Royce Micro-Cap Fund Manager Commentary
article 06-30-2023

Royce Micro-Cap Fund Manager Commentary

Royce Micro-Cap Fund beat its primary benchmark, the Russell Microcap Index, and its secondary benchmark, the Russell 2000 Index, for the year-to-date, 1-, 3-, and 5-year periods ended 6/30/23 and also outperformed the Russell 2000 for the 25-, 30-year, and since inception (12/31/91) periods ended 6/30/23 (data for the Russell Microcap only goes back to 2000).

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Fund Performance

Royce Micro-Cap Fund beat its primary benchmark, the Russell Microcap Index, and its secondary benchmark, the Russell 2000 Index, for the 1-, 3-, and 5-year periods ended 6/30/23. The Fund also outperformed the Russell 2000 for the 25-, 30-year, and since inception (12/31/91) periods ended 6/30/23 (data for the Russell Microcap only goes back to 2000). For the year-to-date period ended 6/30/23, the Fund advanced 9.4%, outpacing both the Russell Microcap, which was up 2.3%, and the Russell 2000, which gained 8.1%, for the same period.

What Worked… And What Didn’t

Seven of the Fund’s 10 equity sectors made a positive contribution to performance in the first half of 2023, led by Information Technology, Industrials, and Health Care. Financials and Communications Services detracted while Real Estate made the smallest contribution. The top-contributing industries were semiconductors & semiconductor equipment (Information Technology), machinery (Industrials), and electronic equipment, instruments & components (Information Technology), while banks (Financials), specialty retail (Consumer Discretionary), and professional services (Industrials) were the biggest detractors.

The Fund’s two top contributing positions in 2023’s first half are benefiting from the growing significance of silicon carbide semiconductors in electric vehicles. While we have been selling shares of each, we continue to hold solid positions because we believe this is a secular trend in its early stages. Axcelis Technologies makes and services ion implantation, dry strip, thermal processing, and curing equipment used in semiconductor chip fabrication. Axcelis is a predominant player in providing ion implantation systems for the semiconductor industry, which is becoming increasingly important as power management devices become critical in numerous industries. Aehr Test Systems has unique semiconductor testing systems that address processes where the cost of chip failure is especially high. Arlo Technologies provides home security cameras and related security monitoring services. For the past year or so, Arlo has been transforming its business from a legacy, low margin hardware focus to a subscription model with recurring revenues and high margins. We believe the stock hit an inflection point in this transition during the second quarter of 2023 when the superior economics of the subscription model and its impact on growth and margins became evident to investors.

The top detractor was aesthetic medical device maker, Cutera, which suffered through an earnings guidance cut as its core business slowed. An ensuing boardroom battle resulted in the firing of the well regarded CEO and Chair, creating more uncertainty. This individual has since rejoined the company as an advisor while the Board looks for a permanent CEO. We held shares as we believe there is significant asset value in the business that, once stabilized by new management, should make it an appealing part of a larger company. Regional bank Investar Holding Corporation was hurt by the recent banking crisis and concerns about increased credit losses in a slowing economy. However, we think these risks are outweighed by its longer-term prospects in a growing economy. DZS manufactures communications network equipment that helps deliver high speed fiber access. DZS lowered earnings guidance and was also in non-compliance with loan covenants that it is working with lenders to renegotiate while also dealing with a revenue recognition issue that DZS described as a one-off discovered during the collection process. We held a small position at the end of June.

Relative to the Russell Microcap, both sector allocation and stock selection were additive to Fund performance. The combination of our larger weighting and stock picks in Information Technology and Industrials helped most, along with our lower exposure to Financials. Offsetting our relative edge somewhat were lower exposure to Health Care, stock selection and our higher weight in Communication Services, and stock picks in Consumer Discretionary.


Top Contributors to Performance Year-to-Date Through 6/30/231 (%)

Axcelis Technologies1.16
Aehr Test Systems0.94
Arlo Technologies0.80
CIRCOR International0.80
Universal Stainless & Alloy Products0.79

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/232 (%)

Cutera-0.65
Investar Holding Corporation-0.61
DZS-0.60
Western New England Bancorp-0.55
Territorial Bancorp-0.53

2 Net of dividends

Current Positioning and Outlook

While Artificial Intelligence (“AI”) has seen ample hype, we see it as one more secular trend that is driving demand for semiconductors and processing bandwidth. This plays into our portfolio positioning as select smaller technology names are providing critical components in this value chain. We view our technology companies as “picks and shovel” providers into a myriad of long-term technology trends while many of our industrial companies appear to possess similar characteristics. We also expect many industrial companies to benefit from the increasing use of AI to drive efficiencies in their operations. More significantly, however, we believe many of these large macro trends require substantial infrastructure investments and have underlying government support, one example being the shift to green energy, which requires significant investments in electrical transmission capabilities. While we are excited about our positioning in the intermediate term, we are also cognizant of short-term market pressures, most notably the unprecedented pace of Fed rate hikes. Although inflationary pressures have meaningfully moderated, the Fed remains in a hawkish mode. These pressures are likely to be exacerbated by commercial banks tightening lending standards. Likewise, the attempted coup in Russia highlighted the ever present black swan risks that are hard to underwrite. That said, we believe the intermediate-term opportunities outweigh the short-term risks, and our outlook remains constructive.

Average Annual Total Returns Through 06/30/23 (%)

QTR1 YTD1 1YR 3YR 5YR 10YR 15YR 20YR 25YR 30YR SINCE INCEPT.
(12/31/91)
Micro-Cap 6.719.4117.6316.076.716.535.918.158.289.5810.33
Russell Microcap 5.292.326.639.092.077.297.707.55N/AN/AN/A

Annual Operating Expenses: 1.24

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. 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 www.royceinvest.com. 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 June 30, 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 June 30, 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 6/30/23, the percentage of Fund assets was as follows: Axcelis Technologies was 1.3%, Aehr Test Systems was 1.2%, Arlo Technologies was 1.1%, CIRCOR International was 0.0%, Universal Stainless & Alloy Products was 1.4%, Cutera was 0.2%, Investar Holding Corporation was 0.7%, DZS was 0.3%, Western New England Bancorp was 0.8%, Territorial Bancorp 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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