Description

The Royce Micro-Cap Trust (RMT) is an interesting closed-end fund when it trades at a sizable discount to NAV.  RMT has a true micro-cap focus, which offers exposure to a market cap segment that is difficult to get from most other closed-end funds or ETFs.  RMT also has an exceptional performance track record, which I will describe in more detail shortly. While I usually target a 15% discount to consider buying an equity CEF, there are a few that I consider buying at narrower discounts to the extent that I find some differentiated value in the fund’s strategy, execution, or if simply feel like their strategy offers a timely investment for some reason. RMT is one of those, and the discount for RMT is about 12%, which is at the wider end of the range for this fund.  

As noted above, RMT is the only closed-end fund that I can find that focused entirely on micro-cap stocks (which Royce defines as anything below $700M in market cap at the time of purchase). There just aren’t many microcap funds around period, and the reason is rather obvious: if it’s truly a good microcap fund, it probably doesn’t scale well.  After all, there probably are not a huge amount of great microcap stocks at any given time, and liquidity will be an issue for many of them.  That means the funds themselves can’t be that big, which means they don’t make great money for the asset management firms that run them, which means…why bother?  There are only a handful of standard mutual funds that appear to be micro-cap specific, and only one of those looks like it has more than $200M in AUM.  Even the iShares Micro-Cap index ETF (IWC) only has $900M in AUM that it spreads across 1,500 stocks. 

RMT also has a very good track record. RMT uses the Russell 2000 as its benchmark, and as of Q3 2023, RMT had outperformed the R2000 for each of the following periods: 1-year, 3-, 5-, 10-, 15-, 20-, 25- and 30 years, going all the way back to the fund’s inception in December 1993!  Below is the performance table through Q3 ’23:

Unhappily for RMT, the big rally in the Russell 2000 over the final quarter of 2023 caused RMT to trail the benchmark for the 1-year period ending Dec 31, 2023. The table on the next page is the updated performance table through Q4 2023, with year-by-year returns by year. As you can see, the R2K managed to just eke out a win versus RMT in 2023, with the benchmark returning 16.9% versus 16.6% for RMT.

RMT’s track record of beating the R2K for as long as it has is quite impressive, but it becomes borderline amazing when the consistency is considered.  This seems particularly so for an asset manager that advertises a value orientation, given the general sense that value investing has trailed other styles in recent years.  One might think that microcap investing is all about finding the outlier growth stocks when they are small rather than simply buying good micro-cap companies at cheap prices, which appears to be more of RMT’s approach (though of course many of RMT’s portfolio companies are growing quickly).  

In short, RMT has been a very solid fund with a unique value proposition, and there is not really a logical reason for it to trade at a substantial discount to NAV.  Unlike some CEFs, RMT doesn’t have a massive amount of accumulated unrealized gains.  According to my calculations from the most recent available balance sheet, the fund carried about $110M of unrealized gains. Assuming RMT were to sell everything and go to cash tomorrow (and assuming an average capital gains tax of 20%) the total hit to shareholders would be about $22M.  On a fund with $510M in NAV, that would constitute a 4.3% dilution of value, which implies that the highest reasonable discount that a taxable investor should demand as a protection against embedded tax gains would be about 5%.  Investors in non-taxable accounts, of course, don’t need to apply any discount for this at all.  

RMT’s reported expenses can seem quite high, and that is partially because while they do charge a 1% management fee, these are magnified in some periods because the fee is calculated in a weird way (using average rolling 36-month net assets). In addition, they use a fulcrum-style mechanism that increases the fees slightly when the fund is beating its benchmark, but also decreases the fees a little when they trail. Overall, it’s a reasonable fee structure, though I think RMT might be better off simplifying it. 

The average discount for RMT tends to range between 10-12%.  Morningstar shows historical discounts for CEF’s, and RMT last exceed a 15% discount in 2020 during the pandemic sell-off.  

Because RMT combines good performance history with true exposure to microcaps, I’ve always been willing to consider buying RMT when the discount is around 12%. As of this writing, RMT trades at right about a 12% discount.

Another feature I like about RMT is that it has a well-defined managed dividend policy – the fund pays quarterly distributions at an annual rate of 7% of the rolling average of the prior four calendar NAVs.  The Q4 distribution is either the quarterly 1.75% of the calculated NAV as described or the minimum distribution required by IRS regulations, whichever is higher. 

I estimate that RMT will be paying about 17.5 cents per quarter beginning in Q1 ‘24, which would be about 70 cents per share. With RMT trading at roughly 89 cents on the dollar, that translates into roughly a 7.7% distribution yield to investors (assuming the next Q4 distribution is not higher than the usual quarterly distribution).  

RMT’s investors do need to understand that the company’s rolling NAV-based dividend policy will result in increases in the quarterly distribution after several quarters of strong performance but will also cause an occasional reduction in the dividend after a period of poor performance. I had been expecting that this policy would help to explain the occasional widening and narrowing of the discount and might provide occasional buying opportunities immediately following an announced distribution cut. However, over the past several years that I’ve been monitoring the fund’s trading, this doesn’t really seem to happen, at least to the magnitude that I thought it might.  This can be either a good thing or a bad thing, depending on how you look at it. 

In any case, another interesting characteristic that RMT has is that the portfolio is not at all concentrated, and in fact is far more diversified than I would expect to see. RMT held ~260 positions as of year-end 2023, though the top 10 positions comprised roughly 20% of fund NAV.  There are just a ton of stocks with very small position weightings in the fund.  The top ten holdings at year-end are shown below:

Still, comparing RMT’s holdings of 260 stocks (of which probably only 75 or so are meaningful position sizes) to the IWC (1,500 microcap stocks) or the R2K (technically, 1964 stocks according to Morningstar) shows that it is much more concentrated than the benchmarks.  This leads me to believe that at the very least RMT makes the effort to screen out the obviously bad businesses, the overpriced stocks, and those that are just too illiquid.  

RMT has historically carried small debt balances from time to time, though I’m not sure it makes sense to run RMT with leverage with today’s interest rates. RMT has never used large amounts in any case. 

One of the solid things about Royce as a firm is that they encourage their team to own shares in their funds, and RMT disclosed that officers, employees, and their families currently own more than 1.8 million shares, which is about 4% of the total shares. Royce itself is now owned by publicly traded asset manager Franklin Templeton (BEN) but continues to operate independently.

Overall, I’m not pounding the table on RMT here, but I think it’s a worthwhile alternative to owning a passive small or micro-cap investing vehicle, and the current discount is wide enough to make it worth a look for investors looking for a way to access a well-managed micro-cap portfolio at a discount. 

Catalyst

• Discount shrinks
• Microcap stocks catch up with the rest of the market