Royce International Premier Fund Performance Discussion

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

Having invested actively in international smaller companies in our core domestic mutual funds for well over a decade, the Royce investment team has ample experience in this large and labor-intensive asset class. In recognition of the long- term opportunities smaller international equities represent, we launched Royce International Premier Fund (RIP) at the end of 2010 with the goal of uncovering and investing in the highest quality and most durable small-cap businesses we can find outside the United States.

Modeled after the highly successful Royce Premier Fund, whose primary selection universe is small-cap companies located in the U.S., RIP (the abbreviation is mere coincidence, we hope) is chartered with the task of investing in a relatively concentrated portfolio of our highest conviction ideas sourced from outside the U.S.

Not lacking in the global intrigue that we all have become accustomed to, 2011's first half was marked by two distinct periods—one of relative complacency and the other of renewed investor unease and risk aversion. Positive economic surprises and solid earnings reports early in the year gave markets an early lift only to be followed by a sharp correction caused by renewed concerns about a multitude of macroeconomic issues.

The potential for a Greek default and resulting financial chaos in Europe, supply chain disruptions in Japan, and a worrisome economic soft patch in the U.S. all led to speculation that perhaps the tenuous global economic recovery was unsustainable. Fortunately, our time-tested and measured discipline of opportunistically deploying cash is very well suited to this type of volatile market environment. For the first six months of 2011, RIP performed admirably on both an absolute and relative basis. Advancing 4.1% for the year-to-date period ended June 30, 2011, the Fund easily bested its benchmark, the Russell Global ex-US Small Cap Index, which gained a paltry 0.8% for the same period.

Gaining 2.7% in the first quarter, RIP beat the Russell Index, which rose 1.0%. As global markets became more volatile in the second quarter, RIP added 1.4% compared to its benchmark, which was in negative territory, falling 0.2%. While pleased with the returns over the six months since the Fund's inception, our time frame for assessing both companies and the absolute and relative results of our portfolios remains firmly focused on the long term.

Seven of the Fund's nine equity sectors generated positive performance for the first half of 2011, led by Health Care and Consumer Discretionary. Information Technology and Consumer Staples were the next strongest sectors, demonstrating that the market's performance characteristics were more stock specific in nature and not predicated on a cyclical or defensive orientation. Financials and Materials—the latter to a quite modest extent—were detractors in the period.

Based in Hong Kong, Luk Fook Holdings (International) was the Fund's top performer. Luk Fook is a leading jewelry designer and retailer in both Hong Kong and China, with more than 700 retail outlets. Benefiting from rising consumer demand for gold jewelry in Asia, the company continues to open new stores and gain market share. With trailing five-year CAGR (Compounded Annual Growth Rate) earnings growth of 54%, ROE (return on equity) of 30% and what we view as a compelling valuation, we continue to see a very bright future for the company.

SMA Solar Technology was another notable winner. Widely derided by the shortselling community, SMA, a German manufacturer of photo voltaic inverters used for solar electricity generation, had become overly cheap, particularly for what is a high cash-generative business. The shares also gained from the company's position in the alternative energy space, as rising oil prices refocused investor attention on alternative sources of electricity generation.

Moshi Moshi Hotline, a telemarketing company based in Japan, was the biggest disappointment, falling sharply on the Tohoku Earthquake/Tsunami that wreaked havoc on the Japanese economy in the period. Profitability was also hurt in the first quarter by the company taking on some lower-margin government work, expenses associated with consolidating subsidiaries, and higher selling costs. With a valuation of 5x the (reduced) pre-tax earnings estimate and offering a 4% dividend yield, Moshi remains among the more compelling valuations in the portfolio.

Hochschild Mining, a UK based gold and silver mining company with operations primarily in South America, suffered a bit in early 2011 owing in large measure to some selling pressure derived from its 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.

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