Royce Capital Fund-Micro-Cap Portfolio Manager Commentary
article 12-31-2022

Royce Capital Fund–Micro-Cap Portfolio Manager Commentary

The Fund beat the Russell Microcap Index for the three- and five-year periods ended 12/31/22 and outpaced the Russell 2000 Index for the three-, five-, 25-year, and since inception (12/27/96) periods ended 12/31/22.


Fund Performance

Royce Capital Fund–Micro-Cap Portfolio was down -22.4% in 2022 versus a loss of -22.0% for its primary benchmark, the Russell Microcap Index, and a -20.4% loss for the small-cap Russell 2000 Index, its secondary benchmark.

The portfolio outperformed the Russell Microcap for the three- and five-year periods ended 12/31/22 and beat the Russell 2000 for the three-, five-, 25-year, and since inception (12/27/96) periods ended 12/31/22.

What Worked… And What Didn’t

Eight of the portfolio’s nine equity sectors finished 2022 in the red, with Health Care, Consumer Discretionary, and Industrials detracting most. The lone positive impact came from Energy while Real Estate and Materials detracted least. At the industry level, health care equipment & supplies (Health Care), specialty retail (Consumer Discretionary), and electronic equipment, instruments & components (Information Technology) detracted most while software (Information Technology), auto components (Consumer Discretionary), and communications equipment (Information Technology) were the biggest contributors.

Shares of medical device company Bioventus declined sharply in 2022 following disappointing earnings that indicated greater complexity in integrating Misonix, which Bioventus acquired in October of 2021. We initially believed that the new entity’s greater scale could accelerate earnings growth, a view that shifted with November’s announcement that yearly guidance was being lowered, leading us to exit the stock. Shares of MeiraGTx Holdings, a clinical stage gene therapy company, declined despite progress in clinical trials for their retinal and salivary disease treatments and ongoing partnership with Johnson & Johnson. Rising rates seemed to drive the sell-off, as much of its earnings potential remains several years away. We remained confident in its long-term promise at year-end. Industrial insulation company Aspen Aerogels saw its shares slide as it completed a dilutive financing deal to fund the capacity expansion necessary to meet growing demand from original equipment manufacturers of electric vehicles. We increased our stake in 2022. While the need for a large new plant admittedly adds timing uncertainty and execution risk, Aspen’s proven solution has been winning ample new business.

Modine Manufacturing provides thermal management systems for an array of industries and is in the midst of a turnaround, moving from commoditized areas to higher-growth and margin segments, such as electric vehicles and data center infrastructure. We maintained our position as we believe the turnaround is in its early stages and not yet fully appreciated by investors. Software developer Agilysys offers a comprehensive suite of solutions targeting the hospitality industry. Management has spent the past several years developing add-on modules to its core Property Management software offering and thus increasing the firm’s competitive advantage. We held our shares at year-end as we view its recent win with Marriott as a potential game changer. Digi International is transitioning from a pure play networking hardware business to offering ancillary software products adjacent to its core offering. These new offerings have provided a significant base of high-margin, recurring revenues. We reduced our position as we believe the market has begun to more fully recognize the company’s successful transition.

The portfolio’s advantage versus the Russell Microcap came from stock selection in 2022. Stock selection provided a sizable relative advantage in Information Technology (overcoming the negative impact of our significantly higher weighting) and Industrials while the Fund’s cash holdings also contributed to relative performance in 2022. Conversely, our lower exposure (and, to a lesser degree, stock selection) hampered relative results most in Energy. Stock picks hurt in Health Care, as did a combination of greater exposure and stock selection in Communication Services.

Top Contributors to Performance 20221 (%)

Modine Manufacturing0.98
Digi International0.74
StoneX Group0.46

1 Includes dividends

Top Detractors from Performance 20222 (%)

Bioventus Cl. A-1.28
MeiraGTx Holdings-0.87
Aspen Aerogels-0.85
Apyx Medical-0.82
Harvard Bioscience-0.82

2 Net of dividends

Current Positioning And Outlook

We see micro-cap value stocks as increasingly well positioned for the next market upturn, as they were disproportionately hurt by the zero interest rate environment that favored long duration assets. While 2022’s pain was sharp for stocks, we believe the Federal Reserve’s pivot to a more normalized interest rate environment should lead to more thoughtful approaches to investing once we exit the current downturn. The key questions revolve around inflation: When will it abate and when will the Fed begin to ease financial conditions? We see their resolution as a prerequisite for a sustained move higher in equity prices. We suspect that many inflationary pressures were related to aggressive fiscal and monetary stimuli in demand-based economies juxtaposed against significant supply chain disruptions in supply-based economies—a classic supply/demand imbalance that, while persisting for longer than we initially thought, is already showing signs of rebalancing, with the price of many goods falling rapidly. Currently invested on a pro-cyclical basis with overweights in retailers, Information Technology, and Industrials, we have made no wholesale changes to our positioning. At the same time, we believe that any easing in financial conditions against a backdrop where earnings expectations still need to come down should create enough volatility for us to find exciting investment opportunities. In short, we are cautiously optimistic about 2023 being a year of normalization in which volatility should offer excellent opportunities to position ourselves for the next significant bull phase.

Average Annual Total Returns Through 12/31/22 (%)

Capital Micro-Cap 11.88-22.43-22.437.676.305.734.467.928.789.24
Russell Microcap 4.72-21.96-21.964.053.698.866.348.64N/AN/A

Annual Operating Expenses: 1.16

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. Gross operating expenses reflect the Fund's total gross operating expenses for the Investment Class and include 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 Fund’s most current prospectus. Royce 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 1.08% through April 30, 2023.

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, 2022, 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, 2022 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 12/31/22, the percentage of Fund assets was as follows: Modine Manufacturing was 1.3%, Agilysys was 1.5%, Digi International was 1.1%, Clearfield was 1.0%, StoneX Group was 1.2%, Bioventus Cl. A was 0.0%, MeiraGTx Holdings was 0.5%, Aspen Aerogels was 0.5%, Apyx Medical was 0.3%, Harvard Bioscience was 0.6%.

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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