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

Royce Capital Fund–Small-Cap Portfolio Manager Commentary

By holding its value better in a bearish 2022, the Fund lost less than both its primary benchmark, the Russell 2000 Value Index, and its secondary benchmark, the small-cap Russell 2000 Index, in the calendar year.


Fund Performance

Royce Capital Fund–Small-Cap Portfolio outperformed both of its small-cap benchmarks in 2022, down -9.2% versus a decline of -14.5% for its primary benchmark, the Russell 2000 Value Index, and a fall of -20.4% for the Russell 2000 Index, its secondary benchmark.

What Worked… And What Didn’t

Five of the portfolio’s nine equity sectors made a negative impact on calendar year period performance, with the largest detractions coming from Consumer Discretionary, Industrials, and Financials while the largest positive impacts came from Health Care, Energy, and Communication Services. At the industry level, specialty retail, household durables (both in Consumer Discretionary), and semiconductors & semiconductor equipment (Information Technology) were the largest detractors while biotechnology (Health Care), pharmaceuticals (Health Care), and oil, gas & consumable fuels (Energy) contributed most in 2022.

Recreational boat dealer OneWater Marine was the Fund’s top detractor. Investors appeared to worry that slowing demand—which has not materialized as of this writing—would sink its prospects, keeping its stock under water for most of 2022. In November, however, the company reported record revenue for the fiscal fourth quarter and full fiscal year of 2022 before closing an acquisition in December that, in our view, should help to shore up its presence in the Gulf Coast region. Wary of a possible slowdown in demand in 2023, we reduced our stake in 2022. Rent-A-Center operates rent-to-own stores. Investors shied away from its stock after the company said that both the end of Covid relief funds and rising inflation would likely hurt its customers’ ability to buy and/or make payments. We were equally concerned about how the company’s 2021 acquisition of lease-to-own solutions provider Acima Holdings put leverage on Rent-A-Center’s balance sheet while also adding credit losses to recent financial results. We sold the last of our shares in March. We also parted ways with apparel retailer American Eagle Outfitters, selling the last of our shares in September because we expect it and other mall-based retailers will face a particularly difficult period ahead given the likelihood of recession.

The portfolio’s top contributor was Catalyst Pharmaceuticals, which focuses on the acquisition, development, and commercialization of prescription drugs that treat autoimmune disorders and rare diseases. We began building our position at what we judged to be a very favorable valuation, attracted to its strong balance sheet and its approved—and profitable—drug that treats Lambert-Eaton myasthenic syndrome (LEMS) in adults. In July, the company favorably settled patent litigation and then acquired the infringer. BioDelivery Sciences International was a specialty pharmaceutical company that makes pain management and neurology products which treat patients living with serious and complex conditions such as chronic pain and acute migraines. In February, Collegium Pharmaceutical, which we held until September 2022 and which also specializes in pain management medicines, announced it would acquire BioDelivery at a sizable premium, leading us to sell our position in February 2022. IBEX is a customer experience company that helps companies engage more effectively with their customers. The company’s services include digital marketing, outsourced sales and support, and brand management. We initiated a position when the company went public and was beginning to add new economy names in industries such as fintech and healthcare—which helped spur revenue and earnings growth in 2022.

The portfolio’s advantage over the Russell 2000 Value came entirely from stock selection in 2022. Stock picking was especially effective versus the benchmark in Health Care and Information Technology (overcoming the negative impact of our overweight), and Communication Services (where our slight underweight also helped). Conversely, a combination of our greater exposure and stock picks detracted from relative results in Consumer Discretionary, as did our lower weight and stock selection in Energy and lack of exposure to Utilities.

Top Contributors to Performance 20221 (%)

Catalyst Pharmaceuticals1.76
BioDelivery Sciences International0.73
Cross Country Healthcare0.66
Sanmina Corporation0.62

1 Includes dividends

Top Detractors from Performance 20222 (%)

OneWater Marine Cl. A-1.14
American Eagle Outfitters-0.95
Shoe Carnival-0.94
Lazydays Holdings-0.75

2 Net of dividends

Current Positioning And Outlook

We are not anticipating a durable end to the bear market over the short term because several formidable headwinds remain, including a still inverted yield curve, stubbornly high inflation, and a hawkish Fed that will likely not pause (much less pivot to reducing rates) until there is sufficient weakness in the labor market to curb inflation. In our view, these factors also contribute to making recession a strong likelihood in 2023. In any event, our expectation is for a more volatile market until we have greater clarity about the state of economic growth. Many companies over-earned coming out of Covid, and many are likely to see earnings decline in a more muted demand environment, which has made getting a read on normalized earnings challenging. In positioning the portfolio amid this uncertainty, we have been focusing on companies that have key fundamental strengths—specifically, low debt balance sheets and the ability to generate free cash flow—and look best positioned for a more stable market over the next 18 to 24 months. We ended 2022 overweight in Information Technology, Consumer Discretionary, and Industrials and underweight in Financials, Real Estate, Utilities, Materials, and Health Care.

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

Capital Small-Cap 13.48-9.20-9.202.793.396.335.978.558.929.26

Annual Operating Expenses: 1.15

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. 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: Catalyst Pharmaceuticals was 0.9%, BioDelivery Sciences International was 0.0%, IBEX was 1.2%, Cross Country Healthcare was 1.4%, Sanmina Corporation was 1.6%, OneWater Marine Cl. A was 0.7%, Rent-A-Center was 0.0%, American Eagle Outfitters was 0.0%, Shoe Carnival was 1.3%, Lazydays Holdings was 0.9%.

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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