First-half results for Royce Special Equity Fund were somewhat disappointing on a relative basis. The Fund was up 0.2% for the year-to-date period ended June 30, 2014 compared to a gain of 3.2% for its small-cap benchmark, the Russell 2000 Index, during the same period. In the context of a market in which many companies with no earnings, no dividend, and other lower-quality attributes continued to outperform, this was not entirely surprising.

The strength of low quality was particularly evident in the first quarter. Although equity performance was generally positive, returns were well off the pace established in 2013, especially in last year’s second half. The Fund, however, had little participation and was down in the first quarter, falling 0.8% versus a gain of 1.1% for the Russell 2000. Several specialty retailers headed up the list of detractors in the Consumer Discretionary sector. The sector’s negative effect on first-quarter returns was exacerbated by its significant overweight versus the Russell 2000. However, as the economy continues to improve (as we believe it will), this will change, perhaps dramatically. The outlook for consumer spending looks healthy as a result of tame inflation, still restrained mortgage rates, rising household net worth, repaired household balance sheets, and improved consumer confidence. In addition, capacity utilization in the U.S. is inching towards the 80% rate; at this level we should start to see more hires and capital expenditures, reigniting the economy.

The second quarter was going well for Special Equity until June. The Fund outperformed during the April decline and the modest gain in May and posted better relative performance than its benchmark from the 2014 small-cap high on March 4 through the end of June. The Fund did lose ground, however, when the small-cap index gained 5.3% in June. As is often typical of that kind of move, it favored stocks without earnings or dividends, low returns on equity, and high betas. For the second quarter the Fund advanced 0.9%. Special Equity outperformed its benchmark for the 15-year and since inception (5/1/98) periods ended June 30, 2014. The Fund’s average annual total return since inception was 10.0%.

Numerous concerns began to register in the first quarter: the change in leadership at the Federal Reserve, the implications this change will have on the central bank’s policies, China’s shadow banking system, and harsh weather in much of the U.S. On March 19, 2014, Janet Yellen, the then-new Chair of the Board of Governors of the Federal Reserve System, mentioned that interest rates could rise “in six months or so” following the end of quantitative easing. Was it intentional to release this negative assessment at that time to get it out of the way? Yellen significantly reduced uncertainties (intentionally or not) when she mentioned this “six months or so” time frame. Investors have now passed three consecutive psychological hurdles: Fed tapering, the end of QE3 (the third round of quantitative easing), and the time frame of rate hikes. We think this good news can continue to lift equities.

Consumer Discretionary stocks remained the portfolio’s most significant detractors for the entire first half, its largest net losses coming from specialty retail. In fact, the sector’s losses as a whole were mitigated by revved-up results for the Fund’s top-performing industry, auto components. Bed, Bath & Beyond led all of the Fund’s detractors. We increased our position in this New Jersey-based retailer of a wide variety of domestic merchandise. It was The Fund's fifth-largest holding at the end of June. We added shares of top-10 position Children’s Place, another NJ-based retailer, which sells children’s specialty apparel throughout North America. Another top-10 holding, Schweitzer-Maudit International, runs a global business from Georgia manufacturing paper and reconstituted tobacco products for the tobacco industry. We increased our stake during the first half.

Industrials contributed most to first-half gains, led by solid results from the electrical equipment and machinery industries. The best-performing stock in the first half was Standard Motor Products, the Fund's tenth-largest position at the end of June. The Queens, New York-based company manufactures and distributes replacement parts for motor vehicles in the automotive aftermarket industry and operates in two segments, engine management and temperature control.

Treasury rates have not risen as of yet. This is an interesting point, as it suggests that rising rates, due to stronger economic activity, will not weigh down the market. We believe we are close to a move towards greater cyclical exposure in the marketplace. We think that investors will increasingly abandon their obsession with counter-cyclicals and start to embrace anything with economic leverage in the U.S. An economic outcome that we increasingly believe in resembles Bill Gross’s “new neutral:” Slower but more consistent growth than we have seen in the past with resulting lower-than-expected inflation and interest rates. This is a variation of the “Goldilocks” outcome—not too hot or too cold. If this is indeed the case, we believe P/E multiples will likely stay at current levels and possibly even increase.

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

Annual Operating Expenses: 1.13%

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

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