Royce International Smaller-Companies Fund Performance Discussion

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

Royce International Smaller-Companies Fund (RIS) managed to generate a modest absolute return over the first six months of 2011 that also compared favorably to two international small-cap indexes. For the year-to-date period ended June 30, 2011, RIS gained 3.5% compared to a gain of 0.8% for its new benchmark, the Russell Global ex-US Small Cap Index, and 3.1% for the MSCI World ex-USA Small Core Index, for the same period.

The first half of 2011 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 a lift only to be followed by a sharp correction caused by renewed concerns about a host 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., brought on by a spike in oil prices following Middle Eastern unrest, all led to speculation that perhaps the tenuous global economic recovery was unsustainable.

In the generally bullish first quarter, RIS gained 4.1% versus an advance of 1.0% for Russell's international small-cap index and 3.3% for the MSCI Index. As market volatility picked up in the second quarter, RIS lost 0.6%, slightly underperforming both indexes, which both fell 0.2%.

RIS was launched mid-year in 2008, just as the storm clouds were gathering for a synchronized global recession and historic bear market. Needless to say, the Fund has seen its share of volatility and market stress. Losing money in its first three quarters of operation, the Fund then fully participated in the rally from the domestic small-cap bottom in March 2009. From 3/9/09, the Fund gained 157.0%, easily outpacing both the Russell and MSCI Indexes, which advanced 146.1% and 142.7%, respectively. More importantly, RIS generated strong absolute and relative performance for the since inception (6/30/08) period, with an average annual return of 11.2% versus a 4.2% gain for the Russell Global ex-US Small Cap Index and a 3.7% return for the MSCI World ex-USA Small Core Index.

Seven of the Fund's ten equity sectors generated positive performance in the first half of 2011, led by Health Care. Energy, Consumer Discretionary and Information Technology were the next strongest sectors, demonstrating that the market's performance was more stock specific. Materials, and to a much smaller extent, Utilities and Industrials, were the detractors in the period.

At the industry level, results were broadly positive as well, with pharmaceuticals, energy equipment & services, and machinery the top gainers. Metals & mining and construction & engineering were the biggest detractors at the industry level as investor concerns about the potential for a global slowdown (or worse) seeped into these economically sensitive industries.

London-based emerging markets asset manager Ashmore Group was the Fund's top-performing company in the first half. With solid investment performance in its flagship funds, Ashmore was able to attract new assets, particularly in its debt and currency funds, in an environment that generally saw outflows for emerging markets asset managers.

Lamprell, a leading UAE-based engineering and construction company focused on the oil and gas drilling market was another stellar performer. Compelling growth in their 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.

Moshi Moshi Hotline, a Japanese telemarketing company, was the biggest disappointment, falling sharply on the Tohuku earthquake/tsunami that wreaked havoc on the Japanese economy. Profitability was also hurt in the first quarter by taking on some lower-margin government work, expenses associated with consolidating subsidiaries, and higher selling costs. With substantial barriers to entry for telemarketing in Japan, 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.

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.

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