Royce Special Equity Fund Performance Discussion

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

The market struggled through the latter part of 2011's first half, reflecting investors' growing concerns about a host of issues, including global debt, the viability of the U.S. economy's recovery, unemployment, etc. Royce Special Equity Fund (RSE) was not immune to the effects of this widespread apprehension. For the year-to-date period ended June 30, 2010, the Fund gained 3.1% versus 6.2% for its small-cap benchmark, the Russell 2000 Index, for the same period. We were not especially disappointed in this result, in part because it was a solid absolute return and in part because the Fund performed largely in line with our expectations.

During the mostly bullish first quarter, RSE was up 5.7%, trailing its benchmark's rise of 7.9%. When stock prices began to plunge in late April, the Fund better held its value, falling 8.4% versus a drop of 10.1% for the Russell 2000 from the interim small-cap high on April 29, 2011 through the subsequent low on June 13. For the second quarter, RSE was down 2.4%, trailing its benchmark, which declined 1.6%.

From the small-cap peak on July 13, 2007 through the end of June 2011, RSE rose 16.0% versus a 2.2% gain for the Russell 2000. In the more bullish phase from the bottom on March 9, 2009 through June 30, 2011, the Fund was up 102.6% while its benchmark rose 148.6%. Finally, from the interim small-cap high on July 6, 2010 through June 30, 2011, RSE climbed 30.0% compared to a gain of 41.9% for the small-cap index. (More on the Fund's results over recent market cycles.)

Longer-term results, were decidedly in favor of the Fund. RSE beat the Russell 2000 for the three-, five-, 10-year, and since inception (5/1/98) periods ended June 30, 2011. The Fund's average annual total return since inception was 9.3%.

Macro forces have dominated the market rather than company-specific themes for most of the semiannual period. Within the past several months, we saw investors' expectations of the $14.5 trillion U.S. economy swing from fears of overheating to angst regarding a double dip. Not to be minimized is the novelty and uniqueness of the situation in which we find ourselves, with investors looking from the top down and swaying with the news, not so much investing as renting. This in part, though only in part, helps to explain corporations' reluctance to part with cash. Absence of clarity causes inaction or extreme reactions to whatever statements are made.

We believe that our ability to differentiate among stocks is crucial at this juncture. One needs, within the confines of strict adherence to discerning metrics, to find securities that could benefit from whatever comes of our tangled situation. We also think that, regardless of the ultimate outcome, inexpensive, quality businesses that generate free cash flow remain, at a minimum, relatively better than other investment choices, and we continue to believe they can provide solid absolute returns and are likely to outperform.

The ability to pay, and even increase, dividends also seems valuable to us in a scenario of either inflation or deflation. Thus, we believe that the tangibility of dividends from companies generating stable cash flow will become more important. We expect the market to be more discerning about stocks—quality and valuation should become increasingly important. Free cash flow's importance should also increase for this reason. It has been a long time since the continuing generation of free cash has been more valuable.

Year-to-date through the end of June, six of the Fund's seven equity sectors were positive performers, with Health Care, Consumer Discretionary and Industrials having the largest impact. Chemicals, electrical equipment, and the textile, apparel & luxury goods group were the Fund's top-performing industries.

Bio-Rad Laboratories was the Fund's largest holding at the end of June and one of its top performers for the period. The Hercules, California-based company manufactures for the life science research, healthcare, analytical chemistry and other markets with a broad range of consumables, instruments, and systems used to separate complex chemical and biological materials and to identify, analyze and purify their components. Its entrenched clinical diagnostic and life science franchise are highly insulated from macroeconomic volatility.

Lubrizol Corporation was the portfolio's best performer during the semiannual period. The Ohio-based manufacturer of performance chemicals to diverse markets worldwide announced that it was going to be acquired by Berkshire Hathaway. National Presto Industries was the largest detractor to performance during the period. The Eau Claire, Wisconsin based company is a diversified manufacturing firm that produces defense products, small appliances, and absorbent products. National products include precision mechanical and electro-mechanical products for the U.S. Department of Defense.

The sum of all contributions to and detractions from performance for all securities would approximate the Fund's year-to-date performance for the period ended June 30, 2011.

See our June 30, 2011 Semiannual Review and Report to Shareholders for a complete list of holdings for Royce Special Equity Fund as of June 30, 2011.

View the complete list of holdings for Royce Special Equity Fund as of the current quarter end.

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