Companies with strong balance sheets, high returns on invested capital, and the ability to generate free cash flow have only been intermittently favored by investors over the last few years. This inconsistency had an effect on the first-half results for Royce 100 Fund. The Fund advanced 2.8% for the year-to-date period ended June 30, 2014 versus 3.2% for the Fund’s small-cap benchmark, the Russell 2000 Index, for the same period.

The first quarter was a period of mostly low positive returns for stocks. It followed in the wake of a highly robust bull phase that ran with particular speed through the second half of 2013. The Fund rose 0.2% in the first quarter while the Russell 2000 gained 1.1%. Stock prices became more volatile before the end of the quarter. Small-caps reached their first-half high on March 4, and the Russell 2000 fell 9.1% between that date and May 15, giving 2014 its only correction so far. The Fund outpaced the benchmark for that period and from that same interim high through the end of June. These better down market results drove the Fund’s advantage over the Russell 2000 for the second quarter. The Fund increased 2.6% between the beginning of April and the end of June versus a 2.0% advance for the small-cap index. This left us mostly pleased with the Fund’s first-half results. We say this is in the context of recognizing that, while the environment has been slowly improving for the sort of companies we seek for the portfolio, the market has still seen fit to reward fast-growing, often unprofitable businesses more than it has the high-quality businesses that we prefer. We were also encouraged by the Fund’s longer-term edge over the Russell 2000. The Fund outpaced the small-cap index for the 10-year and since inception (6/30/03) periods ended June 30, 2014. The Fund’s average annual total return since inception was 11.7%.

Pason Systems was both a top performer and the top contributor in the Energy sector, which led all the Fund’s sector groups by a considerable margin in the first half. In general, positions in Energy attracted more investors as oil prices rose and drilling activity picked up. The difficult winter weather also helped by stoking demand for home heating oil and natural gas. Pason Systems sells and rents instrumentation systems for both land and offshore drill rigs in the oil and gas industry. Its products gather data and help to improve the efficiency of drilling. Increases in both drilling activity and daily rental rates for its rig connectivity and remote diagnostics products boosted its results. The company also provided a favorable outlook based on its pipeline of new products that should continue to grow its rental dollar content-per-rig over the long run. It was 100’s third-largest position at the end of June. Renewed demand also helped Helmerich & Payne, a company we have long admired for its status as a leader in manufacturing technologically superior rigs and related equipment. Other energy businesses are seeing the benefit in using Helmerich’s wares, as upgrading to its more efficient rigs helps to drive down drilling costs. Unit Corporation, the Fund’s second-largest holding at the end of June, explores for oil and natural gas, acquires oil and gas properties, offers contract drilling services, and processes natural gas. Its ability to do each of these jobs well makes it something of an anomaly in an otherwise rigidly specialized industry. Unit seemed to impress investors with double-digit production growth, the introduction of a new advanced drilling rig, and ongoing success in its midstream operations.

Net losses at the sector and position levels were fairly modest, though a number of detractors from the Industrials sector disappointed. The sector is one of those economically sensitive areas in which we have invested heavily over the last few years. At the end of June the portfolio also had a substantial overweight in Industrials compared to its small-cap benchmark. UTi Worldwide is a global supply chain logistics services and solutions company that operates on multiple platforms helping a variety of industries. Its business was hurt by lower freight-forwarding volumes and pricing as well as by delays in collecting receivables. All of this caused the company to violate its debt covenants, resulting in an expensive and dilutive recapitalization. These discouraging developments led us to sell our shares in 100’s portfolio in March. The stock price of KBR fell throughout the first half. The company struggled with the cancellation of some engineering and construction projects and losses on a few others while also contending with pushed-out start dates for certain LNG (liquefied natural gas) ventures. Believing that this Houston-based engineering and construction firm with global operations can ultimately turn things around, we held our shares.

Average Annual Total Returns as of Quarter-End 6/30/14 (%)

Annual Operating Expenses: 1.51%

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

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