Royce Micro-Cap Opportunity Fund Manager Commentary
article 02-12-2018

Royce Micro-Cap Opportunity Fund Manager Commentary

Strong absolute and relative performance helped the Fund to end the year well ahead of the Russell Microcap Index.


Fund Performance

A second consecutive year of strong absolute and relative performance helped Royce Micro-Cap Opportunity Fund to build a relative advantage over its benchmark, the Russell Microcap Index, for the one- and three-year periods ended December 31, 2017. The Fund gained 25.0% in 2017, well ahead of the Russell Microcap, which was up 13.2% for the same period.

Cyclical sectors such as Industrials, Information Technology, and Materials all did well even as they trailed Health Care, the strongest performer in the micro-cap index.

What Worked… and What Didn’t

The Information Technology sector made by far the biggest positive impact on the Fund’s calendar-year performance, leading a group of five equity sectors that finished the year in the black. Industrials and Materials also posted sizable contributions to performance. Along with Financials, these three were also the strongest sectors versus the Russell Microcap.

Those sectors that detracted—Energy, Real Estate, Telecommunication Services, Consumer Staples, and Consumer Discretionary—made only a slight collective negative impact to absolute results in 2017. Ineffective stock picks in Health Care had the biggest negative effect versus the benchmark, most impactfully in the health care providers & services group.

The Fund’s cash position also hurt relative results, as did very modest stock-picking disadvantages in Real Estate and Consumer Staples.

At the industry level, semiconductors & semiconductor equipment, electronic equipment, instruments & components (both from Information Technology), and chemicals (Materials) contributed most while detractors were comparably modest, led by two groups in Consumer Discretionary—textiles, apparel & luxury goods and specialty retail—and equity real estate investment trusts (Real Estate).

The global technology buildout that has been driving widespread innovation and development rolled on through the second half of the year. This led us to sell or trim several technology holdings, many clustered in the previously mentioned semiconductors & semiconductor equipment and electronic equipment, instruments & components groups. While we think demand is likely to remain robust, many holdings reached or exceeded our sell targets in 2017. We continue to watch these companies carefully, with especially close attention to product and valuation cycles.

Top contributor KEMET Corporation, a solid tantalum and multilayer ceramic capacitor manufacturer in the electronic equipment, instruments & components groups, is a great example of both the strength and consistency of this run for certain small- and micro-cap tech companies. In addition to its disproportionately strong performance in 2017, KEMET Corporation was the portfolio’s top contributor in 2016’s fourth quarter and in the first half of this year. We reduced our stake slowly and steadily into the fall.

CareDx, which specializes in diagnostic testing for transplant recipients, probably qualifies for the year’s most dramatic turnaround. One of the portfolio’s top detractors in the first half of the year, its stock benefited in the second half from the favorable resolution of reimbursement issues that had been hampering results.

The Fund’s largest detractor at the position level was cybersecurity specialist KEYW Holding Corporation. The firm’s current CEO came on board in 2015 and has most recently worked to position the company as a cybersecurity expert focused on government contracts, primarily by consolidating its businesses. At year-end, we were confident that these changes would ultimately improve results.

Of the four remaining positions that detracted most, each was a potential turnaround in which ongoing disappointments, along with additional stock price declines, led us to exit. Cherokee markets and licenses numerous lifestyle brand products. TravelCenters of America operates a network of hospitality and fuel service stops primarily along U.S. Interstates. Pengrowth Energy is a Canadian oil and gas business, and RAIT Financial Trust is an internally managed real estate investment trust that provides debt financing to commercial real estate owners.

Top Contributors to Performance 20171 (%)

KEMET Corporation2.69
Ichor Holdings1.38
Forterra, Inc.1.33
Nimble Storage1.29

1 Includes dividends

Top Detractors from Performance 20172 (%)

KEYW Holding Corporation-0.99
TravelCenters of America LLC-0.62
Pengrowth Energy-0.53
RAIT Financial Trust-0.46

2 Net of dividends

Current Positioning and Outlook

With the global economy accelerating and U.S. GDP rising, it’s possible that positive developments can keep lifting the market in the months ahead. However, there are also risks of inflation and rapidly rising deficits in addition to high equity valuations, rising rates, and a Fed that has already begun to taper. This last development could have the largest impact on stocks, as contracting liquidity crimps the funds available for investment. We are therefore measured in our optimism.

While reducing our exposure to technology stocks, we put proceeds to work via investments in industrial and commodity-based businesses in the expectation that global growth will continue to stoke demand. With the recovery of energy prices, nearly all industrial end markets were doing well by year-end. In addition, we hold many companies in cyclical areas where turnarounds were just getting underway or did not occur in 2017, which enhances our cautious optimism for select micro-cap stocks.

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

Micro-Cap Opportunity 4.6024.9924.999.1612.3213.91 08/31/10
Russell Microcap 1.8013.1713.178.9114.2915.24 N/A
Russell 2000 3.3414.6514.659.9614.1215.19 N/A

Annual Operating Expenses: Gross 1.30 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 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, 2018.

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: KEMET Corporation was 1.5%, CareDx was 2.6%, Ichor Holdings was 1.1%, Forterra, Inc. was 0.0%, Nimble Storage was 0.0%, KEYW Holding Corporation was 1.1%, Cherokee was 0.0%, TravelCenters of America LLC was 0.0%, Pengrowth Energy was 0.0%, RAIT Financial Trust 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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