Royce Capital Fund-Small-Cap Portfolio Manager Commentary
article 12-31-2020

Royce Capital Fund–Small-Cap Portfolio Manager Commentary

We continue to seek contrarian investments, and we have positioned the portfolio towards industries we believe should fare well in a vibrant economy.


Fund Performance

Royce Capital Fund–Small-Cap Portfolio was down 7.2% in 2020, underperforming both of its small-caps benchmarks: the Russell 2000 Value Index was up 4.6% and the Russell 2000 gained 20.0% for the same period.

What Worked… And What Didn’t

Four of the portfolio’s nine equity sectors detracted from performance in 2020. Financials, Energy, and Consumer Discretionary had the biggest negative impacts while Consumer Staples detracted modestly. The biggest positive contributions came from Information Technology (which led by a wide margin), Industrials, and Health Care. At the industry level, airlines (Industrials) and banks (Financials) detracted most, followed by thrifts & mortgage finance, also from Financials. Two of the portfolio’s three top contributing industries were from Industrials—construction & engineering and road & rail—and one came from Information Technology, electronic equipment, instruments & components.

At the beginning of 2020, we saw the possibility of accelerating economic growth and positioned the portfolio accordingly. The coronavirus soon unraveled this thesis, with lockdowns and other constraints plunging the U.S. and much of the globe rapidly into recession. Each of the Fund’s five top-detracting positions was in an industry that was hit especially hard by the effects of the pandemic (and each was also a holdover from the top five detractors for the six-month period ended 6/30/20). The position that detracted most was discount carrier Spirit Airlines as few industries were hurt more by the travel restrictions wrought by the coronavirus. These same developments caused major problems for the business of low-cost carrier Allegiant Travel. We exited both positions during the first half.

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Retailers were another area that suffered markedly from contracting economic activity. Plummeting sales led us to sell our positions in footwear manufacturer Caleres and women’s dress shoe retailer Designer Brands, as we thought that neither looked capable of a complete recovery given the challenges afflicting brick-and-mortar retailers. Dramatic declines in sales prompted us to act in a similar fashion by exiting G-III Apparel Group, which sells outerwear and sportswear, has licensing agreements with several sports leagues and universities, and operates retail stores. Selling these holdings allowed us to buy companies in areas such as health care services & providers, biotech, and pharmaceuticals, where we found businesses with solid revenues and profits, ample cash, and promising progress in their respective pipelines. We also added or built positions in insurance, banking, and engineering & construction.

The top contributor at the position level in 2020 was BMC Stock Holdings, a building products company that merged with Builders FirstSource in the summer, creating more scale and a bigger footprint in its industry. We were initially attracted to the very low valuation for MYR Group, a national electrical contractor specializing in transmission and distribution, substation, and commercial and industrial construction. When the impact of COVID-19 proved to have only a minor impact on its business, its shares rose. Evercore is a global independent investment banking advisory firm that’s seen as a leader in large-scale M&A transactions. That business ground to a halt in spring before experiencing a strong rebound, lifting Evercore’s stock.

Relative to the Russell 2000 Value in 2020, the Fund’s disadvantage came from stock selection as our sector allocation decisions were additive. Stock picking in Consumer Discretionary hurt most by far, particularly in the specialty retail and hotels, restaurants & leisure industries. Stock selection also hampered relative performance in Health Care, Industrials, and Information Technology, though in the latter two sectors our higher weightings were a positive. Conversely, stock selection gave the portfolio an advantage in Financials while our lower weighting in Real Estate and lack of exposure to Utilities also helped versus the small-cap value index.

Top Contributors to Performance 20201 (%)

BMC Stock Holdings1.69
MYR Group1.62
Evercore Cl. A1.58

1 Includes dividends

Top Detractors from Performance 20202 (%)

Spirit Airlines-3.01
Designer Brands Cl. A-2.44
G-III Apparel Group-2.04
Allegiant Travel-1.96

2 Net of dividends

Current Positioning And Outlook

While it’s impossible to predict what 2021 has in store, we remain hopeful that the economy will recover. The question is, how much of this optimism is priced into current valuations? We are already seeing the market reflect considerable confidence in the form of share prices for many companies that are ahead—in some cases significantly so—of what even a robustly rebounding economy may provide. The result is a tension between what looks like unsustainably high stock prices on the one hand and the likelihood of a fast-growing U.S. economy on the other—with record low interest rates being an additional factor, one that will probably encourage investors to continue looking toward equities in the absence of viable alternatives. Wide distribution of the vaccine should spur a global rally that should benefit cyclical U.S. small caps, which are very economically sensitive. We have positioned the portfolio towards industrial, financial, and technology stocks as we believe they should fare well in a vibrant economy. We also continue to seek contrarian investments, some of which we currently see in small regional banks.

Average Annual Total Returns Through 12/31/20 (%)

Capital Small-Cap 26.53-7.15-7.150.335.185.565.737.939.35 12/27/96

Annual Operating Expenses: Gross 1.19 Net 1.08

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, 2021.

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, 2020, 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, 2020 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 12/31/20, the percentage of Fund assets was as follows: BMC Stock Holdings was 1.3%, MYR Group was 1.4%, Evercore Cl. A was 2.1%, Rent-A-Center was 2.4%, ArcBest was 2.1%, Spirit Airlines was 0.0%, Designer Brands Cl. A was 0.0%, Caleres was 0.0%, G-III Apparel Group was 0.0%, Allegiant Travel 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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