Two High-Conviction Micro-Cap Holdings
article 11-05-2024

Two High-Conviction Micro-Cap Holdings

Portfolio Manager Jim Stoeffel and Assistant Portfolio Manager Andrew Palen detail their investment approach in our three micro-cap portfolios, discuss two high-conviction holdings, and offer an upbeat long-term outlook.

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We have three micro-cap offerings at Royce: The open-end Royce Micro-Cap Fund, the variable annuity portfolio, Royce Capital Fund–Micro-Cap Portfolio, and the closed-end Royce Micro-Cap-Trust. Portfolio Manager Jim Stoeffel manages these products with Portfolio Manager Andrew Palen, who serves as assistant portfolio manager. Here, they discuss the Funds’ approach and why they have an upbeat long-term outlook.

How would you describe the approach you use in these Funds?

Jim Stoeffel: We generally focus on companies that we think are attractively undervalued because we see fundamental and/or operational strengths that other investors appear to be missing. We like companies that we believe can compound over time and even grow out of the micro-cap universe. These companies may be attractively undervalued stocks compared to our estimate of their worth as a business, turnarounds, or what we think of as “Emerging Quality” companies.

Given that micro-cap companies often lack scale, each Fund is highly diversified. We are deliberate and intentional about weightings because of the inherent volatility in micro-cap stocks. This usually leads us to maintain higher weightings in positions that we see as higher quality or very attractively undervalued but fundamentally sound.
—Jim Stoeffel

Given that micro-cap companies often lack scale, each Fund is highly diversified. We are deliberate and intentional about weightings because of the inherent volatility in micro-cap stocks. This usually leads us to maintain higher weightings in positions that we see as higher quality or very attractively undervalued but fundamentally sound. In this last area, our names tend to be more established companies, with more historically manageable growth rates and associated lower multiples. 

How do you define ‘Emerging Quality’?

Andrew Palen: With ‘emerging quality,’ we’re basically trying to get a jump on companies before the rest of the market. We look at metrics such as attractive margins, asset efficiency ratios, and returns on invested capital—which we can find in a quantitative screen. However, those three characteristics aren’t typically revealed quantitatively when it comes to an Emerging Quality company. So, in the micro-cap universe we focus on qualitative inputs—features like customer-centricity, high or otherwise prohibitive switching costs, and value chain analysis. Emerging quality businesses often possess ample reinvestment opportunities of attractive returns, optionality for growth, and a sufficient probability of persistence that should be rewarded once the market sees them revealed quantitatively. Ideally, we’ve invested before the market recognizes that this is a quality company.

Can you each discuss a high-conviction holding in the Funds?

AP: I’d highlight a business with many of these ‘Emerging Quality’ characteristics called Transcat. The company excels by providing recurring calibration, inspection, maintenance, and other offerings through a network of service centers while distributing complementary test and measurement equipment to similar customers, primarily in the life science, aerospace & defense, and manufacturing sectors. Some of its differentiating features include an independent service model, lower cost to acquire customers, the ability to attach calibration services at the initial sale, and scale-driven service quality in regulated markets with a high cost of failure. While secular trends toward outsourcing, service specialization, and growing regulatory requirements are propelling market growth, we also really appreciate Transcat’s ability to gain share. In the fragmented market for third-party services, the company drives scale economies through growing penetration of automated workstreams, remote monitoring, and continued acquisition of regional or specialist competitors.

JS: Another name that we really like for the long run is Applied Optoelectronics, which provides optical communications products into data centers and cable companies. The company finds itself at the forefront of the rapid expansion of demand for the optical components that are needed to build the infrastructure to support Hyper Scale Artificial Intelligence applications. As we’ll rarely be able to invest in the major scale players at the forefront of big macro trends, a critical element in investing in micro-cap stocks is a careful analysis of supply chains. Our analyses allow us to find interesting niche companies that can profitably benefit from these major trends. We think Applied Optoelectronics is a great example of the opportunities we can find in the micro-cap universe via a thorough understanding of supply chain dynamics.

What is your outlook for the micro-cap portfolios?

AP: A lot has been made of the performance disparity between large-cap stocks and smaller companies over the last several years, particularly micro-caps. However, we remain upbeat about the opportunities in the asset class. We also see the normalization of interest rates as a positive development as the cost of capital differential in a zero interest rate environment was particularly deleterious to many micro-cap companies. Moreover, we view a Fed Rate cut cycle as a nice positive. As our companies often lack operating scale, a slowing economy can be disproportionately challenging. Given current valuations that we think are generally attractive, the set up appears constructive to us.

