FUND PERFORMANCE
Royce Micro-Cap Fund was down 13.3% in 2015, lagging its benchmark, the Russell Microcap Index, which fell 5.2%, and the small-cap Russell 2000 Index, which declined 4.4% for the same period. Small- and micro-cap returns were dominated by growth stocks through much of the year, which created challenges for our more valuation-centric approach— but also presented promising long-term opportunities. Indeed, following a strong fourth quarter, we entered the new year with renewed, though cautious, optimism.
Micro-Cap fell 1.4% for the year-to-date period ended June 30, 2015, while the Russell Microcap and Russell 2000 advanced 6.0% and 4.8%, respectively. In the third quarter stocks experienced a sweeping correction, and the Fund slid 15.7% versus losses of 13.8% for the micro-cap index and 11.9% for the small-cap index. Micro-Cap did better on both an absolute and relative basis in the fourth quarter, outpacing both indexes with a 4.3% advance compared to 3.7% for the Russell Microcap and 3.6% for the Russell 2000. Longer-term relative results were better versus the small-cap index. Royce Micro-Cap outperformed the Russell 2000 for the 15-, 20-year and since inception (12/31/91) periods ended December 31, 2015. (Data for the Russell Microcap only goes back to June 30, 2000.) The Fund’s average annual total return since inception was 10.7%.
WHAT WORKED… AND WHAT DIDN’T
Seven of the portfolio’s nine equity sectors finished 2015 in the red. Four areas detracted significantly—Industrials, Consumer Discretionary, Materials, and Energy. On the industry level, five groups posted sizable net losses: metals & mining, specialty retail, energy equipment & services, diversified consumer services, and machinery. The first of these groups was home to two of the Fund’s five largest detractors. Horsehead Holding produces zinc. Among other challenges, its management struggled to boost production in a newly commissioned processing facility to a level that would generate sustainable returns for shareholders. The combination of falling zinc prices, low utilization, and relatively high levels of project financing led us to sell our position. Universal Stainless & Alloy Products, which manufactures semi-finished and finished specialty steel products, underwent significant pressure on its business as steel prices continued to decline. As part of an ongoing effort to reduce the portfolio’s exposure to the commodity complex, we sold our position.
Gulf Island Fabrication suffered along with most energy businesses in what’s shaping up to be the worst market for its industry in 30 years. The company makes offshore drilling platforms and other structures for use in offshore energy production. We held the bulk of our shares, which were trading at a significant discount to book value at the end of 2015. Liking its efforts to diversify its customer base, we see it as part of an effort to high-grade our holdings with commodity exposure. Two stocks in the for-profit education business (part of Consumer Discretionary) endured losses for the year, mostly due to intense regulatory scrutiny from the current Administration, which has created significant headwinds to enrollment growth. American Public Education focuses on postsecondary school needs for the military and public services sectors. We like its valuation and differentiated focus and thus kept a small position at the end of 2015. We chose to exit our position in Lincoln Educational Services as we did not think its offerings were diverse enough. Net losses for Industrials were spread out across a number of industry groups, including machinery stocks and construction & engineering companies.
On the positive side, two holdings stood out. Firearms manufacturer Smith & Wesson Holding continued to gain market share while recent heavy investments in R&D led to major product innovation. We took gains as its shares climbed. LSI Industries was the portfolio’s largest position at year-end. A leading provider of lighting and graphics products, it’s continued to benefit from its strong position in light-emitting diode (LED) technology.
All but one of the Fund’s sectors came up short versus the Russell Microcap in 2015. Our significant underweight in Financials played the primary role, keyed by our very low exposure to banks. Stock selection was also a factor. The portfolio’s overweight in Materials hampered relative results as did exposure to metals & mining stocks. Stock selection in Consumer Discretionary also contributed to underperformance. In Energy and Industrials, however, stock selection was a positive.
Top Contributors to Performance For 2015 (%)
- Smith & Wesson Holding Corporation (SWHC, Financial) 0.74%
- LSI Industries (LYTS, Financial) 0.62%
- INTL FCStone (INTL, Financial) 0.42%
- Photronics (PLAB, Financial) 0.41%
- Relypsa (RLYP, Financial) 0.29%
Top Detractors from Performance For 2015 (%)
- Horsehead Holding Corporation (ZINCQ, Financial) -0.68%
- American Public Education (APEI, Financial) -0.51%
- Universal Stainless & Alloy Products (USAP, Financial) -0.49%
- Lincoln Educational Services (LINC, Financial) -0.49%
- Gulf Island Fabrication (GIFI, Financial) -0.48%
CURRENT POSITIONING AND OUTLOOK
We made only modest changes to the portfolio in the second half of 2015. We used proceeds from trims to commodity-based holdings to add to Financials as we believe the first steps toward a more normalized interest rate environment should benefit many companies in the sector. At the end of the year, however, we remained underweight. Our largest weightings remained Information Technology, Industrials, and Consumer Discretionary. We continue to find value in these sectors and view select areas as having the potential to benefit from the relative strength of the U.S. economy. Health Care was a large underweight, with significantly less exposure to biotech where multiples continued to look too stretched for our valuation-based discipline.
