Royce International Micro-Cap Fund Performance Discussion

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

Although a six-month period is a distinctly short-term time span, we were nonetheless satisfied with the inaugural performance period of Royce International Micro-Cap Fund (RMI), one of our newest offerings. The Fund gained 1.7% for the year-to-date period ended June 30, 2011, ahead of its international small-cap benchmark, the Russell Global ex-U.S. Small Cap Index, which was up 0.8% for the same period.

The Fund was introduced at the end of 2010, in retrospect an interesting moment. Coming off two very strong years as 2011 began, the stock market has so far been characterized by problems similar to those that last spring temporarily stalled an otherwise strong bull market—revived concerns about European sovereign debt, particularly in Greece, and fears that the U.S. economy was either stalling or headed for a double dip. Additional events unique to 2011, including the calamities in Japan and natural disasters in the U.S., did their part to usher in a global wave of selling in late April that lasted into mid June.

During 2011's first half, both non-U.S. small-caps and domestic micro-caps underperformed their domestic small-cap counterparts. While each was subject to some of the same volatility that rocked the U.S. stock market, both asset classes held up relatively well in the spring downdraft. Their respective underperformance was therefore not attributable to a bear market disadvantage.

First-half results for non-U.S. companies were generally more muted because of lower returns during 2011's far less volatile first quarter, a span in which the Fund rose 3.5% versus 1.0% for its international small-cap benchmark. (For the same period, the smallcap Russell 2000 Index was up 7.9%, and the Russell Microcap Index rose 6.8%.)

For the second quarter, which encompassed the entire bear period, the Fund fell 1.7%, while the Russell Global ex-US Small Cap Index lost 0.2%. In spite of underperforming in the second quarter, we see the first half as a solid start, especially considering the highly challenging period in which the Fund debuted, during which, it should be noted, we sought to take advantage of market volatility to build certain high-confidence positions.

The Fund's approach is vintage Royce—we use our disciplined value methodology to find conservatively capitalized, fundamentally strong micro-cap companies located outside the U.S. trading at what we deem to be attractive discounts to their worth as businesses. Our primary selection criteria include a strong balance sheet, high returns on invested capital and the ability to generate free cash flow.

Year-to-date through June 30, all but one of RMI's eight equity sectors made a positive contribution to performance. Health Care was the Fund's best-performing sector, followed by Materials, Industrials and Information Technology, while a very modest net loss came from Consumer Staples. At the industry level, the leaders were the metals & mining group and electronic equipment, instruments & components stocks.

The semiconductors & semiconductor equipment group, from the otherwise stalwart Information Technology sector, was the industry that detracted most, reflecting a wild (and highly stock-specific) global market for technology stocks. At the individual stock level, net gains were nicely spread out, with the Fund's top-ten contributors hailing from six different sectors—Consumer Discretionary, Financials, Health Care, Industrials, Information Technology and Materials.

Wildcat Silver is a Vancouver-based mineral exploration company with an 80% interest in an Arizona silver project. During the first half, the price of silver first rose more than 50% before correcting more than 30%, making the first half a mostly difficult one for silver mining businesses. Wildcat proved an exception by delivering positive news on exploration—it expanded its drilling program eight-fold and production could hit as much as 10 million ounces annually, about double what was previously expected. We held our shares at the end of June.

A boom in the Asian luxury watch market helped the share price of Oriental Watch Holdings to rise. Rolex, the brand that accounts for the bulk of sales, raised its suggested retail prices substantially, which boosted results, while Patek Philippe and Piaget have pushed through similar price hikes this year. The Hong Kong-based company recently announced plans to expand with new store openings outside Hong Kong.

Accounting irregularities at a U.S. listed Chinese company sent shockwaves through U.S. listed Chinese stocks and others that do the bulk of their business in China. In many cases, investors fled even when companies were continuing to execute effectively. This was the case with China-based BCD Semiconductor, which also suffered from being something of a broken IPO. We built our stake through the first half. Severfield-Rowen's stock price rose dramatically from October 2010 through early January. The company—the UK's leading structural steelwork fabricators—issued a profit warning towards the end of January that was driven by rising steel prices, project delays in India and reduced margins in its slow-recovering home market of the UK, all of which drove its share price down. We added most to our position between April and June.

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