Royce Micro-Cap Opportunity Fund Manager Commentary
article 02-14-2019

Royce Micro-Cap Opportunity Fund Manager Commentary

We used the correction to be diligent and discriminating buyers, leaving us pleased with how we’ve positioned the portfolio with our deep value approach.

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Fund Performance

Royce Micro-Cap Opportunity Fund was down 14.0% in 2018 compared to a decline of 13.1% for its benchmark, the Russell Microcap Index, for the same period. The Fund did, however, lose less than its index in the steep fourth-quarter downturn, -20.0% versus -22.1%. In addition, we were pleased to see that our consistent and time-tested deep value strategy allowed the Fund to outpace the index for the three-year period ended December 31, 2018.

What Worked… And What Didn’t

We have invested most heavily over the last few years in cyclical areas, including homebuilding, infrastructure, semiconductors, and manufacturing materials. The bulk of our holdings in these areas, particularly in the industrial space, were executing very effectively early in 2018, with many reporting earnings strength consistent with the fast pace of U.S. economic growth. In fact, energy was the one end market awaiting a rebound for many of these businesses. By late summer, however, tariffs, trade war worries and falling oil prices coincided to raise suspicions that these cyclical businesses would be unable to maintain their strengths. A slowing global economy only served to exacerbate these fears. So while a number of our companies continued to report attractive results, investors grew, if anything, increasingly unconvinced, as evidenced by the dramatic decline that shook the markets in 2018’s fourth quarter.

Unsurprisingly, then, Consumer Discretionary, Industrials, Materials, and Energy detracted most in 2018, followed by net losses for five other sectors, including its largest, Information Technology. The only portfolio sector to finish 2018 in the black was Health Care. Household durables (Consumer Discretionary) was the largest detractor at the industry level, followed by semiconductors & semiconductor equipment (Information Technology) and machinery (Industrials). The biggest positive contributors were biotechnology (Health Care), which had a nicely outsized effect, and two groups from the broad and diverse tech sector, software and electronic equipment, instruments & components. Forterra, which makes water and drainage pipes, stormwater filtration products, and specialty precast products, detracted most at the position level, as rising costs in its water businesses dampened earnings and outweighed the effects of ongoing strong demand for its services—demand that we think should help it to turn around. New Home was the second-largest detractor in the Fund and the biggest in household durables. The company builds and sells homes in California, where higher home prices and interest rates discouraged customers, which pushed earnings and revenues lower in 2018.


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The portfolio’s top contributor at the position level was CareDx, which specializes in diagnostic testing for transplant recipients. A top-10 position at the end of December, its success extended throughout 2018, as it continued to benefit from the favorable resolution of reimbursement issues and stayed well ahead of the competitors in its niche. Its stock also bucked the downward trend by finishing strong as the company made good on its goal of achieving positive adjusted earnings ahead of schedule in the third quarter.

Relative to the Russell Microcap, stock selection and was the largest contributor versus the index. The biggest relative advantage came from significant stock selection advantages in Health Care and Information Technology. The portfolio’s cash position also benefited the Fund versus the Russell Microcap in 2018. The largest negative impact versus the micro-cap benchmark came from both stock picking miscues and our overweight in Materials while stock selection hurt in Consumer Staples, Energy, and Consumer Discretionary.


Top Contributors to Performance

1 Includes dividends

Top Detractors from Performance

2 Net of dividends

We are guardedly optimistic about the ongoing health of the U.S. economy and the potentially positive effect that this could have on cyclical industries going forward, especially with stock prices falling to such low levels in December. A slower pace of U.S. growth is very different from a recession. To us, a slower growth rate following peak levels is also part of the typical ebb and flow of any healthy economic cycle. So while headwinds are undoubtedly present in the form of tariffs, anemic global growth, contracting liquidity, and the risk of recession, we have enough positive information from companies and on the industry level to indicate that slower growth seems more likely in 2019 than recession. Micro-cap stocks generally looked relatively inexpensive at the end of 2018, but we are focused as much on potential drivers of growth as we are on price. As such, we have been diligent and discriminating buyers, looking for what we see as the most promising combination of attractively low valuations and potential earnings growth, especially for companies that the market seems to have all but abandoned. This has led us to investments in businesses involved in areas such as infrastructure, housing, healthcare services, and select areas within the industrial and technology spaces.

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

QTR1 YTD1 1YR 3YR 5YR SINCE INCEPT. DATE
-19.96-14.01-14.0110.001.2310.14 01/01/01

Annual Operating Expenses: Gross 1.32 Net 1.24

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. 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. Gross operating expenses reflect the Fund's total gross annual operating expenses and 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 Funds 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 1.24% 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: CareDx was 2.2%, Electro Scientific Industries was 0.0%, eGain Corporation was 1.1%, SeaSpine Holdings was 1.8%, Ameresco Cl. A was 3.4%, Forterra was 1.9%, New Home was 2.2%, Basic Energy Services was 0.0%, Celadon Group was 0.0%, Intrepid Potash was 2.3%


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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