Commentary

Royce Value Fund Co-Portfolio Managers Whitney George and Jay Kaplan

As a portfolio manager of smaller-cap companies, how does the current market look to you?

We have clearly been in a phase that favors our style of stock-picking, that is, one which starts with strong balance sheets. Within small-cap, higher quality, upper-end companies have worked well for qualitative reasons and because of liquidity concerns. Among our product offerings, the more high-quality, more focused portfolios, like Royce Value Fund, have been among the best performers lately.

Royce Value Fund has handily outpaced its benchmark the Russell 2000 Index, on both a long-term and a short-term basis. What have you found lately that's working well?

The Fund is significantly overweight in Natural Resources versus the Russell 2000, and that sector was by far the largest contributor to the Fund's performance in the first quarter, with oil and gas related holdings leading the way. Natural gas prices stayed low for a very long time—totally out of step with what was going on with oil prices—staying around the $7 - $8 range, which is a significant discount to oil on an energy equivalent basis. That relationship hasn't really changed much, but recent energy price increases seem to be driving natural gas prices up to the point that we are seeing natural gas at around $10 per Mcf. And at that level, activity should start to pick up again. We also like the energy services area because it takes more and more services to produce the same amount of gas as time goes on. Smaller resource targets and the more technical work needed to get to those resources both require incrementally more services for the same production. So you have a multiplier effect.

Are you investing primarily in domestic energy companies?

We have leaned toward Canadian service companies for a couple of reasons. We discovered them in the early part of the decade, when they were significantly cheaper than their U.S. counterparts. They put greater emphasis on developing technology, so their technology is newer. More recently, we have discovered that their international reach is far greater than domestic companies, so their global growth has been much faster. Some of the Canadian service companies that we started with in 2003 and 2004 did 80% of their business in Canada, and now do less than 50% in Canada, having branched out into the U.S., Russia, the Middle East, etc. So that's buffered a sharp decline in activity in Canada, where they saw a real boom and bust in energy. The appreciated Canadian dollar hurt them as well. All that seems to have turned a corner, and those stocks performed very well in the first quarter.

Where else did you find attractive opportunities during the first quarter?

We did well with our holdings in steel. Three steel companies that we own were among the Fund's top ten largest holdings: Reliance Steel & Aluminum, (3.1% of the portfolio as of 3/31/08) which provides metals processing services, as well as two scrap metal processors: Schnitzer Steel and Metal Management, (2.4% and 2.3% of the portfolio as of 3/31/08 respectively) were all strong performers. Metal Management was acquired by Sims Group for shares that we kept, and was our best performing stock in the portfolio for the quarter.   

Despite rising gold prices in the past six months or so, the Fund's results in the precious metals sector were mixed. What's happening there?

Prices did, in fact, run up, but then corrected sharply. The mining companies are way behind the actual metal prices in terms of what they have done over the last six months. The costs of mining have been going up just as fast as the metals they produce. So that remains an opportunity out there, but it hasn't been as rewarding as one might have thought.  We'll continue to look around the industry, though it is somewhat more difficult to identify the higher quality names because it's been an industry that was out of favor for 20 years. It only came back recently, and it's hard to distinguish between those companies with great long-term track records and those that may not be so solid. But while we have seen lots of opportunities in the precious metals sector, we've also had some short-term disappointments, namely Fronteer Development Group, and Silver Standard Resources, a silver mining company that we continue to believe is of premier quality.

Are you ready to consider financial stocks at this point?

We are going to proceed slowly in this area. Our relatively low exposure to financial stocks has helped in the down phases. And while we still don't have much financial exposure, we did find a couple of opportunities in the first quarter. We're still in discovery mode over what's happened in the last three years, and need balance sheets to stabilize before we can start the work of figuring out where the real potential is. I think that one big theme that will emerge from the credit bubble will be "Away from Wall Street, back to Main Street." There were so many local financial businesses that got sucked up out of local communities, and into Wall Street. They needed massive balance sheets to compete, and to get into businesses like mortgage origination and brokerage services. Now that the balance sheets are maxed out on Wall Street, I think that a lot of the new business going forward is going to be done the old-fashioned way. We are probably going back to more traditional practices in the consumer financial industry. The beneficiaries of this could well be smaller companies and more local businesses, and not the Wall Street investment banks and commercial banks.

Tech stocks continue to struggle. Do you see any opportunities there?

Recently our technology exposure has been low relative to the Russell 2000, but we added to our holdings in this sector during the first quarter. During the last five years, tech has been a difficult part of the market—the hangover from the tech bubble and Y2K has persisted for a long time. Since the end of 2003, tech stocks in the Russell 2000 Index have been negative, so many tech stocks missed the bull market, and have been especially punished in the correction of the past eight months. Yet among all of the major categories in the Russell, they have some of the best balance sheets.

In fact, there are lots of things going on in this industry that make it far more attractive to our way of thinking. We are finding more mature companies with realistic expectations, and arguably better businesses models. Product cycles seem to be lasting a little longer, and new start-ups are harder to finance, reducing some competitive pressures. Option dilution does not seem to be the kind of issue it was five years ago, and corporate governance has improved. While the sector remains relatively depressed, technology could resurface as an important tool for greater productivity in a slow-growth, higher inflation environment.

Thank you, Whitney.

Performance: Royce Value Fund vs Russell 2000*