Royce Micro Cap Trust Has A Lot To Like (NYSE:RMT)

In this article I will cover an actively managed fund that has a great track record of outperforming its indices, strong management, good history of solid distributions and enjoys a decent valuation. This fund could be a good addition to many people’s portfolios especially if they are looking into diversification into smaller stocks.

Royce Micro Cap Trust (NYSE:RMT) is an actively managed CEF that focuses on micro-cap stocks. The fund has been around since 1993 and has a good track record of outperformance when compared to its benchmark of Russell 2000.

The fund’s main strategy includes applying fundamental analysis to determine fair value of a stock and investing in it only if the current valuation warrants a decent margin of safety. This means that the fund’s number of holdings can fluctuate greatly from year to year because some years you will find many stocks that are fundamentally cheap while in order years you might have trouble finding that many of such stocks. Currently the fund holds 263 stocks (subject to change on daily basis since the fund is actively managed) which means the fund’s management was able to identify 263 micro-cap stocks whose current valuation offers a margin of safety.

Some people might be surprised by that considering the general overvaluation in big indices but keep in mind that small cap and micro-cap stocks tend to be much cheaper on average as compared to large caps and mega caps because there isn’t as much crowding in those and investors aren’t willing to pay a premium for smaller stocks as much as they do for mega caps. But cheap stocks also have a bad habit of staying cheap for a long time unless sentiment around them changes completely which can take a very long time.

While subject to change at no notice due to the fund’s active-managed style, the fund’s top holdings include names like Transcat (TRNS), PAR Technology Corp (PAR) and PDF Solutions (PDFS). Notice that no company has a higher weight than 2.3% and the top holdings only account for 16% of the total weight of the fund which is healthy. I would be worried if the fund was top heavy. Also, fund’s weighting of each stock is not necessarily correlated to that stock’s market cap. The fund doesn’t weight stocks by market cap but based on how much fund’s management has conviction on the company given its valuations and prospects so some of the fund’s biggest holdings actually have smaller market caps.

A part of me can’t help but wonder how the fund keeps track of 263 holdings though. Since the fund is known to do through fundamental analysis to determine margin of safety on its holdings, it would be incredibly difficult to do this when you hold hundreds of stocks. It is also possible that the fund uses some sort of software to quickly run those analyses instead of doing manual analysis.

The fund is managed by a small team led by Chuck Royce himself. Chuck Royce has a 60 year experience in this field, 50 of which were spent at Royce and 29 were spent managing this exact fund (which would mean he’s been managing this fund since the inception of the fund in 1993). On one side, it’s great to have Mr. Royce’s expertise and leadership, which has a proven track record but on the other hand given his advanced age, one can’t help but wonder if he were to retire and leave the fund, its performance would continue. I wouldn’t expect fund’s overall strategy and criteria of selecting stocks to change after Mr. Royce departs since it’s been engrained in the fund’s structure for such a long time. It would be unfair to think that Mr. Royce hasn’t been training his possible successors in his proven ways and methods.

As its name already implies, the fund invests a majority of its assets into micro-cap stocks but this shouldn’t make you think that they are investing into speculative penny stocks. In fact, the average market cap of RMT’s holdings is $700 million. A lot of people don’t even consider this to be micro-cap since traditionally micro-caps tend to have a market cap below $250 million but there is no universally agreed upon definition for market cap categorizations and these are simply guidance within ballparks.

Currently the fund is trading at a -12% discount against its NAV which is about average considering the last decade. As a matter of fact, the fund has not traded at a NAV discount in more than a decade. This means you are getting the fund’s holdings at a 12% discount but don’t expect that discount to disappear anytime soon. This could be one of those perpetual discounts we see in some funds even though the fund isn’t exactly underperforming.

The fund typically pays out about 2% of its NAV in dividends each quarter. If the fund was trading at the same price as its NAV, you would expect to receive an annual yield of 8% but since there is a 12% NAV discount, the dividend yield is actually closer to 9.1%. Considering that the fund’s compounded total return average is around 9%, it is safe to say that most if not all of the fund’s returns came from dividends. The fund’s share price is up about 22% since its inception 30% years ago which comes down to annual growth rate of less than 1% but investors typically see this fund as an income play so it’s actually positive that the fund didn’t suffer a NAV decay that a lot of high yield funds do.

A great majority of the dividends paid by this fund come from capital gains or return of capital. The fund actively trades stocks and passes on its capital gains as dividends. If the fund reports no gains or loss, most of the dividend will come from return of capital. For example last year, dividends came entirely from short term and long term capital gains whereas this year the two dividend payments came from return of capital. Even in down years the company can still post long term gains because it can sell some of the stock it bought years ago at much cheaper prices.

Many investors seem to hate capital returns but it can have tax advantages. Still, the fact that this fund has to rely on capital gains for dividends can be worrisome to many investors because if we were to get a prolonged bear market that lasts more than a year, the fund might have to cut dividends significantly.

Here is some interesting data though. The last time we had a multi-year bear market was the period between 2000 and 2003 when the dotcom bubble burst, taking down everything else with it. During this 3 year period Nasdaq was down more than 80% and even S&P 500 index was down about 50% from peak to bottom. You’d think that micro-cap stocks would face destruction at a time like this but interestingly enough RMT outperformed during this period as investors flocked to value stocks. From 2000 to 2003, RMT saw its share price climb 40% and its total return was up 112% while main indices were suffering.

I am not saying that RMT will definitely outperform in the next multi-year bear market but at least we have data showing that it has before. This is obviously a well-managed fund and its management understands stock valuations well enough to survive a bear market or two. As a matter of fact, the fund already survived multiple bear markets and crashes since its inception in 1993. I am more worried about credit crunch events than actual bear markets when it comes to smaller stocks though because they have less access to capital markets and have more trouble rolling their debt when credit crunches happen. When the credit is widely available at cheap prices, small caps tend to thrive and grow. We haven’t had a prolonged period of a credit crunch event in recent history and it would be interesting to see how this fund performs in such a situation.

If you are inclined to buy small and micro-cap stocks, this is a good fund to buy and hold for a long time with a proven track record. If you don’t feel comfortable investing in smaller stocks or smaller funds, then this fund won’t work out for you. I’d recommend keeping this fund in a tax sheltered place like a 401k account if you chose to invest in it and holding for the long term.