Royce Heritage Fund Performance Discussion

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

After a terrific showing in 2010, Royce Heritage Fund (RHF) cooled off bit in the first six months of 2011. The Fund gained 5.0% for the year-to-date period ended June 30, 2011, trailing its small-cap benchmark, the Russell 2000 Index, which was up 6.2% for the same period. The Fund's first-half results left us in something of a mixed mood. On the one hand, we never like to underperform the benchmark, even over a short-term period such as six months. On the other, we saw nothing alarming about the Fund's performance during the first half, and so we are not terribly disappointed with its showing in the semiannual period.

During the first quarter, when the market was mostly bullish and demonstrated relatively low volatility, RHF climbed 7.5%, just behind its benchmark's gain of 7.9%. The second quarter, which was marked by much higher levels of volatility, saw the Fund lose 2.4% versus a 1.6% decline for the Russell 2000. The Fund actually held a narrow edge over the small-cap index during the actual downturn, losing 9.2% versus a decline of 10.1% from the interim small-cap high on April 29, 2011 through the correction's low on June 13. During the late June rally, however, the Fund failed to keep pace.

We were very pleased with the Fund's recent market cycle returns, which were strong on an absolute basis and more than respectable on a relative basis. In the more mixed period from the small-cap market peak on July 13, 2007 through June 30, 2011, RHF rose 19.1% compared to a gain of 2.2% for the Russell 2000. The more bullish phase from the market bottom on March 9, 2009 through the end of June 2011 again saw the Fund in front, in this instance by a wide margin, up 174.3% versus 148.6% for its benchmark. Finally, the Fund narrowly trailed the Russell 2000 from the interim small-cap trough on July 6, 2010 through June 30, 2011, up 41.1% versus 41.9% for the small-cap index. (More on the Fund's results over recent market cycles.)

These performances played an important role in the Fund's edge over its benchmark in longer-term average annual total return periods. RHF outperformed the Russell 2000 for the one-, three-, five-, 10-, 15-year and since inception (12/27/95) periods ended June 30, 2011. The Fund's average annual total return since inception was 14.8%.

At the sector level, the Fund's top contributors came from Information Technology, Industrials and Energy, each of which posted net losses of varying impact in the more topsy-turvy second quarter. The Materials sector posted the most substantial net loss through the end of June, hurt most by generally poor performance from the metals & mining group, including London-based Hochschild Mining, RHF's top performer in 2010. The company mines and processes primarily silver (as well as gold) and operates mostly in Latin America. With several mines producing metals, we still see it as a well-managed, conservatively capitalized business. Its stock was hurt by the significant correction in silver prices and word from Peru's presidentelect that the nation might nationalize or implement a high tax on its mining industries. This was particularly chilling for silver mining businesses as that nation is currently the globe's largest producer of silver. Thinking that the company's exploration and operations elsewhere in the Americas can help it weather the uncertain situation in Peru, we only slightly reduced our position in the first half. Unichem Laboratories is an India-based pharmaceuticals business with a portfolio of more than 200 products. Its stock was hurt by slower revenue growth and rising costs. So while its earnings remained positive, they were lower than expected, which drove many investors away from the stock. We were happy to hold our shares at the end of the period.

As for RHF's top contributors, IPG Photonics makes high power fiber lasers and fiber amplifiers for a variety of applications. Very strong quarterly results, geared by high demand for the firm's products, attracted more investors to the stock. Liking the firm's long-term prospects, we made a net addition to our stake in the first half. Late in 2008, we re-initiated a position in top holding Helmerich & Payne in the portfolio, though the stock is an old Royce favorite. The company provides contract drilling services to oil and gas companies worldwide and was able to take advantage of a pick-up for the energy services industry. It was especially well-positioned to benefit from the increased demand as it recently focused on modernizing most of its rig inventory, making them safer. We took gains in January, April, May and June.

Heritage-Crystal Clean provides industrial and hazardous waste removal services to small and mid-sized businesses. We liked its niche business and strong balance sheet. Other investors seemed to like its ongoing business success. It was the portfolio's twelfth largest holding at the end of June. One example of the robust M&A (merger and acquisition) market for small-cap stocks was the acquisition of technology consulting business SRA International. The move was announced in April. With its shares then priced at a healthy premium, we sold our position.

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