Royce Capital Fund-Micro-Cap Portfolio Manager Commentary
article 06-30-2018

Royce Capital Fund–Micro-Cap Portfolio Manager Commentary

The first half saw some inconsistency in relative results for micro-caps vis-à-vis their small-cap siblings.


Fund Performance

Royce Capital Fund–Micro Cap Portfolio increased 10.3% for the year-to-date period ended June 30, 2018, ahead of the small-cap Russell 2000 Index, which was up 7.7%, but narrowly behind its benchmark, the Russell Microcap Index, which increased 10.7% for the same period. Micro-cap stocks were the top-performing U.S. asset class in the first half of the year, as the greater reliance on U.S. growth left small- and micro-cap stocks better positioned for superior performance relative to large-caps in the first half of the year.

What Worked… And What Didn’t

The Fund boasted strong sector contributions from Information Technology, Health Care, and Consumer Discretionary, while two healthcare companies made strong positive impacts at the position level. Tactile Systems, which makes medical devices used to treat lymphedema, grew its sales force and introduced new products, such as its new system targeted at head and neck lymphedema. Seeing low market penetration and a favorable competitive environment, we continued to hold shares after making modest trims as its stock price rose. Medical device company Surmodics, which specializes in coronary stents and catheters, was another notable pick for the portfolio. A recent agreement gave Abbot Laboratories exclusive global commercialization rights for the company’s SurVeil drug. We saw an extended pipeline of interesting products and therefore maintained our position in the company’s shares.

We reduced our stake in Profire Energy, an oilfield technology specialist in burner management systems that was the portfolio’s top contributor overall. It benefited from the resurgence in oil field activity fueled by higher oil prices. We held our stock in Attunity, a leading provider of data management software, because we saw an increased adoption of its core software platform across an ever increasing number of enterprises. The company’s software addresses new paradigms in data management, which we believed were in the very early stages of adoption. Stoneridge, which supplies electrical components to cars and trucks, was winning new business across several product lines, such as its MirrorEye camera system that offers safety and fuel economy benefits by replacing side mirrors on trucks. We sold a portion of our shares as its share price rose steadily. We also saw positive contributions to return on these positions in relation to the Russell Microcap.

Thanks to effective stock selection, Consumer Discretionary and Information Technology were the areas that contributed most to performance versus the benchmark, while Energy and Financials were the largest detractors—both due to poor stock picking. One position significantly detracted from performance on both an absolute and relative basis: Basic Energy Services, a leading provider of well site services in the oil and gas industry, saw increased pricing pressure as well as project delays in certain markets. We increased our stake slightly within the first six months of the year based on the belief that these pressures were transitory given ongoing strength in underlying energy prices. Gulf Island Fabrication makes specialized structures and marine vessels used in the energy sector. Its shares have been pressured as its off-shore oil well platform business remained sluggish while it also experienced cost overruns on a major marine vessel contract.

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Atlas Financial, which provides insurance for taxis, limos, ride share services, and paratransit transportation firms, was another impactful detractor on an absolute and relative basis. For a second year in a row, Atlas recorded a surprise fourth-quarter loss due to an increase in loss reserves for prior year accidents. Our belief that the first surprise loss was an anomaly and that the company’s market niche could provide high returns on equity was proven incorrect. We sold all of our shares as a result. Shares of Paratek Pharmaceuticals fell due to concerns over incremental FDA approval scrutiny, the potential for a slow commercial ramp up, and a capital raise in April. We increased our position in the first half because of the large market opportunity for a new antibiotic associated with the increased human resistance to older varieties. We chose to trim our position in U.S. Concrete, which saw its shares pressured as poor weather impacted certain large markets and the company had some early execution shortfalls digesting a large acquisition.

Top Contributors to Performance Year-to-Date Through 6/30/181 (%)

Profire Energy0.60
Tactile Systems Technology0.58

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/182 (%)

Atlas Financial Holdings-0.46
Basic Energy Services-0.40
U.S. Concrete-0.29
Paratek Pharmaceuticals-0.27
Gulf Island Fabrication-0.24

2 Net of dividends

Current Positioning And Outlook

We did not make any major changes to portfolio positioning in the first half of 2018. Despite the increasing uncertainty around trade, we remained generally constructive on the U.S. economy, which supported underlying growth and valuations in our overweight sectors, such as Information Technology, Industrials, and Consumer Discretionary. These sectors were also our largest overweights relative to the Russell Microcap. Health Care, particularly biotechnology, continued to be among our largest underweights by nearly 50%. We remained optimistic about micro-cap stocks in anticipation of an increasingly less restrictive regulatory environment. Considering the accelerated pace of U.S. economic growth, lower corporate tax rates, and the slower pace of global economic growth, we were particularly focused on micro-cap companies that had a disproportionate exposure to the U.S. economy.

Average Annual Total Returns Through 06/30/18 (%)

Capital Micro-Cap 10.1010.3114.087.116.555.348.049.6310.21 12/27/96
Russell Microcap 9.9710.7120.2110.4912.7810.639.44N/AN/A N/A

Annual Operating Expenses: Gross 1.39 Net 1.33

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 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, 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 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 1.33% through April 30, 2019. 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.

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 June 30, 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 June 30, 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 6/30/18, the percentage of Fund assets was as follows: Profire Energy was 0.7%, Tactile Systems Technology was 0.9%, Surmodics was 1.1%, Attunity was 1.1%, Stoneridge was 1.1%, Atlas Financial Holdings was 0.0%, Basic Energy Services was 0.4%, U.S. Concrete was 0.4%, Paratek Pharmaceuticals was 0.4%, Gulf Island Fabrication was 0.4%, Abbot Laboratories 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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