Royce Discovery Fund Performance Discussion

This discussion comes from our June 30, 2011 Semiannual Review and Report to Shareholders.

The rough ride that micro-caps had through the first six months of 2011 was reflected in the performance of Royce Discovery Fund (RDF). The Fund was up 2.7% for the year-to-date period ended June 30, 2011 versus a gain of 3.1% for its benchmark, the Russell Microcap Index, for the same period. Relatively low returns for both the Fund and the index—by way of comparison, the small-cap Russell 2000 Index gained 6.2% in the first half—were not entirely surprising given both the robust returns micro-caps enjoyed in 2010 and a slightly decreased appetite for risk among a growing number of investors thus far in 2011.

During the pleasantly bullish first quarter, RDF was up 6.3%, slightly trailing its micro-cap benchmark, which gained 6.8% for the same period. Following the interim small-cap high on April 29, a little less than one month into the second quarter, stock prices throughout the market began to drop before rallying late in June. For the volatile second quarter, the Fund was down 3.4% versus a decline of 3.5% for the Russell Microcap Index.

From the market low on March 9, 2009 through June 30, 2011, RDF gained 117.8% compared to a gain of 147.1% for its benchmark. The Fund was also behind the microcap index from the interim small-cap low on July 6, 2010 through the end of 2011's first half, climbing 30.6% versus a gain of 37.4% for the benchmark. (More on the Fund's results over recent market cycles.) These somewhat disappointing results were a factor in the Fund's relative performance during recent average annual total return periods. However, RDF outpaced its benchmark for the five-year and since inception (10/3/03) periods ended June 30, 2011.

As we have mentioned previously, important changes to the Fund's principal investment strategies took place in August 2010. Primarily, the changes mean that the Fund's portfolio managers will evaluate the purchase and sale recommendations of its proprietary model using both quantitative and qualitative portfolio analysis before making investment decisions. Previously, the Fund's investment decisions were implemented solely on the basis of the recommendations of Royce's proprietary quantitative model.

The model and the Fund's co-managers will continue to use Royce's value approach, which focuses on factors such as balance sheet quality, cash flow levels and various other measures of a company's profitability. We believe that the integration of our portfolio managers' analysis before implementation of the model's investment recommendations should enhance the investment decision making process for the Fund.

Year-to-date through the end of June, six of the Fund's nine equity sectors were in positive territory. Health Care, Consumer Discretionary, and Materials were the best-performing sectors. At the industry level, the leading contributors were metals & mining, software and health care providers and services. Energy was the worst-performing sector for the semiannual period, primarily due to the negative performance of holdings in the oil, gas & consumable fuels industry.

RDF ended the period with 95 holdings, down from the 106 at the end of 2010. Long-time holding Drew Industries was the largest holding. Novatel Wireless and Fushi Copperweld were the top two detractors to performance for the semiannual period. Novatel Wireless provides wireless broadband access solutions for the mobile communications market. Ongoing losses and attractive opportunities elsewhere in the market were factors in our decision to sell our shares in May.

Fushi Copperweld manufactures bimetallic wire products, principally copper clad aluminum and copper clad steel, both of which are lower cost, alternative wire solutions used mostly in the utility and telecom industries. Sales are derived principally from China, where its primary facility is located. Like many small-cap and micro-cap U.S. listed companies that are based in China or derive a large portion of their business from China, Fushi Copperweld was pressured due to the accounting irregularities at another U.S. listed firm. We held our shares of Fushi Copperweld, confident that its stock could rebound.

Universal Stainless & Alloy Products was the largest contributor to performance in the first half. The company manufactures specialty steel products, including stainless steel, tool steel, and other alloyed steels. Its stock price moved around quite a bit during the year's opening half, dropping more than 30% from early May into June. However, it finished June near its 2011 high, due in part to a better view of the global economy and the aerospace market. New management, which helped to make the company more efficient, was also a factor. Continucare Corporation offers a variety of outpatient medical services. We began to reduce our position in June when news of its acquisition led its stock price to rise.

Current month-end performance may be obtained from our Prices and Performance page.