap Fund gained 19.7% in 2016, a strong absolute result that nonetheless fell short of both its benchmark, the Russell Microcap Index, which rose 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 the Fund, microcap and small-cap stocks, and active management: 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 down 0.7%, ahead of its micro-cap benchmark, the Russell Microcap, which lost 1.7%, while trailing the small-cap index, which rose 2.2% for the same period. The Fund advanced 9.0% in the third quarter compared to respective gains of 11.2% and 9.0% for the micro-cap and small-cap indexes.

The Fund gained 10.7% in the fourth quarter versus 10.0% for the Russell Microcap and 8.8% for the Russell 2000. The Fund was ahead of the Russell 2000 for the 20-, 25-year and since inception (12/31/91) periods ended December 31, 2016. (Data for the Russell Microcap only goes back to June 30, 2000.) The Fund's average annual total return since inception was 11.1%.

What Worked... And What Didn't

Of the Fund's 11 equity sectors, 10 made net contributions to performance in 2016. Industrials and Information Technology, its two largest sectors at year-end, made by far the biggest positive impact while Financials and Consumer Discretionary made smaller but still notable contributions. Health Care—the only sector within the Russell Microcap with a negative return in 2016—detracted.

Three industries made substantial contributions: electronic equipment, instruments & components, semiconductors & semiconductor equipment (both from Information Technology), and machinery (Industrials). Software (Information Technology), pharmaceuticals, and biotechnology (both from Health Care) 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 based on our 2017 estimates. We continue to find some pockets of value in Health Care, 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.

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.

Hudson Technologies sells refrigerants and provides related services. It benefited in 2016 from improved pricing associated with the legislatively mandated phase out of R-22 refrigerants, which we expect to drive a significant increase in profitability. An unexpected Department of Defense distribution contract associated with a small tuck-in acquisition from a prior year also helped. We reduced our position as its price rose, though we held some shares as we believe we are still in the early stages of price gains associated with the R-22 phase out.

As for detractors, our view of SeaChange International remained intact. 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.

Medical device maker Avinger developed an image-guided, catheter-based system to treat peripheral artery disease. While its long-term promise remains significant, the roll-out has been beset by execution problems and slower-than-expected adoption. Concerns about the company’s liquidity as it was running through cash led us to sell our position.

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 in banks. Stock picking and, to a lesser extent, our underweight also detracted in Real Estate. Conversely, our underweight in the underperforming Health Care.


Top Contributors to Performance
Through 2016 (%)1

PDF Solutions 0.77
Hudson Technologies 0.77
DTS 0.75
Capella Education 0.63
CryoLife 0.61
1 Includes dividends

Top Detractors from Performance
Through 2016 (%)2

SeaChange International -0.68
Avinger -0.52
Dynavax Technologies -0.52
Rubicon Project -0.52
Ardmore Shipping -0.48
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 based on our 2017 estimates. Health Care saw the biggest weighting decline in the portfolio, though 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. Valuations in some areas of medical technology were looking more reasonable to us. This could provide a source of new ideas in 2017.

Average Annual Total Returns Through 12/31/16 (%)

  QTR 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Micro-Cap 10.66 19.74 -0.16 5.45 3.91 9.40 11.05 12/31/91
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 9.69 N/A
Russell Microcap 10.05 20.37 5.77 15.59 5.47 N/A N/A N/A
Annual Operating Expenses: 1.50%

* 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. 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 at www.roycefunds.com. 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 expense. 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, Hudson Technologies was 0.7%, DTS was 0.0%, Capella Education was 0.7%, CryoLife was 0.7%, SeaChange International was 0.3%, Avinger was 0.0%, Dynavax Technologies was 0.1%, Rubicon Project was 0.6%, and Ardmore Shipping was 0.8%. 

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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