Royce Small-Cap Opportunity Fund Manager Commentary
article 02-15-2024

Royce Small-Cap Opportunity Fund Manager Commentary

Our theme-based Small-Cap Opportunity Fund advanced 19.6% in 2023, well ahead of its primary benchmark, the Russell 2000 Value Index, and its secondary benchmark, the Russell 2000 Index, which were up 14.6% and 16.9%, respectively, for the same period.


Fund Performance

Royce Small-Cap Opportunity Fund advanced 19.6% in 2023, well ahead of its primary benchmark, the Russell 2000 Value Index, and its secondary benchmark, the Russell 2000 Index, which were up 14.6% and 16.9%, respectively, for the same period. The Fund also beat both indexes for the 3-, 5-, 10-, 15-, 20-, 25-year, and since inception (11/19/96) periods ended 12/31/23.

What Worked… and What Didn’t

Eight of the Fund’s 10 equity sectors made positive contributions to calendar year results, led by Industrials, Consumer Discretionary, and Information Technology. Communication Services and Real Estate detracted, albeit slightly, while Consumer Staples made the smallest contribution. At the industry level, construction & engineering (Industrials), household durables (Consumer Discretionary), and metals & mining (Materials) contributed most for the calendar year period, while communications equipment (Information Technology), pharmaceuticals (Health Care), and energy equipment & services (Energy) were the largest detractors.

The top-contributing position in 2023 was Modine Manufacturing, which provides thermal management systems for several industries. It was first added to the portfolio as a turnaround candidate as it was moving from its historical core of automotive radiators toward newer high growth opportunities. The shift is now paying dividends as the company is seeing significant wins in areas such as data centers and electric vehicles. Limbach Holdings is a specialty contractor focused primarily on heating, cooling, and plumbing systems. The company is refocusing its business away from being a general contractor towards working directly with property owners, a customer base that generates significantly higher profit margins, which has become increasingly apparent in operating results.

The Fund’s biggest detractor was DZS, which manufactures mobile transport and broadband access solutions. Its telecom equipment end markets were weak throughout 2023 as customers worked off excess inventory. DZS faced additional challenges managing its working capital as it faced payment issues with certain customers in Asia. Finally, the company announced that it would restate financials for 2023’s first quarter because a certain amount of inventory in Asia was not properly accounted for. However, DZS was able to execute a financing plan with its parent company, selling its Asian assets to the parent in early 2023, enabling DZS to strengthen its balance sheet and focus on selling higher margin products. ADTRAN Holdings sells network access solutions mostly to U.S. and European customers. It endured the same end market weakness in the telecom equipment space as DZS. ADTRAN also announced in its third-quarter earnings release that revenues had dropped significantly and that its business would probably remain challenging through the first half of 2024 because inventory reductions and restrained capital spending across its customer base were likely to continue. We exited the position in November, though it remains on our watchlist.

The Fund’s advantage over the Russell 2000 Value in 2023 came from sector allocation. Our much lower weighting in Financials, higher weighting in Industrials, and both a lower weighting and stock selection in Health Care drove our edge at the sector level. Conversely, stock selection in Information Technology, a higher weighting and stock selection in Communication Services, and stock selection in Energy hurt relative performance most.

Top Contributors to Performance 20231 (%)

Modine Manufacturing1.07
Limbach Holdings1.02
Carrols Restaurant Group0.57
Carpenter Technology0.57
American Superconductor0.55

1 Includes dividends

Top Detractors from Performance 20232 (%)

ADTRAN Holdings-0.53
Babcock & Wilcox Enterprises-0.51
Cambium Networks-0.36
TTEC Holdings-0.34

2 Net of dividends

Current Positioning and Outlook

With inflation rolling over and the U.S. economy remaining healthy, it appears the “soft landing” scenario is playing out. It also seems increasingly likely to us that the Fed rate hike cycle has ended, with the markets anticipating rate cuts in 2024. Despite wars in the Ukraine and Middle East—and related disruptions to global shipping lanes—energy prices have remained stable but were creeping higher as of this writing and bear watching as we enter 2024. With all of this in mind, we remain generally optimistic on the state of the U.S. economy and remain broadly overweight in Industrials and Information Technology. Many of our portfolio companies are reporting that supply chains have returned to normal or near normal conditions after several years of Covid-related disruptions. Despite our view that the long-term competitive dynamics of the industry are challenging, we have been slowly adding to our bank exposure given the outlook for lower rates in 2024, which should help alleviate the risks associated with credit quality issues. We also continue to look for opportunities to take advantage of unprecedented investments from both the private and public sectors in U.S. infrastructure spending. We see investment as being fueled by the realization that companies need shorter and more secure supply chains, as well as the concerns about strategic imperatives around semiconductor production capabilities. We think the increasing demand for Artificial Intelligence (AI) capabilities is accelerating these trends, which, in addition to driving demand for semiconductor capabilities, are driving significant demand for energy efficiency. We view this investment thesis as being in the early innings.

Average Annual Total Returns Through 12/31/23 (%)

Small-Cap Opportunity 11.1719.5819.589.0716.058.6514.499.3011.6811.90

Annual Operating Expenses: 1.23

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 Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

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, 2023, 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, 2023 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 12/31/23, the percentage of Fund assets was as follows: Modine Manufacturing was 0.7%, Limbach Holdings was 0.6%, Carrols Restaurant Group was 0.3%, Carpenter Technology was 0.7%, American Superconductor was 0.4%, DZS was 0.1%, ADTRAN Holdings was 0.0%, Babcock & Wilcox Enterprises was 0.1%, Cambium Networks was 0.0%, TTEC Holdings was 0.5%.

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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