Royce European Smaller-Companies Fund Performance Discussion

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

In a repeat of the first half of 2010, Europe's policy makers found themselves caught in the vortex of seemingly insurmountable sovereign debt issues as Greece once again surfaced as a major liquidity concern for the continent. Not alone, Italy and Spain also saw frightening increases in their funding costs as the interconnected nature of the region's finances became an increasing liability.

Sovereign debt within the core of Europe, particularly France and Germany, remained stable due to far greater fiscal and monetary discipline. However, even those countries were not completely immune to the contagion, as their banks were significantly exposed to the weaker periphery. Nonetheless, equity markets in the region remained resilient, with better performance coming from the core markets and weaker performance from the periphery consistent with the relative state of these countries' finances.

Royce European Smaller-Companies Fund (RES) performed well in what was a volatile first half for European small-caps, gaining 5.9%, trailing the Fund's new benchmark, the Russell Europe Small Cap Index, which advanced 6.4%. The Fund's original benchmark, the MSCI Europe Small Core Index, rose 6.7% for the same period.

Following two very strong years of performance, we were pleased to continue solid performance in 2011's first half. Now well into its fifth year of operation, RES continued to extend its longer-term relative performance advantage over these two benchmarks. For the since inception (12/29/06) period, RES gained 4.7% on an annualized basis as compared to the Russell Europe Small Core (-1.8%) and the MSCI Europe Small Core (0.0%) Indexes. While below our ultimate standard for absolute returns—our preferred measure—the Fund has experienced both a vicious bear market as well as a highly correlated bull market in its history, so overall we were quite pleased with these gains.

During the first quarter, a period when the global economy experienced a range of setbacks, including the tsunami in Japan, floods in New Zealand, rising inflation in China and civil unrest in the Middle East and North Africa, RES gained 5.7% compared to 5.8% for the Russell Index and 5.5% for the MSCI Index.

The second quarter turned more volatile as the shocks of the first quarter translated into economic weakness and investor skittishness. RES eked out a gain of 0.3% in the second quarter compared to slightly better performance by the European small-cap indexes, with the Russell gaining 0.5% and the MSCI adding 1.1%. The second quarter also saw European monetary and political figures thrust back into the global spotlight when early measures to shore up Greek finances proved insufficient to quell investors' anxiety.

Lamprell, a leading UAE-based engineering and construction company focused on the oil and gas drilling market, was a stellar performer. Compelling growth in its backlog of business, particularly driven by demand for new build rigs and the refurbishment of jack-up rigs, was the primary driver behind the share price performance. In addition, Lamprell made an accretive acquisition of a smaller competitor, Maritime Industrial Services (MIS), in the second quarter. This transaction makes a compelling strategic fit—MIS brings onshore capabilities, enhances Lamprell's in-house engineering capabilities and, importantly, has a presence in key regional markets, such as Saudi Arabia, Qatar and Kuwait, that Lamprell has been targeting for future growth.

Widely derided by the short-selling community, SMA Solar Technology, a German manufacturer of photo voltaic inverters used for solar electricity generation, had become overly cheap in our view, particularly for what is a high cash-generative business. The shares seemed to gain from the company's position in the alternative energy space as rising oil prices refocused investors' attention on alternative sources of electricity generation.

Raubex Group, a vertically integrated South African road construction and rehabilitation company, also struggled in the first half. Delays in South Africa's major road construction projects, along with lower-priced competition from imported Chinese construction crews, hurt margins and earnings. There was also unrest in the senior ranks of SANRAL, South Africa's national highway administration, which led to concerns over the pace of new government financed projects.

Hochschild Mining, a UK based gold and silver mining company with operations primarily in South America, suffered a bit in early 2011 owing to some selling pressure derived from the more than 100% share price appreciation from early August to early January 2011. With substantial production based in Peru, the shares also sold off sharply in May as leftist presidential candidate Ollanta Humala moved forward in Peru's polls, and weakened further in June following his victory. Investors become increasingly uneasy given the prospects that his administration might raise the royalty tax on silver-mining or even potentially nationalize some mines. In the case of the former, we see some possibilities of increased royalties, but we view the likelihood of nationalization as remote. Silver prices also had a very volatile first half.

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