Royce Capital Fund-Micro-Cap Portfolio Manager Commentary
article 06-30-2019

Royce Capital Fund–Micro-Cap Portfolio Manager Commentary

Despite the Fund underperforming its indexes during 2019’s first half, we were pleased to see it outpace the micro-cap cap index for the one-year period ended June 30, 2019.


Fund Performance

For the year-to-date period ended June 30, 2019, Royce Capital Fund–Micro-Cap Portfolio underperformed both of its benchmarks. The Fund gained 10.7%, while the Russell Microcap and Russell 2000 Indexes returned 14.1% and 17.0%, respectively, for the same period. We were pleased, however, that the Fund outpaced the micro-cap index for the one-year period ended June 30, 2019.

What Worked... And What Didn't

Eight of the Fund’s 10 equity sectors generated positive returns in 2019’s first half. Our persistent large weighting in Information Technology worked in our favor as it was the top contributor at the sector level. Industrials and Health Care followed Information Technology while Communication Services and Consumer Staples detracted, but with only minor impacts. At the industry level, the greatest source of positive performance came from semiconductors & semiconductor equipment (Information Technology), which saw strong results from Adesto Technologies, the second-largest contributing position in the overall portfolio. Through a series of acquisitions, the company has transformed itself from a niche memory provider to a more comprehensive systems provider targeting industrial “Internet-of-Things” applications. Recent results have exceeded expectations as management has successfully integrated its acquisitions and is beginning to garner new product wins. We maintained our position in the shares as we believe the transformation is in the very early stages.

Machinery (Industrials) and software (Information Technology) followed as the next top-contributing industries. The best-performing position for the year-to-date period was Quanterix Corporation, a medical technology provider that offers ultra-high sensitivity immunoassay platforms used in testing protein biomarkers. Its shares benefited as the company’s leading edge technology drove significant growth in critical life sciences research applications in areas such as neurology, oncology, and cardiology, among others. We also saw a strong contribution from Kornit Digital, a digital printing specialist for the apparel and textile industries thanks to this machinery company’s recent record revenue growth.

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The top detractors at the industry level were specialty retail and leisure products—both in Consumer Discretionary. After a series of successful new product offerings, health and fitness products company Nautilus suffered through two consecutive failed product launches, with a resulting decision to remove the CEO. While we like a number of the strategic decisions the company has made over the past several years, we sold our position as we expect it will take at least a year to rebuild a new product pipeline, and our confidence in management’s ability to effectively navigate the rapidly changing fitness market was shaken. Independence Contract Drilling operates a fleet of state-of the-art drilling rigs throughout North America. Its shares have been hurt by the ongoing slowdown in drilling activity in the U.S. While the outlook for the industry remains cloudy given volatile oil prices, we held our position as we believe its shares trade well below the underlying asset value of its high-end rigs.

Relative to the Russell Microcap, both stock selection and sector allocation hindered performance for the year-to-date period. Health Care hampered relative results most due to both poor stock selection—most notably in biotechnology—and our underexposure, particularly in pharmaceuticals. Consumer Discretionary came next, mostly due to poor stock selection. The specialty retail group hampered results most, as home décor, furniture, and accessories company Kirkland’s suffered a setback in its efforts to redefine itself as an omnichannel retailer capable of competing with the likes of Amazon and Wayfair. While we believe there is an opportunity for well-run retailers to effectively reimagine their business models in the e-commerce age, we moved on from the stock given management’s recent struggles to execute toward their vision. Conversely, Information Technology was the top contributor due to our overweight in the sector, most impactfully in semiconductors & semiconductor equipment. Industrials followed, with construction & engineering the sector’s strongest industry thanks to savvy stock selection.

Top Contributors to Performance Year-to-Date Through 6/30/191 (%)

Quanterix Corporation0.62
Adesto Technologies0.57
Kornit Digital0.57
Zealand Pharma0.55

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/192 (%)

Independence Contract Drilling-0.31
Harvard Bioscience-0.26
NeoPhotonics Corporation-0.22

2 Net of dividends

Current Positioning And Outlook

We remain generally constructive on the U.S. economy despite the increasing uncertainty around trade and late cycle economic concerns. Our constructive stance was further enhanced by the end of the current Fed tightening cycle, which we think should support what we view as attractive fundamentals and valuations for holdings in various technological and industrial areas, as well as in certain pockets of medical technology, where we have been increasingly active. We also continued to incrementally build our exposure to Information Technology. Indeed, we remain optimistic about the overall prospects for micro-cap stocks in the current environment. Anticipating better growth in the U.S. relative to the rest of the globe, we stayed primarily focused on companies that derive most of their revenues from domestic activities.

Average Annual Total Returns Through 06/30/19 (%)

Capital Micro-Cap 0.9110.70-8.728.191.167.545.258.689.29 12/27/96
Russell Microcap 0.9214.15-10.3911.195.5212.546.28N/AN/A N/A

Annual Operating Expenses: Gross 1.39 Net 1.33

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 & 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 June 30, 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 June 30, 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 6/30/19, the percentage of Fund assets was as follows: Quanterix Corporation was 1.1%, Adesto Technologies was 1.2%, Kornit Digital was 1.0%, NeoGenomics was 1.3%, Zealand Pharma was 1.0%, Nautilus was 0.0%, Kirkland's was 0.0%, Independence Contract Drilling was 0.3%, Harvard Bioscience was 0.5%, NeoPhotonics Corporation was 0.6%

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 1000 Index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. 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 Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes approximately 800 of the smallest securities in the Russell 1000 Index. 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 ex USA Small Cap Index is an index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. 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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