Royce Micro-Cap Fund Manager Commentary
article 06-30-2017

Royce Micro-Cap Fund Manager Commentary

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


Fund Performance

Royce Micro-Cap Fund gained 2.0% for the year-to-date period ended June 30, 2017, falling short of both its benchmarks, the Russell Microcap Index, which was up 4.2%, and the small-cap Russell 2000 Index, which advanced 5.0% for the same period. During the first half of 2017, there was both a reversal in small-cap leadership from value to growth stocks and some inconsistency in relative results for micro-cap companies vis-?-vis their small-cap siblings.

The first quarter proved the most challenging period for the Fund on a relative basis. Micro-Cap was down 0.7% for the quarter compared to respective gains of 0.4% and 2.5% for the micro-cap and small-cap indexes. The Fund then enjoyed solidly positive results on an absolute basis, up 2.7% in the second quarter marginally outpacing the Russell 2000 (+2.5%) while trailing the Russell Microcap (+3.8%) in this same period. In addition, the Fund outperformed the Russell 2000 for the 20-, 25-year, and since inception (12/31/91) periods ended June 30, 2017. (Data for the Russell Microcap only goes back to June 30, 2000.) The Fund’s average annual total return since inception was 10.9%.

What Worked… And What Didn’t

Seven of the Fund’s 10 equity sectors finished the semiannual period in the black, with Health Care and Information Technology leading, followed by Industrials. Consumer Discretionary and, to a lesser degree, Energy made the biggest negative impacts while net losses for Consumer Staples were modest. At the industry level, the top contributor for the first half was health care equipment & supplies (Health Care), with the bulk of its contribution coming in the second quarter from two medical device makers, Novadaq Technologies, which was acquired, and Tactile Systems Technology. Machinery (Industrials) came next, with several companies contributing, including Kornit Digital, Alimak Group, and Kadant. It was followed by semiconductors & semiconductor equipment (Information Technology). Detractors at the industry level included the specialty retail group (Consumer Discretionary), where companies continued to struggle with secular shifts in consumer spending and behavior, and energy equipment & services (Energy), where tumbling oil prices impacted the shares of tech-based energy product maker Tesco Corporation.

Capital equipment subsystem provider Ultra Clean Holdings was the Fund’s top contributor at the position level in the first half. The company has been gaining market share with key OEM customers in a vibrant environment for semiconductor capital equipment spending. We held shares at the end of June because the rise in its shares has been driven primarily by earnings growth rather than multiple expansion and because we think Ultra Clean is positioned to grow faster than its underlying industry. Corium International manufactures transdermal patches that range from drug delivery to consumer products. While historically a contract manufacturer, Corium has been developing its own generic drugs over the past several years to leverage its delivery expertise. Constructive results in early clinical trials helped to push its shares higher.

Value-priced department store operator Stein Mart detracted most from first-half results. Like many retailers, it suffered from ongoing sales pressure associated with the shift to online shopping. This challenge was exacerbated by a series of internal merchandising miscues. We held a small position at the end of the first half based on our view that correcting the internal miscues should provide a better exit point. CUI Global offers a unique solution for measuring pipeline gas quality that’s quicker, cheaper, and more accurate than other existing technologies. While orders were respectable and the sales pipeline looks solid, the delivery schedule proved longer than expected. This exerted downward pressure on its shares, especially given CUI Global’s relatively small size and resources. Proceeding cautiously, we added shares in the first half because we believe its technology can ultimately be monetized successfully.

Relative to the Russell Microcap, the Fund was disadvantaged most in the first half by poor stock selection in Consumer Discretionary, particularly in specialty retail, and Information Technology in the electronic equipment, instruments & components group. Conversely, we benefited from our underweight and better stock picking in Financials while enjoying a smaller advantage from stock selection in the Energy sector.

Top Contributors to Performance Year-to-Date Through 6/30/171 (%)

Ultra Clean Holdings0.59
Corium International0.50
Novadaq Technologies0.39
Everspin Technologies0.39

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/172 (%)

Stein Mart-0.49
CUI Global-0.35
Tesco Corporation-0.33

2 Net of dividends

Current Positioning and Outlook

We did not make significant changes during the first half. We continued to build positions in financial stocks, particularly in banks where we believe micro-cap names can benefit from a more relaxed regulatory environment. Financials remained, however, among our largest sector underweights at the end of June. We also maintained our lower exposure to Health Care, although we have been selectively adding to positions in medical device companies that we believe have created defensible competitive positions. Our largest weightings at the end of June remained Industrials, Information Technology, and Consumer Discretionary, with the first of these also reflecting our largest overweight. We continue to find value in all three of these sectors and view them as areas in which select companies have the potential to benefit from the relative strength of the U.S. economy.

Average Annual Total Returns Through 06/30/17 (%)

Micro-Cap 2.702.0123.040.165.323.117.618.9810.91 12/31/91
Russell Microcap 3.834.2327.606.6913.735.478.44N/AN/A N/A

Annual Operating Expenses: Gross 1.60 Net 1.58

1 Not annualized.

Important Performance, Expense and Disclosure 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 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 and other expenses.

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, 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 June 30, 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 6/30/17, the percentage of Fund assets was as follows: Ultra Clean Holdings was 0.6%, Corium International was 0.7%, Novadaq Technologies was 0.0%, Everspin Technologies was 0.7%, Novanta was 0.6%, Stein Mart was 0.2%, CUI Global was 0.4%, Tesco Corporation was 0.5%, BioAmber was 0.3%, Kirkland's was 0.3%, Kadant was 0.7%, Tactile Systems Technology was 0.7%, Alimak Group was 0.8%, Kornit Digital was 0.7%.

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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