Commentary

Boniface Zaino

Are you pleased with Royce Opportunity Fund’s performance thus far in 2007?

Yes. Although July and August were a bit wilder than we anticipated, I’d say that so far the Fund is doing fine. It was ahead of the Russell 2000 Index for the year-to-date period ended 9/30/07, up 6.1% versus 3.2% for the small-cap index. It has also outperformed the Russell 2000 for the one-, three-, five-year and since inception periods ended 9/30/07.  Of course, the longer-term results are what matter most to us.

Have recent increases in market volatility created more opportunities for Royce Opportunity Fund?

Not to any significant extent. In the absence of a sustained correction, we've been trying to turn market volatility to our advantage for some time now. This summer’s downward swing was more dramatic than most, but it didn't last any longer.

It certainly gave everyone a scare, from the consumer to the high-level executive, because it was so sudden and violent. Much of this was due to the fact that mortgage portfolios had not been priced to reflect the risk involved. These portfolios were also highly leveraged. Equity-based hedge funds were caught up in this as well. Their shorts had to be covered and stocks had to be sold to cover the margin calls.

In some cases, quality stocks felt the pinch, so there were some opportunities in July and August. However, I don’t see this as entirely different from what we’ve dealt with over the last five years, a period in which we’ve acted opportunistically during short-term downdrafts.

Have any financial stocks begun to look attractive in light of last summer’s subprime implosion?

Yes. The subprime implosion hurt a lot of financial stocks, regardless of company quality. We’ve bought some regional banks, for example, with terrific balance sheets and what we think are responsible lending practices whose stock prices took significant hits because the selling in July was so indiscriminate. It seems likely that in a slowing U.S. economy, loan losses could rise, but they’d be rising from previously low levels, so it would be bad news, but not devastating. Based on these factors, I think that the long-term case for a stock price turnaround is strong for these stocks.

You’ve had a lot of success with industrial companies over the last few years. What are your thoughts on the sector today?

Those companies that were benefiting from the worldwide boom in large-scale infrastructure construction have still been doing pretty well. We’ve pared back our position in those companies in which stock price appreciation was making them too large for the Fund’s diversification goals.

In general, I like the prospects for these industrial businesses. Even in the event of a recession in the U.S. economy, I think that many of them would be all right. However, we’re as cautious as we are opportunistic in managing Royce Opportunity Fund, so we also keep a close eye on international events. If China’s growth were to slow, it would cause a correction in the industrial sector. So although we’re feeling good, we are watching closely, as things can change quickly in the market.

Are you concerned about the potentially negative effect a recession could have on U.S. stock prices?

I’m more concerned about the intimation of recession. When it comes to the economy, the perception can be the reality. We’ve already seen this in predictions about the retail holiday season. Each year, people are asked if they will spend more or less, and every year, regardless of economic conditions, they say “less.” The media then claim that the consumer is losing confidence, and that the economy is headed for trouble. This could create some bad news for stocks, even if for a limited time.

Right now, I think the economy looks pretty solid. Industrial companies are doing well, there is a quietly growing demand for housing, and people continue to spend. I’m not suggesting that everything is perfect, but I’m not as pessimistic about the current economy as others are.

What other areas of the market look intriguing right now?

Valuations in consumer stocks have looked attractive lately. They were beaten down a bit, so we have been making some purchases. These companies are a long-term play for us. If a recession materializes, or the holiday season is as bad as some are predicting, then any turnaround would take some time. However, when valuations in good companies are as attractive as we've seen in this area, we’re more than happy to show patience and wait for improvement. Most of our successes have come from seeing opportunity, building positions little by little, and then being content to hang in there through the tough times and await better days.

Thanks, Buzz.

Royce Opportunity Fund: Performance Comparison