Royce Micro-Cap Opportunity Fund Manager Commentary
article 06-30-2018

Royce Micro-Cap Opportunity Fund Manager Commentary

Despite the curious situation in which stocks showed weakness even as the companies reported strong results, we are pleased with how our deep value approach to micro-caps is positioned.


Fund Performance

After two consecutive years of strong absolute and relative performance, we were not terribly surprised to see a moderation in the pace of gains for our deep value approach to micro-cap stocks in the first half of 2018, and we were pleased that the Fund outperformed its benchmark for the one-year period ended June 30, 2018. Royce Micro-Cap Opportunity Fund increased 7.8% for the year-to-date period ended June 30, 2018, trailing its benchmark, the Russell Microcap Index, which rose 10.7% for the same period.

What Worked… And What Didn’t

Information Technology led a group of eight (out of 10) equity sectors with positive contributions, followed by Health Care and Financials. The first of these three had an outsized impact on results in the first half, while net losses in Consumer Discretionary and Real Estate made only a minor collective impact. The top portfolio industry by a wide margin was Internet software & services (Information Technology). eGain Corporation, which specializes in cloud-based customer engagement software primarily for ecommerce applications, was the top contributor in this group and in the portfolio as a whole. It was also the portfolio’s second-largest holding at the end of June. Growing acceptance of ecommerce solutions and important customer wins helped to push its stock price up. And even with its accelerating share values, eGain still looked relatively inexpensive to us compared to others in its group at June 30th.

From the Health Care sector, CareDx specializes in diagnostic testing for transplant recipients. The Fund’s largest position at the end of June, it was one of the portfolio’s top detractors in the first half of 2017 before rebounding to finish as a top contributor for the full year. Its success extended into the first half of 2018, as it continued to benefit from the favorable resolution of reimbursement issues and stayed well ahead of the competitors in its niche. KEMET Corporation is a solid tantalum and multilayer ceramic capacitor manufacturer with a strong position in its own niche that has been on a remarkably successful run of its own—it was among the Fund’s best performers in 2016 and 2017. We have acted opportunistically with its shares, buying late in 2017 when its price fell on what looked to us like a minor earnings disappointment and trimming in 2018 when its stock recovered.

The position that detracted most was Basic Energy Services, which provides oil and gas companies with well site services, such as well maintenance, pumping, and contract drilling. It emerged from bankruptcy before we bought shares. During the first half of 2018, earnings were hurt by more weakness than was expected outside its core markets. We, on the other hand, think its key end markets are still attractive, so we built our stake as its shares fell. Celadon Group is a trucking and transportation services business with newer management, which has been handling issues that involve restating several years’ of financial results. Certain investors, ourselves excluded, were expecting resolution of these issues at some point in the first half and began to abandon the stock when it failed to materialize. As with Basic Energy, we chose a different course and added shares.

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Relative to the benchmark, the Fund was hurt most by poor stock selection and—to a lesser degree—our large overweight in Industrials, where holdings in the road & rail, electrical equipment, and machinery groups underperformed. Ineffective stock selection detracted in Energy while our lower exposure to Health Care, as well as a few stock picking mishaps, also had a negative impact. Conversely, stock selection was a major advantage versus the micro-cap index in Financials—most notably in capital markets—though our underweight also contributed. Smaller relative advantages came from the portfolio’s lower weightings in Consumer Discretionary and Real Estate.

Top Contributors to Performance

1 Includes dividends

Top Detractors from Performance

2 Net of dividends

Current Positioning and Outlook

The U.S. economy continues to strengthen, which we see as a positive for many holdings, in particular those in Information Technology and Industrials. We saw the negative effect of tariffs and trade disruption on many industrial holdings that had performed well previously before giving back some of their gains in the first half, creating a curious situation in which the stocks showed weakness even as the companies reported strong results. We think the ultimate resolution of these issues should provide recovery in this sector. We like industrial businesses with exposure to aerospace & defense, energy, and infrastructure. In technology, automation, cloud storage, and other innovations are moving forward with the consequence that companies must adopt newer technologies out of necessity, which should create ongoing, though cyclical—and at times volatile—demand for companies involved in semiconductor and capital equipment manufacturing, as well as other related industries. These positions, along with still recovering holdings in Consumer Discretionary and Energy, make us pleased with how the portfolio is positioned as we anticipate ongoing economic growth.

Effective October 1, 2018, Bill Hench will be the Fund’s sole portfolio manager. Portfolio Manager Buzz Zaino will stay on at Royce as a Senior Adviser to the portfolio team.

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

8.787.7922.7310.3610.3214.07 01/01/01

Annual Operating Expenses: Gross 1.32 Net 1.24

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. 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, 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 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: eGain Corporation was 2.1%, CareDx was 2.9%, KEMET Corporation was 1.9%, Mammoth Energy Services was 1.2%, Surgery Partners was 1.6%, Basic Energy Services was 1.1%, Celadon Group was 1.0%, Commercial Vehicle Group was 0.6%, Invuity was 0.6%, Babcock & Wilcox Enterprises was 0.5%

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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