In a market that could not quite figure out if it was interested more in fast growth or high quality during the first half, Royce Smaller-Companies Growth Fund (formerly Royce Value Plus Fund), which looks for elements of both, acquitted itself quite nicely. The Fund gained 4.1% for the year-to-date period ended June 30, 2014, ahead of the 3.2% gain for its small-cap benchmark, the Russell 2000 Index, for the same period.

The Fund remains unique among our portfolio offerings. Its approach differs from most traditional value approaches, including those used in many Royce-managed portfolios, because growth prospects are usually not a critical factor in the stock-selection process. In fact, they may not be a factor at all. However, this approach also contrasts with most growth approaches because we continue to look closely at a company’s valuation as part of the security analysis process, a process that is generally an afterthought, if it is considered at all, in many growth funds. In essence a growth-oriented approach with a value overlay, it stood the Fund in mostly good stead in a market that had trouble establishing a clear direction through much of the year’s first six months.

The first quarter was a much more low-key bull phase than what stocks experienced through much of the red-hot 2013. Smaller-Companies Growth gained 3.4% in the year’s opening quarter, outpacing the small-cap index, which picked up 1.1% for the same period. The year-to-date high for the Russell 2000 came on March 4. While small-caps rallied through the last two weeks of May and through much of June, they could not push past that late winter summit. The Fund struggled a bit on a relative basis through the correction that lasted from March 4 through May 15, though its strength in the first quarter and June rally allowed it to stay ahead of the benchmark for the year-to-date period. The Fund was up 0.6% in the second quarter. While the Fund has not yet pulled ahead of the small-cap index for recent longer-term and market cycle periods, we were pleased with its first-half performance. (Market cycle results can be found here.) The Fund outperformed the Russell 2000 for the since inception (6/14/01) period ended June 30, 2014. The Fund’s average annual total return since inception was 12.7%.

As might be expected in a solid performance period, net losses at the sector, industry, and position level were fairly modest. Three sectors detracted from performance—Information Technology, Consumer Discretionary, and Financials. A sliding share price led us to increase our stake in SciQuest during the first half. The company provides procurements and spending management software on a subscription basis. SciQuest provides automated purchasing primarily to universities, hospitals, and local and state governments, though it has expanded its focus to include more commercial sectors. Its earnings pattern has been erratic, almost consistently inconsistent, and some recent misses drove investors to sell, though we like the growth potential of its core business and expect earnings to improve. It was the Fund’s eleventh-largest position at the end of June. The Fund’s twelfth-largest contributor in 2013, California-based Cerus Corporation makes the INTERCEPT blood system, a pathogen inactivation technology. Already selling INTERCEPT in Europe, the company has submitted its application for FDA approval for distribution here in the U.S., which could arrive as early as this fall. After doing fine in 2013, the company’s stock performance was more challenged in the first half.

Other Health Care holdings enjoyed better times, with four of the top five contributors in the first half calling the sector home. Furiex Pharmaceuticals first saw strong results in phase III clinical trials for an IBS treatment before being acquired at a healthy premium, the announcement of which in April prompted us to sell our shares. In February the stock price of InterMune soared on news of positive phase III trial results for a drug that treats IPF (idiopathic pulmonary fibrosis), a chronic and ultimately fatal condition that leads to a decline in lung function. Top-10 holding Actelion rose during the first quarter around the launch of a PAH (pulmonary arterial hypertension) drug. It is the dominant player in this pharmaceutical niche.

Myriad Genetics made a significant leap for us in the first half. After detracting most from 2013 results, it was the Fund's second-best contributor for the semiannual period. The company faced several headwinds last year: reimbursement change concerns from payers, a Supreme Court decision in June that held that human genes cannot be patented, and new competition in the breast cancer gene testing market. This led its stock to fall, though the company retained some of its patents on certain genetic testing processes. Its shares then came back strong in the first half. The reimbursement issues were resolved at a rate that was more favorable than many investors were expecting, the firm has demonstrated an impressive rate of growth, while competition, especially in the breast cancer genetic screening area, has not materialized to the degree many were anticipating. It was the Fund’s second-largest position at the end of June.

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

Annual Operating Expenses: 1.49%

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

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