Quality small-cap stocks—those with strong balance sheets, high returns on invested capital, and the ability to generate free cash flow—have not yet seized market leadership. However, several holdings with these characteristics did well enough in Royce Small-Cap Value Fund (formerly Royce Value Fund) to provide a small relative edge in the first half of the year. The Fund gained 3.4% for the year-to-date period ended June 30, 2014, narrowly ahead of its small-cap benchmark, the Russell 2000 Index, which was up 3.2% for the same period.

Stocks as a whole had a slower start to the year, which was not a surprise considering the breakneck pace of returns in 2013. Returns remained mostly positive, however, and for the first quarter Small-Cap Value rose 1.0%. The Russell 2000 reached its year-to-date high before the quarter ended on March 4, and the index declined 9.1% from that date through May 15. Investors seemed to be trying to determine the effects on the market of a new Fed chair, a miserable winter, and potentially dangerous international situations in Ukraine and Syria. The verdict was apparently that the first of these was a positive (or at least not a negative), the second temporary, and the third not worth selling stocks over. Small-caps rallied from mid-May through the end of June. For the second quarter, the Fund climbed 2.3% (just ahead of the 2.0% gain for the Russell 2000). The bulk of the Fund’s admittedly small advantage in the first half was the result of better performance following the March 4 interim high. We are hopeful that these more encouraging returns can help the Fund to close the relative performance gap over long-term and market cycle periods. (Market cycle results can be found here.) Small-Cap Value outpaced the small-cap index for the 10-year and since inception (6/14/01) periods ended June 30, 2014. The Fund’s average annual total return since inception was 11.6%.

The market over the last few years has presented numerous challenges for risk-conscious, value-oriented investors. Our preference for companies with strong balance sheets, high returns on invested capital, and attractively low stock prices has been mostly out of favor. The unintended consequences of the Fed’s easy money and zero-interest-rate policies have heightened the charms of fast-growing and/or higher-yielding companies while crimping the appeal of the more conservatively capitalized, steadily growing businesses that we seek for Small-Cap Value’s portfolio. We have also had a virtually correction-free market over the last 18-plus months; the Russell 2000 has not experienced a decline of more than 10% since the autumn of 2012. This has resulted in a relative dearth of compelling purchase opportunities. So while we were pleased with the Fund’s first-half showing, we are looking forward to a more pronounced shift in sentiment toward companies with strong fundamentals. We suspect this may develop as the economy continues to gain momentum.

The Fund's dual consumer sectors were the only ones to detract from performance year-todate through June 30, 2014. Net losses in the specialty retail group, part of Consumer Discretionary, created the largest drag on results. Problems for the industry began with poorerthan- expected holiday sales and continued as the wet and chilly winter kept shoppers out of the stores. For the most part, we opted to build, hold, or slightly trim positions because we believe that the best-run retailers will recover. Of the portfolio’s most significant detractors in the specialty retail category—GameStop Corporation, Buckle (The), Ascena Retail Group, and American Eagle Outfitters—only the last of these was not among its largest 15 positions at the end of June. We were reasonably confident at the end of June in the rebound potential for Nu Skin Enterprises. The Utah-based manufacturer and distributor of personal products endured accusations in China of being a pyramid scheme back in January. The firm quickly resolved the problem, paying a modest fine to the Chinese government in March while buttoning up some training procedures. Solid fiscal first-quarter results failed to convince other investors that the company’s problems were behind it.

Two companies from the top-performing Energy sector led other holdings by a wide margin. Helmerich & Payne provides contract drilling of oil and gas wells in the Gulf of Mexico and South America and operates land and platform rigs. The company has long enjoyed an advantage in its industry by making higher-quality, technologically superior rigs. In late April, the firm reported record quarterly revenues and rig activity, part of a longerterm string of successes that helped to drive its share price higher. It was the Fund’s twelfthlargest holding at the end of June. The Energy sector traditionally separates oil and gas producers from those companies that provide services. Unit Corporation has always been an anomaly because it offers some of both. It’s a stock that we have liked for years because it has been historically successful in all of its related businesses while its unique status in its industry has often led to its full value being misunderstood. During the first half, it saw accelerated production growth and introduced new drilling rigs, with continued success in its midstream operations. It was the Fund’s third-largest position at the end of June.

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

Annual Operating Expenses: 1.48%

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

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