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

Royce Micro-Cap Fund Manager Commentary

The Fund generated a strong absolute return for 2019 despite underperforming its benchmarks, and we remain optimistic about micro-cap stocks in the current environment.


Fund Performance

Royce Micro-Cap Fund delivered a strong absolute return of 21.2% for 2019, though the Fund lagged 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 finished 2019 in the black. Information Technology made the most sizable positive contribution by far, followed by Industrials and Health Care. Consumer Discretionary, Energy, and Communication Services detracted from performance, but they did so on a modest scale. At the industry level, semiconductors & semiconductor equipment (Information Technology) generated the biggest impact on performance, more than tripling the impact of the portfolio’s next best contributor, machinery (Industrials). Conversely, energy equipment & services (Energy) was the worst performing industry, followed by leisure products (Consumer Discretionary).

Biotechnology company Axsome Therapeutics was the top-contributing position in 2019. The company saw positive clinical results across its product portfolio, which includes developing therapies for central nervous system disorders. AXS-05, Axsome’s lead molecule, has been performing well in clinical trials that are expected to be finished quickly because two of its ingredients were previously approved by the Food and Drug Administration. Ultra Clean Holdings develops and supplies critical subsystems for the semiconductor capital equipment and flat panel display industries. Not only did the stock benefit from the recent semiconductor industry upturn, but performance was also boosted by management’s decision to diversify its service offerings and customer base. Zealand Pharma focuses on developing peptide-based therapeutics for metabolic and gastrointestinal diseases. The Copenhagen-based company’s two latest stage products targeting short bowel system and hypoglycemia in diabetics had positive results during the year. Zealand Pharma also completed its first ever acquisition, buying Encycle Therapeutics in October.

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Conversely, Red Lion Hotels was hurt 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 position. Correvio Pharma develops and discovers cardiovascular drugs for the treatment of atrial arrhythmia, congestive heart failure, and bacterial skin infections. The company’s atrial fibrillation drug, which is used extensively in Europe, failed to gain approval from an FDA Advisory Panel. This led us to exit the position. Branded fitness and apparel product maker Nautilus also detracted from performance. Two consecutive failed product launches resulted in a decision to remove the CEO. While we liked several of the strategic decisions the company made over the past several years, we sold our position based on our lack of confidence in management’s ability to effectively judge the rapidly changing fitness markets. We also expected it to take at least a year to rebuild its product pipeline.

The Fund’s narrow relative underperformance versus the Russell Microcap was a result of sector allocation—stock selection was additive to relative results in 2019. Consumer Discretionary hampered relative performance mostly due to poor stock picks—our overexposure detracted very modestly. The sector was home to three of the top five relative detracting positions: Red Lion Hotels, Nautilus, and Kirkland’s. Ineffective stock picks in Energy also hindered results. Our lower exposure to biotechnology (Health Care)—the strongest contributor to the micro-cap index’s returns—hurt results most at the industry level. Conversely, Information Technology was the strongest contributor to performance, as the sector’s relative contribution made more than six times the impact of the next best contributor, Industrials. Savvy stock selection drove outperformance in both sectors. Two of the top five relative performing positions came from Information Technology—Ultra Clean Holdings and Adesto Technologies. At the industry level, semiconductors & semiconductor equipment (Information Technology) aided performance versus the benchmark most, followed by construction & engineering (Industrials).

Top Contributors to Performance 20191 (%)

Axsome Therapeutics2.07
Ultra Clean Holdings1.30
Zealand Pharma1.28

1 Includes dividends

Top Detractors from Performance 20192 (%)

Red Lion Hotels-0.65
Correvio Pharma-0.53

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 of 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 (%)

Micro-Cap 12.7221.1621.165.173.845.665.798.5110.40 12/31/91
Russell Microcap 13.4522.4322.436.396.5711.266.16N/AN/A N/A

Annual Operating Expenses: Gross 1.34 Net 1.24

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. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at Gross operating expenses reflect the Fund's total gross annual operating expenses and 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 1.24% 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: Axsome Therapeutics was 1.3%, Ultra Clean Holdings was 1.4%, Zealand Pharma was 1.4%, NeoGenomics was 1.1%, Photronics was 1.4%, Red Lion Hotels was 0.0%, Correvio Pharma was 0.0%, Nautilus was 0.0%, Kirkland's was 0.0%, ORBCOMM 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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