Fund performance
Royce Micro-Cap Opportunity Fund was down 16.0%, lagging both its new benchmark, the Russell Microcap Index, which lost 5.2%, and its former yardstick, the small-cap Russell 2000 Index, which was down 4.4% for the same period. (We are using the Russell Microcap as the fund’s new benchmark because it better reflects the fund’s selection universe, part of changes that became effective on May 1, 2015.)
For the year-to-date period ended June 30, 2015, the fund gained 4.3% versus respective increases of 6.0% and 4.8% for the micro-cap and small-cap indexes. Returns for most equities reversed dramatically in the year’s third quarter, when Micro-Cap Opportunity fell 19.8% versus a loss of 13.8% for the Russell Microcap and a decline of 11.9% for the Russell 2000.
For the fourth quarter the fund was up 0.5% versus respective gains of 3.7% and 3.6% for the portfolio’s new and former benchmarks. So while it was a difficult year, it was also a year in which we built a portfolio that we believed looked attractively cheap and poised for growth at the end of 2015. Measured by P/B and price-to-sales, valuations for companies in several industries looked good to us, and we remained bullish even in the midst of January’s painful declines. For the period ended Dec. 31, 2015, Micro-Cap Opportunity Fund’s average annual total return since inception (Aug. 31, 2010) was 10.2%.
The fund’s name change became effective on May 1, 2015, when it also began to operate under a new nonfundamental investment policy requiring 80% of its assets to be invested in stocks with market caps up to $1 billion. The fund is being run closely to the way in which it has been since its inception, investing primarily in a limited number (generally less than 100) of mostly micro-cap stocks.
What worked and what didn't
Eight of the fund’s nine equity sectors finished the year in negative territory. Consumer Discretionary was the clear loss leader, though Industrials and Energy also detracted notably. At the industry level, three groups were significantly in the red –Â electrical equipment (from Industrials), health care equipment and supplies and specialty retail. The fund’s largest net loss at the position level came from Power Solutions International (PSIX, Financial), which makes environmentally friendly natural gas engines.
Exposure to the energy markets was the major factor in its share-price slump, which was also affected by reduced full-year guidance announced in November. Confident in its growth prospects, we built our position through much of the year. Earnings growth for surf-and-skate apparel retailer Zumiez (ZUMZ, Financial) trended in the wrong direction in 2015, which led us to begin selling our shares. Exar Corporation (EXAR, Financial), with which we’ve enjoyed success in the past, saw its stock price fall when a rumored acquisition did not happen. Shares fell further when its CEO departed. We chose to sell our stake in the fourth quarter. Century Aluminum (CENX, Financial), which produces the metal, had to contend with significant commodity price weakness, exacerbated by China’s decision to export its excess capacity. We sold our position in October. Tangoe (TNGO, Financial) makes software that helps companies manage their fixed and mobile communications assets and costs, which in our view makes it a unique business that offers considerable value. We built a position throughout 2015.
We still liked the ongoing prospects for U.S. Concrete (USCR, Financial), which supplies concrete and related products to the construction industry throughout the country. We remain bullish on nonresidential construction, particularly in the Northeast. Although its rising stock price led us to take gains in 2015, it was the portfolio’s 15th-largest holding at year end. We acted in a similar fashion with EarthLink Holdings (ELNK, Financial). We like how the company has moved from providing general Internet services to focusing on more business-oriented activities. Initially seeing it as an asset play, we also liked its new management’s plans to better focus the business and their ability to cut costs in a flat-growth environment. The company’s steady march toward profitability attracted investors in 2015. We held shares in part because we think it possesses valuable assets that are likely to attract premium prices. Builders FirstSource (BLDR, Financial), which makes building products for homebuilders, acquired a private competitor and saw its shares rise, prompting us to take gains.
Relative to the Russell Microcap, the Fund suffered most from ineffective stock selection in Consumer Discretionary, a combination of our large underweight and ineffective stock selection in Health Care, and an underweight in Financials. Conversely, we had relative advantages in Information Technology and, less impactfully, Materials. In each case, stock selection provided the edge.
Top contributors to performance for 2015 (%)
- U.S. Concrete 1.33%.
- EarthLink Holdings 1.20%.
- Builders FirstSource 1.06%.
- RTI International Metals (RTI, Financial) 0.85%.
- Applied Optoelectronics (AAOI, Financial) 0.60%.
Top detractors from performance for 2015 (%)
- Power Solutions International -2.26%.
- Zumiez -1.19%.
- Exar Corporation -0.98%.
- Century Aluminum -0.87%.
- Tangoe -0.85%.
Current positioning and outlook
We remained significantly overweight in Information Technology, Industrials, and Consumer Discretionary at the end of 2015. This positioning is consistent with our view that valuations for the majority of our portfolio holdings look attractive to us and are poised to benefit from ongoing U.S. economic growth. We expect the increased federal spending and business tax credit plans passed in anticipation of the 2016 elections to boost the pace of growth in the U.S., which should help areas such as nonresidential construction, defense, consumer and technology.
