Royce Capital Fund-Micro-Cap Portfolio Manager Commentary
article 02-15-2024

Royce Capital Fund–Micro-Cap Portfolio Manager Commentary

The Fund advanced 18.8% in 2023, beating its primary benchmark, the Russell Microcap Index, which was up 9.3%, and its secondary benchmark, the Russell 2000 Index, which climbed 16.9% for the same period. The Fund also beat the Russell Microcap for the 3-, 5-, and 20-year, periods ended 12/31/23.


Fund Performance

Royce Capital Fund–Micro-Cap Portfolio advanced 18.8% in 2023, beating its primary benchmark, the Russell Microcap Index, which was up 9.3%, and its secondary benchmark, the Russell 2000 Index, which climbed 16.9% for the same period. The Fund also beat the Russell Microcap for the 3-, 5-, and 20-year, periods ended 12/31/23.

What Worked… And What Didn’t

Seven of the Fund’s 10 equity sectors finished 2023 in the black, led by Industrials, Information Technology, and Consumer Discretionary, while Health Care, Communication Services, and Consumer Staples made small detractions. At the industry level, semiconductors & semiconductor equipment (Information Technology), commercial services & supplies (Industrials), and metals & mining (Materials) contributed most, while health care equipment & supplies (Health Care), professional services (Industrials), and entertainment (Communication Services) were the largest detractors.

The Fund’s top-contributing position was Applied Optoelectronics, which manufactures optical communications products. Microsoft selected the company to provide a significant number of leading-edge components to support Microsoft’s build out of data centers for AI applications. While we were excited about Applied Optoelectronic’s prospects prior to this announcement, we see the relationship as a potential long-term game changer for the company. Modine Manufacturing provides thermal management systems for several industries and was added to the portfolio as a turnaround candidate as the company was moving from its historical core of automotive radiators toward newer high growth opportunities. The shift is now paying dividends as the company sees significant wins in areas such as data centers and electric vehicles. Camtek manufactures metrology and inspection tools for the semiconductor equipment industry. Its Advanced Packaging segment has been benefiting from the shrinking line widths of semiconductors and the corresponding need to stack many semiconductors together to drive improved performance. This phenomenon is even more acute for semiconductors being developed for AI applications, where Camtek is beginning to see significant orders.

The Fund’s top detractor was aesthetic medical device maker Cutera, whose acne treatment Aviclear was supposed to drive its business but has been slower to ramp up than anticipated. This combined with weakened demand for aesthetic procedures, which we see as relating to a weakening economy, and the general lack of insurer reimbursement for such procedures, caused the shares to correct meaningfully. Clearfield provides equipment and cable products principally to more rural cable companies. Like many telecom related infrastructure providers, it has been hurt by inventory corrections as supply chains have normalized post Covid. DZS manufactures mobile transport and broadband access solutions. Its telecom equipment end markets were weak throughout 2023 as customers worked off excess inventory. DZS also faced additional challenges managing its working capital as it faced payment issues with certain customers in Asia. Finally, the company announced that it would restate financials for 2023’s first quarter because a certain amount of inventory in Asia was not properly accounted for. However, DZS was able to execute a financing plan with its parent company, selling its Asian assets to the parent in early 2023, which we believe enables DZS to strengthen its balance sheet and focus on selling higher margin products into the North American and European markets.

The Fund’s advantage over the Russell Microcap came overwhelmingly from stock selection in 2023, though sector allocation was also additive. Stock selection boosted relative performance most in Industrials, Information Technology, and Consumer Discretionary—and our larger weighting in the first and third of these sectors also helped. Conversely, stock selection in Health Care, stock selection and a higher weighting in Communication Services, and stock selection in Financials each detracted from relative performance.

Top Contributors to Performance 20231 (%)

Applied Optoelectronics2.73
Modine Manufacturing1.70
Universal Stainless & Alloy Products1.45
American Superconductor1.30

1 Includes dividends

Top Detractors from Performance 20232 (%)

Territorial Bancorp-0.67
Chicken Soup for the Soul Entertainment Cl. A-0.59

2 Net of dividends

Current Positioning And Outlook

The fourth quarter saw a much needed rally during an otherwise challenging year for most micro-cap stocks. As 2023 drew to a close, investors became more hopeful that the Fed had reached the end of its tightening cycle and may be on the verge of cutting rates in 2024. We view financial liquidity as a key element of micro-cap performance, which could be seen in 4Q23 results. Although we believe we have not yet seen the full lagged impact of the Fed’s tightening cycle, the U.S. economy remains fairly resilient and inflationary pressures have eased as supply chains have normalized from Covid related disruptions. In spite of lingering macro uncertainty, we remain upbeat on the intermediate to long-term opportunities for companies in our domestically focused portfolio. Key among these is the ongoing trend towards re-industrialization of the U.S. economy, which we believe is being driven by a desire to shorten supply chains as well as an increasing realization of the strategic importance of domestic semiconductor manufacturing. The increased fiscal spending on domestic infrastructure projects is also just beginning to take hold, which we expect to provide tailwinds to many of our companies in the near to intermediate term.

Average Annual Total Returns Through 12/31/23 (%)

Capital Micro-Cap 12.3818.7818.786.1912.135.539.736.699.369.58
Russell Microcap 16.069.339.330.618.565.7910.656.39N/AN/A

Annual Operating Expenses: 1.18

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. 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. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include 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 December 31, 2023, 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, 2023 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 12/31/23, the percentage of Fund assets was as follows: Applied Optoelectronics was 1.3%, Modine Manufacturing was 1.4%, Camtek was 1.2%, Universal Stainless & Alloy Products was 1.3%, American Superconductor was 0.9%, Cutera was 0.0%, Clearfield was 0.5%, DZS was 0.0%, Territorial Bancorp was 0.2%, Chicken Soup for the Soul Entertainment Cl. A 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 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 2500 is an unmanaged, capitalization-weighted index of the 2,500 smallest publicly traded U.S. companies in the Russell 3000 index. The returns for the Russell 2500-Financial Sector represent those of the financial services companies within the Russell 2500 index. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The MSCI ACWI Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks.The MSCI ACWI ex USA Small Cap Index is an index of global small-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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