Commentary

Charlie Dreifus

Despite the recent volatility of the market, Royce Special Equity Fund has posted strong relative results thus far in 2007, gaining 5.53% versus -0.83% for the benchmark Russell 2000 Index for the YTD period ended July 31. Can you comment?

While the Fund enjoyed nice results in the first quarter, the second quarter was particularly strong.  As the market became more volatile, investors moved in the direction of becoming a bit more risk averse. For the quarter, Royce Special Equity Fund advanced 8.1% compared to the 4.4% gain in the Russell 2000 Index (Index). During the July sell-off, we were able to weather the downturn with greater resilience than the Index, losing 5.5% compared to the Index's 6.8% decline.

Although we're certainly enjoying this relative performance advantage, it's important to reiterate our long-term objective: Absolute performance first and relative advantage second over a full market cycle.

Can you explain the Fund's resilience in July?

In such a severe, quick correction, when investors sell, often indiscriminately, it becomes very difficult to swim against the tide. But during downturns like these, Royce Special Equity Fund has traditionally held up relatively well. I am not surprised. A cornerstone of my conservative philosophy is to attempt to ensure that shareholder wealth is preserved during flat or difficult markets – alas, the jumping off the pancake analogy. But this focus on capital preservation may mean that we give up some returns during dynamic up-market periods.

In contrast to its superior short-term results, can you explain why Royce Special Equity Fund has lagged the Index over the longer-term, five-year period?

That past four-and-a-half out of the last five years have been somewhat bittersweet for the Fund, given that the market favored more speculative, risk embracing approaches. Lower-quality companies with less earnings, lower dividends and inferior balance sheets often did better.

Because of this, Royce Special Equity Fund's three- and five-year numbers, while fine in our view on an absolute basis, lag the Index. On the other hand, our seven-year and since-inception results show the combined importance of both our absolute bias, as well as Royce Special Equity Funds's ability to outperform the Index over a full market cycle. To paraphrase Will Rogers, "Our concern is both the return of your money as well as the return on your money." We think that we have done well on both counts.

What time period represents the most recent full market cycle?

You need to roll back to the small-cap peak in March 2000 peak in order to get a full market cycle – which means both an up and a down market. This seven plus year period includes the declines that prefaced the current bullish phase that began when the market started advancing again in October 2002. During this period [3/09/00 to 6/30/07], Royce Special Equity Fund posted a cumulative gain of 217.1% compared to 50.8% for the Index.

Do you think the market is now favoring your more risk-averse approach?

With the July rout, it seemed as if Goldilocks finally got a haircut. And with volatility continuing in August, it does feel as though the mood has changed, at least for now, and that the appetite for risk has reversed. The re-calibration away from risk can be seen by the increase in rates on high-yield debt vis-à-vis the decline in yields on Treasuries, which has resulted in a well deserved widening in credit spreads. This shift toward greater capital preservation bodes well for our approach.

While we cannot totally escape the environment in which we operate, we can benefit from some of its fallout. We believe that the renewed interest in reducing risk in general, the need to be far more selective in choosing companies to consider to invest in or acquire, and the demand for stronger, cleaner financials, should all work to our benefit.

Has the economic climate changed substantially this summer?

Clearly, both the U.S. economy and the equity market are facing some challenges. The U.S. economy continues to slow. The housing market continues to undergo extreme stress and could easily grow more negative. This has dampened retail activity as "non-defaulters"—those struggling to pay their mortgages—cut back on expenditures. Yet the labor market remains stronger than the Federal Reserve wants it to be.

Absent a crisis, the Federal Reserve is unlikely to reduce rates or even hint at doing so, until evidence of a weaker economy grows more pronounced. Outside the U.S., central banks have also been raising rates, and it seems that the direction globally is likely to be slower growth all around. In large part, the direction and magnitude of the U.S. economy will continue to depend on liquidity.

Second quarter earnings reports overall were OK on the surface. However, earnings continue to benefit from share repurchases as well as a foreign contribution. That contribution is the result of stronger activity outside the U.S., as well as the currency benefit.

What about merger and acquisition activity? Is it being adversely impacted by the credit crunch? Are M&A opportunities within Royce Special Equity Fund likely to be impacted?

M&A activity has definitely slowed in recent weeks. With credit problems not limited to housing, financial borrowers wishing to engage in transactions have suddenly become disadvantaged compared to the strategic buyer. They also need to be more quality sensitive in seeking candidates.

Interestingly, of the eight completed company buyouts in Royce Special Equity Fund over the past twelve months, five have been strategic. Thus, the reduced capacity of financial buyers we suspect should have less effect on us. In fact, we think that our strongly positioned companies could receive even more attention.

The increased unwillingness of lenders and investors to finance transactions will result, in our opinion, in a shift towards transactions occurring in financially stronger, higher-quality companies where financing is less difficult. In essence, these will be companies that are stronger and in better pre-deal condition and thus are likely to pose less transaction risk. Obviously, investors will also be seeking these attributes.

The Fund's allocation to Industrial Products was its largest at midyear. How has this group contributed to the Fund's performance? 

As of June 30, 40.7% of the Fund's net assets were invested in Industrial Products holdings. This group dominated dollar-based performance through the end of June, and included seven of the Fund's top performers for the first half. The machinery and metal fabrication and distribution industries were the biggest winners, as these groups continue to have excellent underlying fundamentals and to benefit from the worldwide industrial expansion.

Are there any holdings in this sector worth noting?

As we mention in the Semiannual Shareholder Review and Report's "Good Ideas that Worked", some notable names in this sector include Cascade Corporation, which manufactures materials handling products for industrial vehicles [CAE: NYSE; 2.2% of assets as of 7/31/07]. We took profits as the company's stock price steadily climbed throughout the first half. We also enjoyed gains by selling some shares of Sun Hydraulics, a manufacturer of high-performance screw-in hydraulic cartridge valves and manifolds for fluid power systems [SNHY: Nasdaq; 0.7% of assets as of 7/31/07]. Sun declared a 3-for-2 split and a 35% increase in the quarterly payout in June to cap-off a strong opening half.

But not all has been so bright among the Fund's Industrial Products names. For example, we've been content to hold onto our languishing shares of Lawson Products, a manufacturer and distributor of repair and maintenance parts [LAWS: Nasdaq; 2.5% of assets as of 7/31/07].

Just one more year and you and Royce Special Equity Fund will celebrate 10 full years?

Yes, and it's been an incredibly beneficial period – over which time, we believe, investors can effectively evaluate the Fund's characteristics.

Thanks, Charlie.

Royce Special Equity Fund: Performance Comparison