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

Royce Micro-Cap Opportunity Fund Manager Commentary

Driven by the success of tech holdings, the Fund handily outperformed its small-cap benchmark, the Russell Microcap, in the first half.


Fund Performance

Royce Micro-Cap Opportunity Fund advanced 9.8% for the year-to-date period ended June 30, 2017, outperforming its benchmark, the Russell Microcap Index, which was up 4.2% for the same period. We were especially pleased with the success of our deep value approach because it came in a period that was otherwise highly challenging for value stocks. The Russell Microcap Value Index was up 1.9% in 2017’s first half versus 8.1% for the Russell Microcap Growth.

Micro-Cap Opportunity outpaced the Russell Microcap in the first quarter, up 4.5% versus a 0.4% gain while in the second quarter it increased 5.0% compared to 3.8% for the benchmark. We were also happy that the Fund outperformed the Russell Microcap for the one-year period ended June 30, 2017, up 31.8% versus 27.6%. Micro-Cap Opportunity’s average annual total return since inception (8/31/10) was 12.8%.

What Worked… And What Didn’t

Six of the Fund’s 10 equity sectors made contributions to first-half performance, with the most impressive result coming from Information Technology. We did much of the seed work in tech stocks 18-24 months ago, when a slow business cycle lowered share prices in many industries in which we have a perennial interest, such as semiconductors and electronic components. In fact, much of the appeal of technology stocks is that the business cycle tends to go to extremes on both the up and the down side, which often creates attractive opportunities as long as one has the patience to wait and the discipline to endure falling prices. In addition, other value investors tend to avoid or underinvest in these companies, which in our view often enhances the attractiveness of the valuations.

The recovery we’ve seen in many technology companies over the last several months has been keyed by one of the largest buildouts since the early days of the Internet. It has been benefiting companies in a number of industries because the expansion encompasses multiple developments and innovations, including the move from 4G to 5G, artificial intelligence, autonomous driving, public and private cloud storage, and the expansion of the semiconductor industry in China. Prices in many cases began to exceed our sell targets in the spring, leading us to trim our overall exposure to the sector. However, we are confident that the buildout is in its early stages, so we will be watching carefully (as we always do) for opportunities to materialize.

Four industry groups from the sector helped to drive first-half results—electronic equipment, instruments & components, communications equipment, technology hardware storage & peripherals, and semiconductors & semiconductor equipment. The health care providers & services group also made a notable contribution to performance. KEMET Corporation, a solid tantalum and multilayer ceramic capacitor manufacturer that was also the top contributor in 2016’s fourth quarter, was the Fund’s top performer at the position level. Strong sales and earnings combined with margin expansion to fuel the rise of its shares. Nimble Storage is a leader in predictive flash storage solutions, a niche with growing importance in cloud storage, which helps to explain why Hewlett-Packard announced that it would buy Nimble for about a 45% premium in March.

Of the four sectors that detracted from first-half results, only Energy made a significant negative impact—net losses for Real Estate, Telecommunication Services, and Consumer Discretionary were modest. Detracting most at the industry level were road & rail (Industrials) and energy equipment & services (Energy), where declining oil prices led to disappointing results. The former industry is home to Celadon Group, which provides long-haul, full-truckload freight services as well as supply chain management solutions. The company had accounting issues in which the financing of its assets was questioned. We think the combination of its very cheap valuation and the value of its trucking assets make a turnaround possible. CareDx specializes in diagnostic testing for transplant recipients. It’s endured some reimbursement issues that have hurt results, but we anticipate favorable resolutions and like the commercial potential of its technologies.

The Fund’s biggest relative advantage in the first half came overwhelmingly from stock selection in Information Technology, where our larger weighting also helped. Stock selection in Industrials and a lower exposure to Financials provided an additional relative edge. Conversely, our low weighting and ineffective stock picks in biotechnology (Health Care) hurt relative performance, as did stock selection in Telecommunication Services.

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

KEMET Corporation1.83
Nimble Storage1.12
Community Health Systems0.83
Ichor Holdings0.75
Kratos Defense & Security Solutions0.75

1 Includes dividends

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

Celadon Group-0.66
Pengrowth Energy-0.48
Sucampo Pharmaceuticals Cl. A-0.48
TravelCenters of America LLC-0.45

2 Net of dividends

Current Positioning and Outlook

We remain encouraged by the pace of global economic growth, which should have a positive impact on the capital goods sector. We began to reduce some positions in Information Technology prior to June’s sell-off based on their lofty valuations, while we maintained most of our holdings in Industrials. We have also been looking to take advantage of improved consumer income by adding select names in Consumer Discretionary. In addition, we reduced the portfolio’s exposure to Financials as valuations for many holdings appeared full relative to where we began to buy three to five years ago. Finally, we benefited from a number of takeovers, which are running at a pace similar to last year.

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

Micro-Cap Opportunity 5.019.7731.771.6712.6912.85 08/31/10

Annual Operating Expenses: Gross 1.28 Net 1.24

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 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 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: KEMET Corporation was 1.4%, Nimble Storage was 0.0%, Community Health Systems was 1.6%, Ichor Holdings was 1.5%, Kratos Defense & Security Solutions was 1.4%, Celadon Group was 0.6%, CareDx was 0.5%, Pengrowth Energy was 0.3%, Sucampo Pharmaceuticals Cl. A was 1.5%, TravelCenters of America LLC 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 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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