What accounted for Royce Micro-Cap Fund's underperformance in 2012?
There was significant bifurcation in the micro-cap market in 2012, where strong performance came from two extremes in the asset class while many companies left in the middle languished. This barbell-shaped market consisted of high-yielding, fixed-income-looking issues at one end—primarily REITs (real estate investment trusts) and MLPs (master limited partnerships)—which many investors saw as more stable. The other end was made up of companies that were growing very quickly, but were mostly more speculative types of companies that lacked the strong business qualities that we seek for the portfolio. These were primarily higher-growth and higher-risk investments in sectors and industries such as biotech, fast-growing consumer oriented companies, and high-growth tech stocks.
When it came to micro-cap equities, people seemed either very willing to take on risk or were highly risk averse. Very few investors were interested in the kinds of micro-cap companies that were attracting our attention—businesses with strong balance sheets and high returns on invested capital. The bulk of these stocks apparently looked too risky to one segment of investors and not fast-growing enough to another.
Have you been repositioning the portfolio or altering your stock selection methods?
We have not changed anything about the way that we pick stocks. Our process is the same bottom-up, business buyer's approach that's been used in the portfolio since its inception more than 20 years ago. We remain squarely focused on micro-cap stocks with business and/or financial strength that are also trading at what we think are substantial discounts to their private worth. Our investment horizon remains a three-to five-year time span for portfolio holdings.
Coming on the heels of a disappointing down year in 2011, poor results in 2012 were especially frustrating. With sizable investments in the Fund ourselves, we understand this frustration. We spend a lot of time, in good times and bad, looking over the portfolio and reevaluating our decisions. So while the approach has not changed, we have done a fair amount of fine-tuning over the last two years, holding on to those companies that we think represent the best combination of quality and valuation and/or that look best poised to grow when investors are more focused on the same attributes that we are.
What specific changes have you made?
We sold some non-U.S. holdings over the last year, including certain Chinese and European stocks that were ongoing disappointments, as well as domestic companies that were performing well below our expectations. These moves were across various sector and industry groups. We've also purchased shares of tech businesses that look very attractive from both a quality and valuation perspective. We have seen the stock prices of certain retailers punished— disproportionately in our view—for what look to us like comparatively minor earnings disappointments, so we're trying to take advantage by buying on those dips. One area in which we haven't been very active, but could be in the next year or so, is Healthcare. The business cycle for many of its industries seems to be slowing, which is a promising sign for bargain-hunting investors like us. In addition, the final implementation of the Affordable Care Act in 2014 is likely to create enough misunderstanding of healthcare-related business values to create more opportunities for us.
In what other areas are you currently seeing quality?
Holdings in some of the Fund's largest sectors were beaten up pretty badly in 2012, in some cases despite doing well, or not doing that badly, as businesses. In the Energy sector, for example, companies involved in drilling suffered declines in 2012 that were worse for their share prices than for their admittedly slower businesses. We expect a pick-up at some point in 2013. We own other energy services businesses that have done steady business and are posting solid earnings, but did not catch the attention of many investors in 2012. We're holding these companies because their cap rates—that is, earnings yields—are high and their valuations remain compelling.
A slower-growth environment has also kept investors away from many industrial stocks. Although such a large and diverse sector is difficult to generalize about, we saw a number of holdings struggle in the face of a more tepid pace of growth in Asia. Our holdings are primarily well-run companies with strong balance sheets that have grown leaner and meaner in the slowdowns of the last two years and look poised to rebound strongly once industrial activity picks up again.
Do you anticipate more M&A activity in the months ahead?
I don't know if we'll see more M&A, but recently there's been an increase in the particular kind of M&A activity that we like to see—strategic activity in which acquirers are looking for ways to grow and improve their own business. It's always a healthy sign when businesses are being bought because they're regarded as really good businesses. We think it could be an early positive sign that quality considerations are assuming more importance.
Important Performance and Expense InformationAll 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 180 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.roycefunds.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.
Jenifer Taylor is a Portfolio Manager of Royce & Associates, LLC, investment adviser to The Royce Funds. Ms. Taylor's thoughts in this piece are solely her own and, of course, there can be no assurance with regard to future market movements.
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. The Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus). The Fund may invest up to 35% of its net assets in foreign securities, which may involve political, economic, currency and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)