Royce Special Equity Multi-Cap Fund Performance Discussion

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

We are pleased to report for the first time on Royce Special Equity Multi-Cap Fund (RSM). The Fund, which started on December 31, 2010, seeks long-term growth of capital by using an intensive value approach that attempts to combine classic value analysis, the identification of good businesses and accounting cynicism.

Although the Fund has no market capitalization restrictions, we expect the bulk of its assets to be invested in mid-cap and large-cap companies with market capitalizations of more than $5 billion. At the end of the semiannual period, approximately 97% of the Fund was greater than $5 billion in market cap, while 49.5% was above $15 billion.

The market struggled through the latter part of 2011's first half. In retrospect, the second half of the second quarter was a critical time in which many of the market's greatest macro fears—supply-chain disruptions as a result of the Japanese tsunami, a standoff between the ECB and fiscal policymakers in both Europe's core and its periphery, and our own anxieties about America's fiscal viability—all came to the fore. For the year-to-date period ended June 30, 2010, the Fund gained 7.7% versus 6.4% for its large-cap benchmark, the Russell 1000 Index, for the same period. This was all the more impressive considering that the large-cap index rose 1.1% on the first trading day of 2011, before we began to invest the portfolio.

During the mostly bullish first quarter, RSM was up 5.0%, trailing its benchmark's rise of 6.2%. When stock prices began to correct in late April, the Fund effectively held its value, falling 6.6% versus a drop of 7.0% for the Russell 1000 from the high on April 29, 2011 through the correction's low on June 15. For the second quarter, RSM gained 2.6%, handily outperforming its benchmark, which advanced 0.1%.

Macro forces have dominated the market rather than company-specific items 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 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 be 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, all but one of the Fund's seven sectors were positive performers. The Consumer Discretionary sector led by a wide margin, followed by solid net gains in Consumer Staples, Heath Care and Industrials. Chemical companies, the textiles, apparel & luxury goods group, and food products stocks were the Fund's top performers at the industry level. The Consumer Discretionary and Information Technology sectors were the largest at mid-year.

Microsoft Corporation was the largest individual holding in the Fund. The Redmond, Washington based business is the world's largest software company. Interestingly, despite diversification into various hardware markets from computer peripherals to video game consoles, as well as the internet and cloudbased computing, over 80% of its revenues and nearly all of its profits continue to be derived by its ubiquitous Windows Operating System, its server business (Windows Server), and the business division (Office).

Lubrizol Corporation was the best performer during the semiannual period. The Ohio manufacturer of performance chemicals announced that it was going to be acquired by Berkshire Hathaway in March. Apparel maker VF Corporation also enjoyed a strong first half.

Staples was the largest detractor to performance during the period. The Framingham, Massachusetts based company is a leading retailer in the office products distribution. The company operates in 26 countries in North and South America, Europe Asia and Australia. Weaker-than-expected sales weighed on the company in the first quarter of 2011, prompting it to cut its full-year earnings guidance. Cisco Systems was also one of the larger negative performers during the semiannual period.

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 Multi-Cap Fund as of June 30, 2011.

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

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