Royce Smaller-Companies Growth Fund (formerly Royce Value Plus Fund) gained 3.9% in 2014, trailing its small-cap benchmark, the Russell 2000 Index, which gained 4.9% for the same period. Smaller-Companies Growth finished the first half of 2014 with an advantage over the small-cap benchmark, up 4.1% versus 3.2%. Holding this gain through the third quarter, when small-cap stock prices began to slip rapidly following a high for the Russell 2000 on July 3, the Fund was down 6.5% while the small-cap index declined 7.4%. When small-caps rallied through much of the fourth quarter, however, the Fund could not match the benchmark's pace. Smaller-Companies Growth increased 6.8% in the final quarter of 2014, a fine result on an absolute basis, but still behind the 9.7% advance for the Russell 2000. This had its effect on certain intermediate- and long-term results, many of which fell short of what we would like on a relative basis even as they were strong on an absolute basis. The Fund outperformed the Russell 2000 for the since inception (6/14/01) period ended December 31, 2014. The Fund's average annual total return since inception was 12.2%.

What Worked... And What Didn't

Health Care had a robustly positive effect on calendar-year results, leading all of the Fund's sectors by a large margin. Two of these holdings were takeover targets in 2014. Furiex Pharmaceuticals first saw strong results in phase III clinical trials for an IBS treatment before being acquired at a healthy premium. The announcement 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. It shot up again in August on news that Roche was buying the firm. Elsewhere in the sector, Myriad Genetics was a top contributor after detracting from 2013 results. The company faced several headwinds that 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, and the firm has demonstrated an impressive rate of growth. Additionally, competition, especially in the breast cancer genetic screening area, has not materialized to the degree many were anticipating. For example, it has retained about 90% of its market share in breast cancer genetic screening. It was the Fund's third-largest holding at year end.

We also had success with holdings involved in big data and machine-to-machine (M2M) technology, sometimes known as "the Internet of Things." The latter typically involves using technology on one piece of equipment that captures and relays information through a wireless or wired network. This information then goes to a computer, which translates it into meaningful data that makes machines work better. Sierra Wireless, a wireless data communications equipment company with a global business providing M2M communications and mobile components, was one beneficiary of solid fundamentals and burgeoning investor interest in this important area. It was the Fund's fourteenth-largest holding at the end of 2014.

Net losses at the sector level were relatively modest. Energy led the detractors followed by Materials, Consumer Staples, and Financials. After increasing our exposure to Energy in the first half, we began to trim as share prices were climbing, a fortuitous shift in light of the rapid decline in oil prices. With Energy, our preference is for service businesses rather than E&P (exploration & production) companies. Triangle Petroleum is involved in several facets of energy, including fracking and well services as well as production. Its shares plummeted with the second-half plunge in commodity prices. As with the Fund's other holdings in the sector, we like its longer-term potential to recover in an improved business climate for the industry.

E2open initially looked to us like a broken SaaS business ("software as a service," a software licensing and delivery model in which software is licensed on a subscription basis) that had terrific rebound potential. Three lost customers later, we concluded that its growth potential looked likely to remain untapped for longer than we were willing to wait and sold our shares despite some positive product feedback. SciQuest provides procurement and spending management software on a subscription basis primarily to universities, hospitals, and local and state governments. Its planned expansion into more commercial sectors did not materialize along the lines we had been anticipating. The firm also exhibited an earnings pattern that had grown too consistently inconsistent and was made worse by some recent misses. All of this led us to take our losses and move on, selling the last of our shares in October.

Current Positioning and Outlook

We sought to bring sector weightings more into balance with one another during 2014, reducing some (such as Energy) and adding to others, such as Health Care. Looking forward, the latter sector and Consumer Discretionary are areas of particular interest. While we slightly reduced our overall exposure to Information Technology, the big data and Internet of Things themes remain focal points.

Average Annual Total Returns as of Quarter-End 12/31/14 (%)

* Not Annualized

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

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