Royce Smaller-Companies Growth Fund Manager Commentary
article 02-15-2024

Royce Smaller-Companies Growth Fund Manager Commentary

The Fund outpaced the Russell 2000 Growth for the 5-year and since inception (6/14/01) periods ended 12/31/23 while trailing for the 10-year period.


Fund Performance

Royce Smaller-Companies Growth Fund gained 17.0% in 2023 versus an 18.7% increase for its primary benchmark, the Russell 2000 Growth Index, and a 16.9% advance for its secondary benchmark, the Russell 2000 Index, for the same period. The Fund outpaced the Russell 2000 Growth for the 5-year and since inception (6/14/01) periods ended 12/31/23, while trailing for the 10-year period.

What Worked… and What Didn’t

Six of the portfolio’s 10 equity sectors made a positive impact on performance in 2023, led by Industrials, Information Technology, and Consumer Discretionary. The largest detractors were Health Care, Materials, and Energy. At the industry level, trading companies & distributors (Industrials), software (Information Technology), and hotels, restaurants & leisure (Consumer Discretionary) contributed most in 2023, while biotechnology (Health Care), pharmaceuticals (Health Care), and communications equipment (Information Technology) were the largest detractors.

The Fund’s top-contributing position was Distribution Solutions Group, which distributes maintenance and repair products. The company was the result of a three-way merger of maintenance, repair, and operations companies. The new CEO has set higher revenue growth and meaningful margin expansion targets, despite recent economic headwinds. It was a top-three position at year-end given the multi-year transformation of the business, improved growth characteristics, and its high-return industrial distributor model. Aehr Test Systems is a semiconductor capital equipment company that focuses on silicon carbide microprocessors, which are well suited for the EV, charging, and power supply markets. Exceptional demand spurred its shares in the first half of 2023, when we chose to take profits. FTAI Aviation provides aircraft engine leasing services to global airlines. The company has benefited from an acute engine supply shortage due in part to lower new aircraft production rates, which created the dual benefit of making FTAI’s inventory of overhauled engines more valuable while also allowing for higher lease rates.

ViewRay, the Fund’s top detractor in 2023, markets a medical system that combines real-time MRI imaging and cancer radiation treatment, resulting in superior patient outcomes, fewer treatment sessions, and fewer side effects. The appeal of its treatment, a new CEO, and more conservative guidance could not compensate for a tighter hospital spending environment, higher financing costs, and lengthening sales cycles that created a significant cash flow crunch. We therefore exited the position in July. InMode is the leader in the aesthetic/plastic surgery “bipolar radio frequency/bipolar RF” systems business and has been both an innovator and a historically solid performer. While new products were its trademark, its latest offerings have been unable to transcend a tougher consumer/economic spending environment and decelerating system utilization and placements. We sold the last of our shares in November. Halozyme Therapeutics has a biotechnology licensing platform that enables large pharmaceutical companies to convert IV therapeutics to subcutaneous injections. The company did not see a previous pattern of rapidly replacing an existing IV therapeutic, followed by a lower market growth rate once maximum penetration rate was reached. Given Halozyme’s product revenue concentration, we exited the position in May.

The portfolio’s disadvantage versus the Russell 2000 Growth was attributable to stock selection in 2023. Our sector allocation decisions were additive. Stock selection hurt most in Health Care, Information Technology, and Materials. Conversely, stock selection in Industrials, Consumer Discretionary, and Consumer Staples contributed most to relative results.

Top Contributors to Performance 20231 (%)

Distribution Solutions Group1.93
Aehr Test Systems1.62
FTAI Aviation1.57
TransMedics Group1.51
Atlas Technical Consultants Cl. A1.50

1 Includes dividends

Top Detractors from Performance 20232 (%)

Halozyme Therapeutics-0.97
AMG Critical Materials-0.75

2 Net of dividends

Current Positioning and Outlook

We suspect there is ample room for small-caps to catch up to large-caps in 2024. The primary driver of small-cap’s outperformance in 4Q23 was the combination of more evidence that inflation was moderating and the consequent likelihood that the Fed would be more likely to pause or even cut rates in 2024. While a soft landing for the economy is still a question mark, the market headwinds from monetary tightening appear to be easing. Lower rates should, in our opinion, be a positive backdrop for small-cap equities, capital investment, and risk-taking in general. Of course, many factors drive investor sentiment, and the geopolitical situation has worsened with Israel’s military reaction to a domestic attack and the ongoing Ukraine-Russia conflict. While several of our investment themes and positions have not yet delivered as we had hoped—drug discovery tools, increased electrification, and medical devices, we believe it is only a matter of time before they begin to recover from the temporary headwinds of excess post-pandemic inventories, decelerating electric vehicle demand in the U.S., and concerns over the impact new GLP-1 diabetes drugs may have on medical procedures. We have added to drug discovery tools and software as service stocks after some meaningful valuation contraction, while taking some profits on recent winners, Celsius and DraftKings. We have also added aerospace & defense related stocks given the multi-year demand outlook, while buying a few AI “picks & shovels” names as we monitor the robust spending in that technology innovation.

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

Smaller-Companies Growth 13.8516.9716.97-5.189.496.3810.257.879.95

Annual Operating Expenses: Gross 1.57 Net 1.49

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 gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service 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 Service 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 1.49% through April 30, 2024.

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: Distribution Solutions Group was 2.7%, Aehr Test Systems was 0.0%, FTAI Aviation was 2.7%, TransMedics Group was 2.2%, Atlas Technical Consultants Cl. A was 0.0%, ViewRay was 0.0%, InMode was 0.0%, Halozyme Therapeutics was 0.0%, Harrow was 0.7%, AMG Critical Materials was 0.8%.

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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