Royce: Exploiting Micro-Cap Market Inefficiencies

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Royce Micro-Cap Opportunity Fund: Exploiting Market Inefficiencies by Bill Hench, Royce Funds

While relatively more volatile than some of our other products and larger-cap peers, Royce Micro-Cap Opportunity Fund attempts to manage risk by utilizing four distinct investment themes that each focus, first and foremost, on valuation and a company’s ability to turn around its business.

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Royce Micro-Cap Opportunity Fund is a fund that tries to take advantage of what is probably the least efficient part of the U.S. equity market—we’re buying value stocks. For the life of this Fund we’ve used a theme approach, and our portfolio has been made up of four different types of themes.”

Four Investment Themes

“The first one is our asset plays, and those are traditionally things that provide you with an opportunity to sort of steal a part of a business that’s not being valued by the market, for whatever reason. In many instances that could be property, it could be a patent, it could be a process, it could be a number of different things. But for whatever reason, the market currently doesn’t think that that particular asset really deserves a multiple or a valuation.

“In our turnarounds, what we’re mainly dealing with are new managements coming in and taking over an existing base of business. Many times, companies will be founded by people who have great ideas, or a great process or a great product, but don’t necessarily have the skills to manage a business. So what you see a lot are boards that will go out and actively recruit professional management teams to bring them back to whatever it was that made them a very appealing and profitable company when they started out.

“A third theme is what we call undervalued growth stories, and those principally are companies that are doing well in parts of the economy or sectors that you wouldn’t consider normally to be growth. If you look back a couple of years ago after the U.S. auto industry ran into trouble, there was a big restructuring not just at the big corporate OEMs, but also at the parts makers. And what we did was we found that many of those parts makers had actually better returns going forward when things got straightened out than they would have had they not gone through this gut-wrenching bankruptcy with the big three. What we try to do is take advantage of undervalued growth stories—we’re looking for companies, essentially, that are growing at double-digit rates but are trading at things that are growing at mid- to single-digit levels.

“Lastly, we have what we call our interrupted earnings, which really are broken IPOs. And these companies usually provide us with the best returns over time. When they fix themselves, when they get back to growing at levels that they talked about usually when they did their deal, you’re talking about companies with 20%+ growth rates. When we find these things they’re usually trading at levels that are very depressed but also trading with a lot of cash and with something that got people excited about them prior to whatever it was that caused them to get cheap. So these things, again, when they get back and when they recover, their growth rates provide very good returns for us.”

Managing Risk

“We try to manage risk in two ways. One is by being diverse. We like to have a lot of names. No position becomes an overwhelmingly large position in the portfolio. The other way of controlling risk is by keeping our valuations very low. If the market is trading at a multiple, say, two times the book value of the Russell, we want to be below that. If the Russell is trading at a certain multiple to sales, we want to be cheaper than that as well. Traditionally, we found those are the best ways to control risk. It is a riskier part of the market, but it does give you the opportunity to get paid for that risk.

“Royce Micro-Cap Opportunity Fund is for investors looking to take advantage of a very inefficient part of the market. It is a complementary fund. It is one that will probably be more volatile than a lot of other funds, especially bigger and mid-cap funds, but one that we think, over time, can pay you for the risk of investing in these smaller companies.”

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