Royce Capital Fund-Micro-Cap Portfolio Manager Commentary
article 12-31-2019

Royce Capital Fund–Micro-Cap Portfolio Manager Commentary

We took advantage of buying cyclical micro-cap stocks in the second half of 2019 as they are selling at a steep discount, and we are optimistic about their future given the current environment.


Fund Performance

Royce Capital Fund–Micro-Cap Portfolio advanced 19.6% in 2019, trailing the Russell Microcap and the Russell 2000 Indexes, which returned 22.4% and 25.5%, respectively, for the same period.

What Worked…And What Didn’t

Six of the Fund’s 10 equity sectors positively contributed to performance. Information Technology generated the most sizable impact by far, followed by Industrials and Health Care. Consumer Discretionary, Energy, and Communication Services detracted from performance, but did so modestly. On the industry level, semiconductors & semiconductor equipment (Information Technology) generated the biggest contributiOn, more than tripling the impact of banks (Financials) and machinery (Industrials), which followed. Conversely, energy equipment & services (Energy) was the worst-performing industry, followed by leisure products and hotels, restaurants & leisure (both in Consumer Discretionary).

The top-contributing position for the year was Ultra Clean Holdings, which develops critical subsystems for the semiconductor capital equipment and flat panel display industries. The company benefited from the recent semiconductor industry upturn and management’s decision to diversify both its customer base and service offerings. Zealand Pharma is a Copenhagen-based company that focuses on developing peptide-based therapeutics for metabolic and gastrointestinal diseases. Its two latest stage products had positive results during the year, and the company also completed its first ever acquisition, buying Encycle Therapeutics in October. Pharmaceuticals company Axsome Therapeutics also made a strong contribution, as the company had positive clinical results across its product portfolio, which includes developing therapies for central nervous system disorders. Axsome’s lead molecule, AXS-05, has been performing well in clinical trials that are expected to be finished relatively quickly because two of its ingredients were previously approved by the Food and Drug Administration.

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Red Lion Hotels was the portfolio’s largest detractor in 2019, as the company suffered a setback in its efforts to transition from company-owned hotels to a franchise model. Selling its company-owned units took longer than anticipated, and Red Lion experienced greater-than-expected attrition in its newly acquired franchisees—factors that led us to sell our stake. We also saw poor performance from branded fitness and apparel product maker, Nautilus, which suffered through two consecutive failed product launches that resulted in a decision to remove the CEO. While we liked several strategic decisions that the company made over the past several years, we sold our position when our confidence in management’s ability to effectively judge the rapidly changing fitness markets was shaken. We also expected that it would take at least a year to rebuild its product pipeline. Correvio Pharma also hampered performance during the year. The pharmaceuticals company develops and discovers cardiovascular drugs for the treatment of atrial arrhythmia, congestive heart failure, and bacterial skin infections. We exited our position after the company’s atrial fibrillation drug, which is used extensively in Europe, failed to gain approval from an FDA Advisory Panel.

The Fund’s relative underperformance versus the Russell Microcap was driven entirely by sector allocation—stock selection was additive. Consumer Discretionary was the largest source of underperformance due to stock selection in multiple industries, including specialty retail and hotels, restaurants & leisure. Health Care also hurt relative performance due to our underexposure to the sector, particularly to biotechnology, which was the strongest contributor to the micro-cap index’s returns. The portfolio’s cash holdings were an additional drag on relative performance in 2019. Conversely, we saw very strong relative outperformance in Information Technology, driven mainly by savvy stock selection, though our overexposure to the sector helped modestly. Industrials and Materials were also additive thanks to successful stock selection. At the industry level, the aforementioned biotechnology group (Health Care) and energy equipment & services (Energy) hurt relative performance most, while semiconductors & semiconductor equipment and software (both in Information Technology) helped.

Top Contributors to Performance 20191 (%)

Ultra Clean Holdings1.27
Zealand Pharma1.25
Axsome Therapeutics1.07
Adesto Technologies0.78

1 Includes dividends

Top Detractors from Performance 20192 (%)

Red Lion Hotels-0.61
Correvio Pharma-0.46
Independence Contract Drilling-0.41

2 Net of dividends

Current Positioning And Outlook

While issues surrounding trade have finally begun to stabilize, we find ourselves in the midst of what promises to be an eventful U.S. election cycle, with outcomes that could have major implications for investors. Despite this uncertainty, we remain generally constructive on the U.S. economy, particularly because the current Fed tightening cycle appears to have ended. Along with a possible truce in the trade wars, we believe the favorable backdrop should support underlying growth for our overweighted sectors, such as Information Technology and Industrials. Valuations look relatively attractive to us in many corners of the micro-cap world, even as recent returns show that the performance gap between micro-caps and large-caps is gradually beginning to narrow. We took advantage of these opportunities for much of the second half of 2019 as micro-cap stocks were selling at their steepest discount to large-caps since 2001. We don’t know if this recent upward move will last, but after a long period of underperformance for micro-caps, we anticipate some degree of mean reversion.

Average Annual Total Returns Through 12/31/19 (%)

Capital Micro-Cap 10.4419.5519.554.583.695.585.288.309.45 12/27/96
Russell Microcap 13.4522.4322.436.396.5711.266.16N/AN/A N/A

Annual Operating Expenses: Gross 1.43 Net 1.33

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 & 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 1.33% through April 30, 2020.

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, 2019, 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, 2019 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 12/31/19, the percentage of Fund assets was as follows: Ultra Clean Holdings was 1.4%, Zealand Pharma was 1.3%, Axsome Therapeutics was 1.1%, NeoGenomics was 1.1%, Adesto Technologies was 1.2%, Red Lion Hotels was 0.0%, Nautilus was 0.0%, Correvio Pharma was 0.0%, Kirkland's was 0.0%, Independence Contract Drilling 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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