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

Royce Micro-Cap Opportunity Fund Manager Commentary

Lead Portfolio Manager Bill Hench and Portfolio Manager Buzz Zaino anticipate headwinds to start 2017 and tailwinds in its second half. A list of the former would include higher interest rates and uncertainty around federal spending. As for tailwinds, there is the momentum of business improvement since the election and pent-up demand from the inhibited environment of the six months prior to it.

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Fund Performance

Royce Micro-Cap Opportunity Fund gained 23.8% in 2016, well ahead of the Russell Microcap Index, which was up 20.4% for the same period. This was largely due to the fact that 2016 was particularly favorable to the kind of inexpensive micro-cap stocks that we focus on, as measured by our primary metrics, companies with low P/B (price-to-book) and P/S (price to sales) ratios. Effective stock selection, of course, also played a significant role.

The Fund outperformed the Russell Microcap in 2016’s first half, advancing 3.2% versus a decline of 1.7% for the benchmark. This advantage grew in the third quarter, when Micro-Cap Opportunity handily outpaced the micro-cap index, up 13.9% versus 11.2%. The post-election rally that boosted many small- and micro-cap returns saw the Fund actually lose some ground on a relative basis as it gained 5.4% in the fourth quarter while the benchmark gained 10.0%.

For the year as a whole, we were pleased to see the Fund participate fully in a period that saw value retake leadership from growth and cyclical stocks outpace defensive areas. We were also happy with Micro-Cap Opportunity's longer-term absolute returns. The Fund's average annual total return since inception (8/31/10) was 12.3%.

What Worked... And What Didn't

Seven of the portfolio's 10 equity sectors contributed to 2016’s return. Information Technology led by a sizable margin while meaningful contributions also came from Industrials, Consumer Discretionary, and Financials. Telecommunication Services and Energy detracted modestly, Health Care more so.

As is typically the case in a good year, most of the portfolio’s successes in 2016 resulted from opportunities we pursued in 2015 or earlier, when valuations looked attractively low and the potential for earnings recovery was promising. As is always the case, we were prepared to wait for improvements, usually in the form of earnings recovery, to take effect.

The top industries by contribution were semiconductors & semiconductor equipment, electronic equipment, instruments & components (both from Information Technology), and aerospace & defense (Industrials). Those industries that detracted most— health care equipment & supplies, biotechnology (both from Health Care), and electrical equipment (Industrials)—had far less impact.

As is typically the case in a good year, most of the portfolio's successes in 2016 resulted from opportunities we pursued in 2015 or earlier, when valuations looked attractively low and the potential for earnings recovery was promising. As is always the case, we were prepared to wait for improvements, usually in the form of earnings recovery, to take effect.

Top contributor Amber Road was also a top-10 holding at the end of 2016. A software company with a compelling niche, it develops single platforms to automate and streamline global trade, offering import and export, global logistics, and trade agreement management solutions. We first bought shares in 2014 on the understanding that its turnaround would take time and patience. Throughout 2016, investors anticipated a growing client base for the firm, driving up the value of its shares.

Spartan Motors makes chassis for commercial vehicles. We always thought of it as a terrific manufacturer in a very solid niche. The company had high revenues but tended to generate low profits. When the current CEO joined the firm in 2014, he began to revamp the management team, bringing people in who were committed to improving the company’s operational efficiency. We liked his plan and built a large position in the stock. The new team's efforts came to fruition as earnings and margins began to improve.

Even a good year has its share of disappointments. Power Solutions International manufactures low-emission engines for off-highway industrial equipment that run primarily on natural gas and propane. We thought its exposure to several different end markets would help it to turn around, but downward revisions to earnings and accounting issues, which we think can be resolved fairly easily, have stalled its progress. With the energy industry recovering, however, we were optimistic about its long-term potential and built our stake in 2016.

We did the same with CareDx, which specializes in diagnostic testing for transplant recipients. After receiving an unfavorable reimbursement ruling from the Centers for Medicare & Medicaid Services in September, its stock tumbled, failing to get back to health even when the reimbursement ruling was rescinded in November. We estimated the value of its technology to be in excess of its market cap at the end of 2016.

The Fund enjoyed its most significant relative advantage in 2016 with stock selection in the Information Technology sector while our lower exposure to Health Care, which corrected through much of 2016, was also a strength. Relative detractors were far less impactful and included an underweight in Financials, poor stock picking in Materials, an underweight in Real Estate, and our cash position.


Top Contributors to Performance
For 2016 (%)1

Amber Road 2.11
Spartan Motors 1.82
PCM 1.65
KEMET Corporation 1.64
KEYW Holding Corporation 1.35
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Power Solutions International -1.25
CareDx -1.07
Accuray -0.76
Civitas Solutions -0.73
SunEdison -0.71
2 Net of dividends

Current Positioning and Outlook

We anticipate headwinds to start 2017 and tailwinds in its second half. A list of the former would include higher interest rates and uncertainty around federal spending. As for tailwinds, there is the momentum of business improvement since the election and pent-up demand from the inhibited environment of the six months prior to it. In addition, employment is strong, and consumer balance sheets are in better shape.

Finally, expansionary fiscal policy should ultimately be implemented at a reasonable pace assuming spending is restrained so as not to balloon the federal deficit. The performance of micro- and small-cap stocks depends on a growing economy and higher earnings. We have focused the portfolio on areas such as on-residential construction, industrial stocks, and technology companies. We are emphasizing turnaround situations that we think are most likely to benefit from a stronger economy.

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

  QTR 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Micro-Cap Opportunity 5.40 23.85 -0.37 14.09 N/A N/A 12.26 08/31/10
Russell Microcap 10.05 20.37 5.77 15.59 5.47 N/A 15.57 N/A
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 15.28 N/A
Annual Operating Expenses: Gross 1.39% Net 1.25

* 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. Gross operating expenses reflect the Fund's total gross annual operating expenses and include management fees, dividends on securities sold short, 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 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 dividend and interest expenses relating to short sale activities, 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, 2015.

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, Amber Road was 1.8% of the Fund's net assets, Spartan Motors was 2.0%, PCM was 1.5%, KEMET Corporation was 2.1%, KEYW Holding Corporation was 1.4%, Power Solutions International was 1.2%, CareDx was 0.8%, Accuray was 1.1%, Civitas Solutions was 1.5%, and SunEdison was 0.0%. 

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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