JS: We see significant intermediate opportunities in broad macroeconomic trends, many of which are interrelated. Reindustrialization in the U.S., the shrinking of worldwide supply chains, and the rapid ascent of Artificial Intelligence (AI) provide investment opportunities across a broad spectrum of the micro-cap universe and inform our overweight positions in both Industrials and Information Technology. These opportunities often come in tangential areas such as the emerging power demands of AI or the increasing penetration of Electric Vehicles that require a significant amount of electricity that our grid system cannot currently handle. These trends square nicely with our U.S.-centric micro-cap universe. A great deal of volatility remains in areas beyond our control, such as the pace and ultimate size of rate cuts and the outcome of upcoming U.S. elections, but we expect increasing clarity going forward. In the meantime, we are trying to use this volatility to our advantage.

Important Disclosure Information

Average Annual Total Returns as of 9/30/2024 (%)

  QTD1 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE ANNUAL
OPERATING EXPENSES
NET               GROSS
Micro-Cap 5.23 21.71 2.27 12.91 7.56 10.46 12/31/91  1.24  1.25
Capital Micro-Cap 5.19 21.69 2.08 12.13 7.32 9.62 12/27/96  1.18  1.18
Mico-Cap Trust 6.54 25.89 3.38 12.85 9.20 10.16 12/14/93  N/A  N/A
Mico-Cap Trust (NAV) 4.58 23.38 3.10 13.13 9.64 10.71 12/14/93  N/A  N/A
Russell Microcap
8.29 24.63 -3.74 8.45 7.29 N/A N/A  N/A  N/A
Russell 2000
9.27 26.76 1.84 9.39 8.78 N/A N/A  N/A  N/A
1 Not annualized.

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. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.royceinvest.com. Gross operating expenses reflect the Fund’s total gross annual operating expenses for the Investment Class and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund's most current prospectus. Royce & Associates has contractually agreed, without right of termination, to waive fees and/or reimburse expenses to the extent necessary to maintain the net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) for the Investment Class of Royce Micro-Cap Fund at or below 1.24% through April 30, 2025.

As with any mutual fund that invests in common stocks, the Funds are subject to market risk—the possibility that common stock prices will decline over short or extended periods of time. As a result, the value of your investment in a Fund will fluctuate, sometimes sharply and unpredictably, and you could lose money over short or long periods of time. Each Fund’s investments in securities of micro-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (see "Primary Risks for Fund Investors" in the respective Prospectus.) Please read the prospectus carefully before investing or sending money. Fund investments in foreign securities may involve political, economic, currency, and other risks not encountered in U.S. investments. A broadly diversified portfolio does not ensure a profit or guarantee against loss. (See "Primary Risks for Fund Investors" in the respective prospectus.) Please read the prospectus carefully before investing or sending money.

Royce Micro-Cap Trust is a closed-end fund—a registered As with any mutual fund that invests in common stocks, the Funds are subject to market risk—the possibility that common stock prices will decline over short or extended periods of time. As a result, the value of your investment in a Fund will fluctuate, sometimes sharply and unpredictably, and you could lose money over short or long periods of time. Each Fund’s investments in securities of micro-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (see "Primary Risks for Fund Investors" in the respective Prospectus.) Please read the prospectus carefully before investing or sending money. Fund investments in foreign securities may involve political, economic, currency, and other risks not encountered in U.S. investments. A broadly diversified portfolio does not ensure a profit or guarantee against loss. (See "Primary Risks for Fund Investors" in the respective prospectus.) Please read the prospectus carefully before investing or sending money.

investment company whose shares of common stock may trade at a discount to their net asset value. Shares of the Fund's common stock are also subject to the market risks of investing in the underlying portfolio securities held by the Fund. Royce Fund Services, LLC ("RFS") is a member of FINRA and may file this material with FINRA on behalf of the Fund. RFS is not an underwriter or distributor of the closed-end funds.

Mr. Stoeffel’s and Mr. Palen’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

Percentage of Fund Holdings As of 9/30/24 (%)

  Capital Micro-Cap Micro-Cap Micro-Cap Trust

Transcat

1.2

1.2

3.2

Applied Optoelectronics

1.1

1.1

0.5

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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.

Frank 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 is an unmanaged, capitalization-weighted index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. 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. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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