Royce Micro-Cap Discovery Fund was up 0.7% for the year-to-date period ended June 30, 2015, lagging its benchmark, the Russell Microcap Index, which advanced 6.0% for the same period.
The Fund was again challenged by its lack of participation in a mostly bullish period for both micro-cap and small-cap stocks. It is also worth pointing out, however, that returns for each asset class were extremely narrow, led by biotech stocks and concentrated beyond that industry among a small handful of groups during the first half of 2015.
In the first quarter, Royce Micro-Cap Discovery got off to a promising start on an absolute basis. The Fund gained 2.8% versus a 3.1% advance for its benchmark. Though disappointing from a relative standpoint, Micro-Cap Discovery performed largely as we would expect. The Fund lost less than its benchmark during the bearish January before falling behind the micro-cap index when stock prices recovered in February and March. Unfortunately, the Fund ceded more ground to the Russell Microcap in the second quarter, underperforming in each of its three months. Although it stayed close to the benchmark in April when share prices again tumbled, the portfolio also fell in May, when most micro-cap shares were rallying. Micro-Cap Discovery was down 2.1% in the second quarter while the Russell Microcap increased 2.8%. The Fund underperformed its benchmark for the one-, three-, five-, 10-year, and since inception (10/3/03) periods ended June 30, 2015, though the Fund’s average annual total returns for the three- and five-year periods remained strong on an absolute basis.
WHAT WORKED… AND WHAT DIDN’T
Health Care was something of a double-edged sword for the portfolio. The sector led both the Fund and the Russell Microcap in the first half, though results for the index were (as mentioned) dominated by stratospheric performance for biotech stocks as well as healthy returns for pharmaceuticals. These businesses generally lack the attributes sought by the portfolio’s quantitative model, which looks for what it determines are undervalued micro-cap businesses with strong fundamentals. Not only was the Fund significantly underweight in Health Care during the first half, but it also had no exposure to biotech and very little exposure to pharmaceuticals. Net gains came mostly from holdings in the health care equipment & supplies industry. So even as the sector was the portfolio’s top contributor in the first half, its net gains were not nearly as strong as were those for Health Care within the Russell Microcap.
Ebix (EBIX, Financial) made the largest contribution to first-half performance by a sizable margin. The company supplies software and e-commerce solutions to the insurance industry and experienced solid growth in its business. We sold our shares in the second quarter as its stock rose. Seeing more room for potential growth, we chose to hold our shares of Culp (CFI, Financial), which supplies upholstery fabrics and mattress tickings to the furniture and bedding industries. Its shares took flight in March after the firm announced strong fiscal third-quarter results and a positive outlook for the rest of fiscal 2015.
Of the Fund’s three sectors that finished the semiannual period in the red, only Energy and Materials posted sizable net losses. The first of those sectors was home to Gulf Island Fabrication, which fabricates offshore drilling and production platforms, as well as other steel structures for the oil and gas and marine industries. Recent results have been hurt by the decline in commodity prices, which has led to a slowdown in its business. We held shares at the end of June. We also added to the portfolio’s position in TESSCO Technologies (TESS, Financial), which distributes equipment used to equip cell phone towers. One of its larger customers curtailed spending, which has hurt recent earnings. We sold our shares of United States Lime & Minerals, which supplies lime and limestone products to a number of industries, including energy. A slowdown in several of the industries it serves depressed earnings markedly.
Top Contributors to Performance:
- Ebix (EBIX, Financial)
- Culp (CFI, Financial)
- Invacare Corporation (IVC, Financial)
- Village Super Market Cl. A (VLGEA, Financial)
- Journal Communications Cl. A (JRN, Financial)
Top Detractors from Performance:
- TESSCO Technologies (TESS, Financial)
- United States Lime & Minerals (USLM, Financial)
- Gulf Island Fabrication (GIFI, Financial)
- UFP Technologies (UFPT)
- Computer Task Group (CTG)
CURRENT POSITIONING AND OUTLOOK
To cull potential portfolio candidates, we combine a proprietary quantitative screening model with traditional fundamental analysis to help find companies that exhibit certain value-based characteristics. Several key elements comprise this proprietary model. At the end of June Micro-Cap Discovery was significantly underweight versus its benchmark in Health Care and Financials and had no exposure to Utilities and Telecommunications Services. The portfolio was overweight in Consumer Discretionary, Energy, Industrials, and Information Technology, while it had substantial overweights in Consumer Staples and Materials.
