Royce Focus Value Fund Performance Discussion

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

A highly volatile market, particularly for many hard asset and industrial stocks, made for a disappointing first half for Royce Focus Value Fund (RFV), one of our offerings that can include selections beyond our core small-cap universe. The Fund was up 0.9% for the year-to-date period ended June 30, 2011, well behind the 8.1% gain posted by its benchmark, the Russell 2500 Index, for the same period. Although the Fund began the year with a strong absolute performance in the first quarter, in which it rose 6.6%, it was still behind its benchmark, which was up 8.7%.

The onset of higher volatility in the second quarter only worsened matters on both an absolute and relative basis. RFV fell 5.4% in the second quarter compared to a decline of 0.6% for the Russell 2500. The Fund declined 11.3% from the first half's small-cap high on April 29 through the low on June 13, while the small-cap and mid-cap index declined 8.8%. Needless to say, we were working toward a better result on both an absolute and relative basis and were more discouraged by the Fund's failure to hold its value during the downdraft than we were in its inability to keep pace in those first-half periods when share prices were mostly on the rise.

The Fund's inception in February 2007 came not long before the 2008 financial crisis. Sifting through purchase candidates, first in a deep bear market then in a dynamic rally, left the portfolio holding more cash than was ideal in its early months. This, combined with 2011's first-half showing, left RFV at a considerable disadvantage relative to its benchmark in recent market cycle periods. From the March 2009 bottom through June 30, 2011, the Fund rose 80.6% compared to a gain of 153.6% for the Russell 2500. RFV narrowed the spread from the interim small-cap low on July 6, 2010 though the end of June 2011, gaining 30.3% versus 42.5% for the benchmark. Nevertheless, the Fund's average annual total return since inception (2/27/09) was 28.0%.

The Materials sector detracted most from first-half results, and within the sector the biggest losses came from holdings in the metals & mining industry. Many of these stocks were among 2010's top performers, including the Fund's largest detractor in 2011's first half, Pan American Silver, a Canadian company with operating mines in Mexico, Argentina, Bolivia and Peru. It passed a key test that we have for mining companies, successfully transitioning from metals exploration to production. Its stock was punished by both the sharp reversal in silver prices and the negative effect of the president-elect of Peru campaigning on threats to nationalize or highly tax the country's mining industries, a position he considerably moderated once he was elected. We thought that the company was eminently capable of effectively managing its comparatively low Peruvian exposure and thus bought more shares in May.

It was the Fund's eleventh largest holding at the end of the semiannual period. While the Arab Spring was a momentous event, unrest in Egypt had little effect on the gold mining business of Centamin Egypt. Its name alone, however, appeared to be enough to drive investors away. Seeing that operations at its primary mine in Egypt were continuing largely unaffected by political events, we added to our position in the first half.

Also in the Materials sector, Allied Nevada Gold reflected the volatility of both the stock market and precious metals prices, though it ended the first half as the Fund's second-largest positive contributor. A longer-term holding in older Royce portfolios, we were first drawn to its pristine balance sheet and skill at moving from exploration to production in several gold mines. We built our position in RFV's portfolio between September 2010 and June 2011. The first half's top performer came from the IT sector, Varian Semiconductor Equipment Associates. We were impressed by its strong balance sheet and impressive market leadership in the semiconductor capital equipment business. Like many smallcap businesses of late, it was subject to M&A (merger & acquisition) activity—its acquisition at a substantial premium was announced in May, when we sold our shares as its price rose.

Helmerich & Payne provides offshore drilling services worldwide and land drilling in the U.S. Its stock price was a bit volatile through the end of June, reflecting energy prices in general. However, it finished June near its 2011 high, due in large part to demand for its innovative services and the company's large number of new, modernized rigs that offer both higher safety and increased efficiency. Adding shares in January, we were impressed that management chose to upgrade the company's rig supply recently when most competitors were content to refurbish theirs.

While the share price of Xyratex rebounded in the June rally, it was not nearly enough to keep it from being a detractor to first-half performance. The company makes hard disks for large-scale data storage needs. High expectations for its business led its share price to rise in the second half of last year, and helped lead to a vicious sell-off when middling results were announced earlier this year. Although we still like the company's core business and balance sheet, we sold our position in May thinking that there were quality opportunities elsewhere in the market.

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