article 06-30-2014

Royce SMid-Cap Value Fund Manager Commentary

Royce SMid-Cap Value Fund enjoyed an excellent first half, posting the highest return among all of our open-end portfolios. The Fund advanced an impressive 13.7% for the year-to- date period ended June 30, 2014, more than doubling the return of its small- and mid-cap benchmark, the Russell 2500 Index, which was up 5.9% for the same period.

As the year began, there was a lot of speculation as to what direction equities would take. Considering the breakneck pace of returns in 2013, many market watchers argued that valuations were unsustainably high. Others held that with rates still basically at zero and the economy growing slowly but steadily, the case for a “melt up” remained strong. Returns for most stocks continued to climb in the first quarter, though results were far more muted overall. The Fund more than participated in this lower key-up phase, gaining 7.1% for the first quarter, well ahead of the Russell 2500, which rose 2.3% for the same period. The small- and mid-cap index endured a bearish April before rallying in May and June, while the Fund finished each of those months in the black. For the second quarter, SMid-Cap Value again outpaced the benchmark, increasing 6.1% compared to 3.6% for the Russell 2500.

It appears that we are returning to a more historically typical performance cycle in which company fundamentals matter. This began more than a year ago when we first heard taper talk and interest rates started to rise. Around this same time it became fairly clear that legislative agendas were being closed down in Washington, creating a gridlock that seems to have removed some uncertainty. Businesses no longer need to guess what might happen politically because it has become almost impossible to get anything done. This does not seem likely to change until after this year’s mid-term elections at the earliest. These developments, along with the ongoing decline in correlation levels across all asset classes, are a series of signs pointing to a better market for active management overall.

All of the Fund’s eight equity sectors posted net gains in the first half. Net losses at the industry and position level were comparatively minor. The Medicines Company provides acute and intensive care medications. Its stock plummeted on news of a negative patent ruling that would allow a competitor to produce a generic version of its highest revenue-producing drug in the second half of 2015. (The company is appealing the decision.) Uneven trial results for one of the six new drugs in its pipeline also helped to keep investors away. Jacobs Engineering Group continued to struggle with trying to convert its backlog of business into revenue. It also endured a mining industry-driven shortfall in results from a recently acquired company and losses on a few key projects. All of this led management to reduce guidance for the current fiscal year. Thus rattled, investors fled. However, the company is also set to unveil a cost reduction program that could help its margins to recover in 2015 and beyond.

The Energy sector led by quite a wide margin in the first half, with Materials, Information Technology, and Health Care also posting notable net gains. A long-time Royce favorite, the portfolio’s major contributor in the Energy sector, and the Fund’s twelfth-largest holding at the end of the semiannual period, Helmerich & Payne is a contract driller that specializes in high-tech rigs that were in increasingly high demand as drilling activity picked up. Top-five position SanDisk Corporation provides data storage products and solutions, including flash memory, proprietary controller and firmware technologies, as well as USB drives, digital media players, and other components. Capacity concerns have abated and global demand has been growing, both of which helped its shares to rise in the first half.

Molecular diagnostic company Myriad Genetics was one of the Fund’s five largest detractors in 2013 (when we added shares) before winding up as the top net gainer for the first half of 2014. The company specializes in genetic testing for cancer and ended last year facing increased competition, particularly in breast cancer screening tests, and some still unresolved reimbursement issues that remained under federal review at the end of December. It was also confronted with skepticism from some quarters about the fallout from a June 2013 Supreme Court decision which held that genes could not be patented. Our take was that neither the high court ruling nor the increased competition would hurt the firm’s long-term health. We see the quality of its predictive tests as the industry’s gold standard, so we were quite pleased to see it continue to execute successfully (and profitably), as well as make a savvy acquisition of Crescendo Bioscience, in the first half. The acquisition diversifies Myriad’s already promising pipeline. It was the Fund’s third-largest holding at the end of June.


GOOD IDEAS THAT WORKED
Top Contributors to Performance
Year-to-Date through 6/30/14
1

Myriad Genetics 2.80
Helmerich & Payne 1.61
SanDisk Corporation 1.10
Westlake Chemical 0.99
Semperit AG Holding 0.86
1 Includes dividends

GOOD IDEAS AT THE TIME
Top Detractors from Performance
Year-to-Date through 6/30/14
1

Medicines Company (The) -0.36
Jacobs Engineering Group -0.27
Alamos Gold -0.26
Value Partners Group -0.21
HollyFrontier Corporation -0.20
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR SINCE
INCEPTION
INCEPTION
DATE
 
SMid-Cap Value 6.13 13.70 33.34 10.82 16.94 7.59 9/28/2007
Russell 2500 3.57 5.95 25.58 15.51 21.63 8.31 N/A
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Annual Operating Expenses: Gross 2.2% Net 1.35%

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

Important Disclosure Information

All performance information in this Report reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Gross operating expenses reflect gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service fees, and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Service Class’s net annual operating expenses, (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business), at or below 1.35% through April 30, 2015 and at or below 1.99% through April 30, 2024. Regarding the two “Good Ideas” tables shown above, the sum of all contributors to, and all detractors from, performance for all securities in the portfolio would approximate the Fund’s year-to-date performance for 2014.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at June 30, 2014, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds' portfolios and Royce's investment intentions with respect to those securities reflect Royce's opinions as of June 30, 2014 and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Royce-managed portfolio in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small- and mid-cap companies, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) In addition, as of 6/30/14 the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. The Fund may invest up to 35% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2500 Index measures the performance of the 2,500 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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