Commentary

Bill Hench and Boniface "Buzz" Zaino

After a few difficult quarters, Royce Opportunity Fund has rebounded nicely since the most recent small-cap market low on 3/10/08, doing especially well in April and May. What has helped to fuel the Fund's recovery?

Buzz: The Fund's recovery has been fairly broad based. We've seen particularly solid gains from portfolio holdings in the Industrial Products sector, as well as in retail stocks, where the Children's Place (NasdaqGS: PLCE) has had strong net gains since the end of the first quarter. Retail is an area that we began looking at more closely in 2007, while industrial companies have been a mainstay in the portfolio since 1998, and have been very successful for us as a group over the last several years. So far in the second quarter, the share prices of Industrial Products holdings Gardner Denver (NYSE: GDI) and GrafTech International (NYSE: GTI) have picked up. Steel companies have done well, as has Walter Industries (NYSE: WLT), which has multiple businesses, involving coal and natural gas, mortgage financing and home construction.

Bill: Many earnings announcements, especially from smaller companies, have been encouraging over the last three months, and that's helped a lot. People seemed to be expecting really bad news, so stronger-than-expected earnings obviously encouraged a lot of buying throughout the market following the small-cap low on March 10. We've taken some gains in some of these companies, mostly because they've reached our sell targets, though we're also concerned about rising oil prices, and the effect those increases have on consumers.

What sort of buying opportunities were you seeing during the recent decline between the small-cap peak on 7/13/07 and the most recent small-cap bottom on 3/10/08?

Buzz: It's interesting that, in spite of all the volatility that we've seen in the market over the past year, we haven't made many dramatic changes to the Fund's portfolio over the last year or so. As I mentioned, we began looking at retail in 2007, as well as some of the smaller banks that were untouched by the subprime mess and whose financial condition looked solid. We also built positions in some 'old' media companies while we continued to look for opportunities in Technology and in various industrial areas. None of that has really changed, though we have trimmed some of our positions in media stocks because the turnarounds we anticipated were looking more and more remote, especially with the ongoing softness in the economy.

Bill: The semiconductor capital equipment industry is one area where we've been more active buyers in 2008. The industry has been slumping, so we found what we thought was attractive value in several businesses. Industry analysts are calling for a trough this coming fall, and much of what we've seen seems to support that idea—inventories are low, demand has been rising slowly but steadily, and there are newer and more efficient products out there. We've also looked at some homebuilding companies as a longer-term investment. Historically, this business has rebounded well after housing slumps. Along with everyone else, we have no idea when the current slump will end, so we're buying slowly and cautiously. Employment will also need to be strong, and financing will obviously need to be accessible before these companies come back.

Over the last five years especially, Opportunity Fund enjoyed a lot of success with industrial companies. What is your current take on industrial stocks?

Buzz: They've really been a terrific high-growth area for the Fund—we think they're the true growth stocks of the current decade. The demand for construction and other industrial areas remains robust in China, parts of the Arab world and in Eastern Europe. The stock prices of many of these companies were running high in the first half of 2007, so when the correction hit the market as a whole last July, it wasn't surprising to see share prices decline in this area. However, to us it looked more like a typical cyclical correction, not a sign that there was any serious trouble. We added a bit to our existing positions and have been pleased to see the sector recovering during the second quarter.

Even in the context of the small-cap upswing since mid-March, are you still seeing attractive value among smaller stocks?

Bill: Definitely. Many of the areas that Buzz and I already mentioned are still showing what we think is attractive value—semiconductor capital equipment, consumer stocks and homebuilders. The homebuilding companies that we've looked at are generally companies with terrific balance sheets, so we think that they're well-positioned to wait out what could be a lengthy slump in their industry. It's also important to remember that the recovery to date has been very short-lived. We're happy that the Fund's performance has been improving, but the market is still working through a lot of difficulties and faces plenty of uncertainty.

The market seems to be betting that the economy in the second half of 2008 will be better than it was in the year's first half. Is this too optimistic a wager?

Buzz: I think that oil prices are the X-factor. Consumers are responsible for two-thirds of spending in the economy. If oil prices continue to rise, then spending contracts and the market's current outlook is much too optimistic. If oil prices stabilize or fall a little, then it's not. We're acting cautiously because no one really knows what's going to happen next. Every market cycle is unique, but each cycle's down phase is rough for different reasons—for example, 1974 was really painful and 1980-81 was also pretty bad. However, the one thing every down market has historically had in common is that a recovery—often a very good one—has followed. Bill and I are stock pickers. We stay out of the prediction business. We don't know when the market will recover, so we look for what we believe are good stocks with a catalyst for future growth. The cycles change all the time, but the way that we run the portfolio stays the same.

Performance: Royce Opportunity Fund vs Russell 2000*