Royce SMid-Cap Select Fund Performance Discussion

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

Throughout market cycles, it is important to keep a watchful eye on the behavioral aspect of investing because periods of both fear and exuberance can meaningfully alter the market value of companies far in excess of what underlying business conditions might warrant. Fear and greed can be equally dangerous at times, but in the former investors can find opportunity, while in the latter only risk awaits.

Never has this been more apparent than in the fragile recovery economies and markets have experienced following the depths of the financial crisis more than two years ago. As we survey the landscape today, we are encouraged by the results individual companies have produced in this challenging environment, but remain wary of the increasingly unstable macroeconomic environment.

We are clearly not alone. The first six months of 2011 was a period in which larger systemic risks, such as the ballooning sovereign debt crises in Europe and the deficit/budget impasse in the U.S.—along with the resulting risk to the cherished (and vitally important) AAA credit rating—captivated investors and led to an extension of high levels of anxiety.

Royce SMid-Cap Select Fund (RSS), with its sharp focus on the larger end of the smaller company universe, performed well on an absolute basis—our preferred measure—while trailing its benchmark. For the year-to-date period ended June 30, 2011, the Fund gained 6.3% compared to its small-cap benchmark, the Russell 2500 Index, which advanced 8.1% for the same period.

The first two quarters of 2011 were strikingly similar to the comparable periods in 2010, with market strength in the first driven by solid corporate results followed by a correction in the second that was precipitated by the systemic concerns discussed above. During the bullish first quarter, the Fund's more defensive positioning and high cash position was a slight drag on performance relative to the benchmark. RSS gained 7.9% versus 8.7% for the Russell 2500.

The volatile second quarter contained both a downturn in equity prices and a partial recovery at the quarter's close. Between April and June, RSS posted a decline of 1.4% versus a loss of 0.6% for its benchmark. Thus far, the Fund's absolute returns have been below what we would ideally like, though we were encouraged by its outperformance of the benchmark since the Fund's inception (9/28/07). RSS gained 3.8% on an annualized basis since inception through June 30, 2011 versus a 2.9% result for the Russell 2500 over the comparable period.

Information Technology (IT) was the Fund's best performing sector in the first half. It benefited from continued M&A (mergers and acquisitions) activity in this cash rich area of the market. Industrials, Energy and Materials also made healthy contributions to returns in a period that saw seven of the Fund's nine equity sectors contribute positively.

Financials were the only weak spot of note, along with a very modest detraction from the Diversified Investment Companies sector. At the industry level, the Fund showed similar strength, with the majority of industries generating a positive aggregate return. Energy equipment & services was the leading group, and semiconductors & semiconductor equipment and electronic equipment, instruments & components from the IT sector also contributed nicely. Commercial banks and capital markets—both from the weak Financial sector—were the biggest detractors in the first half.

The meaningful pickup in M&A activity that began in 2010 continued to ramp up in the first half of 2011. Particularly evident in the IT sector, companies short on organic growth but flush with credit availability and excess liquidity are increasingly looking to grow their businesses through acquisitions. Varian Semiconductor Equipment Associates agreed to be acquired in an all cash deal early in May.

Helmerich & Payne was another notable gainer, as this leading contract oil and gas drilling company profited from the ongoing surge in horizontal drilling activity in the U.S. onshore market. With its superior fleet of Tier 1 rigs and proprietary FlexRig design, the company looks very well positioned—exploration companies are increasingly moving to these rig designs for both conventional and nonconventional reservoirs.

Comerica, the fifteenth largest commercial bank holding company based in the U.S., suffered along with many of its peers as the regulatory environment remained uncertain for large financial institutions and loan growth was anemic. With lower credit costs than its peers, the bank still looks promising, especially since greater capital flexibility could allow for dividend increases, stock buybacks and acquisitions going forward.

Westlake Chemical manufactures a range of polymers and fabricated products. It suffered margin erosion due to higher input costs and increased supplies in some of its key products. With its strong balance sheet and experienced management team, we continue to like Westlake's prospects, recognizing that returns may be uneven over time given the uncertain pace of the U.S. economic expansion.

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