Royce Capital Fund-Small-Cap Portfolio Manager Commentary
article 06-30-2020

Royce Capital Fund–Small-Cap Portfolio Manager Commentary

As we navigate the unsettling climate, we have turned our focus to companies that appear likely to participate in a sustainable economic recovery.


Fund Performance

Royce Capital Fund–Small-Cap Portfolio, which uses a disciplined contrarian value approach, had a difficult first half of 2020. The Fund was down 28.4% for the year-to-date period ended 6/30/20 and underperformed both of its small-caps benchmarks: the Russell 2000 Value Index fell 23.5% and the Russell 2000 Index lost 13.0% for the same period.

What Worked… And What Didn't

For the year-to-date period ended 6/30/20, six of the nine equity sectors in which the Fund had investments finished in the red, with three sectors—Financials, Industrials, and Consumer Discretionary—making substantial negative impacts on results. Communication Services, Health Care, and Consumer Staples made positive, yet very modest, contributions to performance. Banks (Financials) detracted most at the industry level, followed by airlines (Industrials) and specialty retail (Consumer Discretionary). The holding that detracted most in the first half was discount carrier Spirit Airlines as its industry continued to be hit especially hard by substantial restrictions on travel created by the coronavirus. These same developments caused problems for the business of low-cost carrier Allegiant Travel. We exited both positions during the first half.

Retailers have been suffering markedly from contracting economic activity, and this led us to sell our position in footwear manufacturer Caleres. We chose to significantly reduce, rather than sell off, our shares of Designer Brands, whose core business in women’s dress shoes looks capable of an eventual recovery. Throughout the first half, that line was out of step with work-from-home trends which have been more favorable for casual and/or athletic footwear. We acted along similar lines by reducing our position in G-III Apparel Group, which makes and distributes clothing and other items under its own and licensed brand names. We believe the company has been managing its way through the pandemic effectively, even as its exposure to a large multiline retailer remains a concern for us. We also liked its decision in January to reduce the number of retail outlets it manages on behalf of other brands, a move that looks even wiser with hindsight.

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The top two contributing industries in 2020’s first half were from Industrials: road & rail and construction & engineering. Global infrastructure, IT, and logistics support service company Vectrus was the top-contributing position for 2020’s first half as it moved full steam ahead on its significant Logcap-V contract with the U.S. army as well as expanding its business into other branches of the military. Recreational boat dealer OneWater Marine benefited from strong sales as outdoor activities that can encompass physical distance saw vibrant consumer demand in the first half. Trucking business Saia expanded its regional reach from the southeastern U.S. into the Northeast, which helped its business to accelerate.

Stock selection drove first-half relative underperformance versus the Russell 2000 Value as sector allocation was moderately additive. Our stock selection and, to a lesser degree, higher weighting made Consumer Discretionary the largest-detracting sector. Health Care also hurt performance via stock selection and our lower exposure, with the former having a greater impact. Industrials followed, also due to stock selection. By contrast, Financials was the top relative performing sector, mostly because of stock selection, though our lower exposure was also modestly additive. Finally, our underweight in Real Estate helped as did the Fund’s cash holdings.

Top Contributors to Performance Year-to-Date Through 6/30/211 (%)

Shoe Carnival1.60
Kulicke & Soffa Industries1.53
Aaron's Company (The)1.16

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/212 (%)

James River Group Holdings-0.31
Heritage Insurance Holdings-0.15
PROG Holdings-0.12
BioDelivery Sciences International-0.10

2 Net of dividends

Current Positioning And Outlook

We continue to see the effects of COVID-19 on the market and the economy, along with the uncertain outlook created by the lack of a vaccine or effective treatment. The Fed has reacted quickly and effectively to keep the financial system liquid, which led the market to price in a relatively quick, ‘V-shaped’ recovery. Yet companies are providing little guidance, if any, and we continue to see cases of the virus growing and spreading in many locations. So while the market is reacting in a manner that indicates 2021 will be similar to 2019, we are anticipating more volatility in the coming months, especially as the election nears. In this unsettled climate, most stocks look expensive to us. Our focus is therefore on companies that appear likely to participate in a sustainable economic recovery. Certain companies that were doing well in 2019 should be able to tread water until either a vaccine or an effective treatment is available. We have been adding names in engineering & construction companies that we think look underpriced, as well as purchasing some property & casualty insurance companies that are showing fewer and more short-lived adverse effects from the pandemic. The downturn also provided an opportunity to buy a software company and a handful of contract manufacturers in the tech space. By contrast, we sold positions in airlines and energy while also cutting back on retail and banks as these areas appear less likely to rebound in the intermediate term.

Average Annual Total Returns Through 06/30/21 (%)

Capital Small-Cap 2.1223.4860. 12/27/96

Annual Operating Expenses: Gross 1.11 Net 1.08

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 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 1.08% through April 30, 2021.

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, 2020, 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, 2020 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 6/30/20, the percentage of Fund assets was as follows: Vectrus was 1.9%, OneWater Marine Cl. A was 1.2%, Saia was 1.3%, MasTec was 1.5%, Rent-A-Center was 2.5%, Spirit Airlines was 0.0%, Designer Brands Cl. A was 0.5%, Caleres was 0.0%, Allegiant Travel was 0.0%, G-III Apparel Group was 0.4%

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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