RMT: Diversified Micro-Cap CEF, Strong Yield, Outperforms Market

Royce Micro-Cap Trust (NYSE:RMT) is a closed-ended diversified equity mutual fund (CEF) that primarily invests in value stocks of micro-cap companies with market capitalization of less than $500 million. These micro-cap stocks, which are often overlooked by investors, helped RMT outperform the market on many occasions. Many of these companies still remain underserved as the broader market lacks a focus around Microcap companies. RMT itself is a small sized fund, with an asset under management (AUM) of $422 million. In this asset class with a portfolio of micro and small-cap stocks, generating consistent and strong distributions itself is praiseworthy. RMT outperformed its benchmark for the past 1, 3, 5, 10, 15, 20, and 25 years, and also since its inception almost 29 years back.

Royce Micro-Cap Trust is Focused on Micro-Cap Companies

Royce Micro-Cap Trust was formed on December 14, 1993 and is launched and managed by Royce & Associates, LP. Royce & Associates, LP, a pioneer in small-cap and micro-cap investing, was rebranded as Royce Investment Partners in December 2019, and was acquired by Franklin Templeton (BEN) a year later. The management team is led by America’s leading portfolio manager, Chuck Royce, and its talented group of managers offers unique and fruitful investment approaches that have been able to meet a variety of investors’ goals.

The fund benchmarks its performance against Russell 2000 Microcap Index, which comprises the 1,000 smallest equities in the Russell 2000. Microcaps account for less than 5 percent of total market capitalization in US stock markets and are mostly overlooked due to unknown brand names, and concern over their lack of liquidity. It is also quite difficult to forecast or predict the returns of such micro-cap stocks. These may be a few reasons why income-seeking investors stay away from such stocks.

Is Investment in Micro-Cap Stocks Helpful?

However, micro-cap stocks present some unusual attractions for investors. The primary advantage of investing in small-cap and micro-cap stocks is the significant upside growth potential. A lot of large and medium sized companies today were initially considered micro-cap firms. Shareholders can derive confidence from the fact that the fund is managed by a capable team of portfolio managers who are highly experienced with micro-cap stocks. The management combines multiple investment themes and invests in companies with strong fundamentals and have good prospects of being acquired. RMT’s management also owns over 1.5 million shares, equating to roughly 5 percent of the fund’s total value. This shows their confidence in RMT’s portfolio.

RMT has been producing strong returns for decades, generating steady cash flows. Royce Micro-Cap Trust has been paying steady and consistent quarterly pay-out for the past 20 years, except during the 2009-10 global financial crisis. However, it declared strong pay-out during the covid-19 pandemic in 2020-21. Since 2017, RMT has generated an average yield of almost 8 percent. Prior to that, the yield was exceptionally high, which I did not consider purely because it wasn’t sustainable. Interestingly a majority of these micro-cap stocks either don’t pay dividends or offer negligible yield. That means, RMT is utilizing capital gains from these stocks to generate dividends for its shareholders.

RMT’s Portfolio of Micro-Cap Stocks Have Delivered Results and Outperform

Almost half of the entire fund is invested in stocks from technology and industrial sectors. Major investment in technology stocks included PAR Technology Corporation (PAR), Onto Innovation Inc. (ONTO), Photronics, Inc. (PLAB), Agilysys, Inc. (AGYS), Richardson Electronics, Ltd. (RELL), PDF Solutions, Inc. (PDFS), Nova Ltd. (NVMI), nLIGHT, Inc. (LASR), Kulicke and Soffa Industries, Inc. (KLIC), Clearfield, Inc. (CLFD), etc. However, unlike the large-cap technology stocks like Microsoft Corp (MSFT), Apple Inc (AAPL), Alphabet, Inc (GOOG) (GOOGL), Amazon.com Inc (AMZN), or Meta Platforms, Inc. (META), half of those above-mentioned micro-cap technology stocks (CLFD, RELL, PLAB, PDFS, AGYS) generated positive price growth over the past 12 months. CLFD grew by 88 percent, while RELL grew by 59 percent. Barring PLAB, other four stocks generated positive growth in the past 3 months, too.

Major investments in micro-cap stocks from the industrial sector included Transcat, Inc. (TRNS), Universal Logistics Holdings, Inc. (ULH), Lindsay Corporation (LNN), Eagle Bulk Shipping Inc. (EGLE), CIRCOR International, Inc. (CIR), Distribution Solutions Group, Inc. (DSGR), Titan International, Inc. (TWI), Heritage-Crystal Clean, Inc. (HCCI), Forrester Research, Inc. (FORR), and EVI Industries, Inc. (EVI). Again, half of these stocks generated positive growth during the past one year. These are – TRNS, ULH, EGLE, TWI, HCCI. While ULH and TWI grew by 68 percent, TWI recorded a 93 percent price hike. So, we can say that the micro-cap stocks of RMT’s portfolio have been able to generate higher growth than their giant-cap peers, and also outperform the market.

Investment Thesis

While many investors are wary of micro-caps, Royce Micro-Cap Trust has been successful in generating strong returns from this often-overlooked asset class. This diversified micro-cap CEF presents prospective shareholders a value investment option, in order to create wealth through small investments in publicly traded securities. During the past 5 years, the stock traded mostly at a price lower than $10. Having distributed strong pay-outs with more than average yield for the past 20 years, RMT is undoubtedly a reliable fund. However, it may struggle to sustain the pay-out, as it lacks the backing of reliable dividends delivered by large-cap stocks. In absence of price growth of those micro-cap stocks, this fund will have little value for its investors.

No doubt, every investment option has some risks involved. But RMT’s successful track record demands sincere consideration. Investors who have the appetite to absorb volatility have been adequately rewarded in the past. The problem of absence of brand names and lack of liquidity has been effectively managed through intelligent stock selection. Strong market fundamentals of micro-cap stocks resulted in price growth, which has been translated into strong yield for RMT’s investors. In my opinion, Royce Micro-Cap Trust has been able to achieve its stated objective to a large extent. As stated by Mr. Chuck Royce,

Our task is to scour the large and diverse universe of micro-cap companies for businesses that look mispriced and underappreciated, with the caveat being that they must also have a discernible margin of safety. We are looking for stocks trading at a discount to our estimate of their worth as businesses.