article 05-01-2014

Combining the Elements of a Value and Growth Approach

After recognizing the need to reposition its portfolio late in 2010, we believe Royce Smaller-Companies Growth Fund's emphasis on a "growth at a reasonable price" (GARP) investment approach and multi-year growth themes are helping the Fund rebound nicely.

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Although we have been happily committed value investors since 1972, we occasionally, like the good contrarians that we are, move beyond our investment management comfort zone. That was the case in June 2001 when we introduced Royce Smaller-Companies Growth Fund (formerly Royce Value Plus Fund).

From its beginnings, the portfolio was established to go about its business a little differently than our other funds. At its inception, the Fund looked at small- and mid-cap companies with market capitalizations up to $5 billion. Really differentiating the Fund, however, was the way in which we considered a company's growth prospects, which made it a more singular product than most of our other offerings. In fact, the "Plus" in the Funds' name refers not so much to the relatively wide-ranging equity universe from which it makes its selections as it does to our search for companies with strong growth prospects.

Our Smaller-Companies Growth strategy differed from most traditional value approaches, including those used in many Royce-managed portfolios, because growth prospects are typically not a critical factor in the stock-selection process. Indeed, they may not be a factor at all.

However, the Fund was also not a pure growth fund. Its approach to this day contrasts with most growth approaches because Portfolio Manager Chip Skinner continues to look closely at a company's valuation as part of his security analysis, a process that is generally an afterthought, if it is considered at all, in many growth funds.

During its first six full calendar years, from 2002-2007, the Fund turned in strong absolute results and outpaced the small-cap Russell 2000 Index in each year. The onset of the 2008 financial crisis saw the portfolio begin to struggle somewhat versus its benchmark, though in the context of the seismic events of the time and the Fund's growth-oriented approach, this was not initially surprising or cause for alarm.

The "Plus" in the Funds' name refers not so much to the relatively wide-ranging equity universe from which it makes its selections as it does to our search for companies with strong growth prospects.

We first recognized the need to reposition the portfolio near the end of the third quarter of 2010, which was the first quarter in which the Fund underperformed the Russell 2000 by a troubling margin. In trying to amend matters, we closely scrutinized those factors that were driving—or failing to drive—performance.

These moves did not involve a major change in strategy. Instead, we modified the existing process by repositioning the portfolio. We remain long-term investors, and the Fund remains a growth-oriented portfolio with a value overlay, so these changes represented more of a shift in emphasis away from turnarounds and toward stronger, higher-quality growth.

During much of 2011, we opted to pay a little more for what we deemed to be exceptional growth prospects. In introducing more growth, we also began to sell problem positions more quickly and hold growing companies a bit longer. With the economy slowly recovering, the last several years have not seen an enormous number of great growth stories, but in 2011 we began to uncover many smaller companies that were generating above-average growth that also fit well in the portfolio.

As time goes on, it's becoming clearer that these efforts have resulted in improvement through solid absolute returns, better stock selection, and an emphasis on a "growth at a reasonable price" (GARP) investment approach. By targeting robust, multi-year growth themes and focusing on what we see as quality companies benefiting from those themes, we think the Fund has done well in the recent slow-growth economy. While we have more ground to cover with respect to performance relative to our benchmark, we firmly believe we are on the right path.

Royce Smaller-Companies Growth Fund [RYVPX]
Average Annual Total Returns as of Quarter-End 3/31/14 (%)

QTR* YTD* 1 YR 3 YR 5 YR 10 YR 15 YR 20 YR SINCE
INCEPT.
DATE
Smaller-Companies Growth 3.43 3.43 25.28 9.99 20.79 8.60 N/A N/A 12.90 6/14/2001
Russell 2000 1.12 1.12 24.90 13.18 24.31 8.53 8.91 9.48 8.39 N/A
Annual Operating Expenses: 1.49%

*Not Annualized

Important Performance and Expense Information

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained here. Operating expenses reflect total annual operating expenses for the Service Class as of the Fund's prospectus dated 5/1/13 and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investment in mutual funds, hedge funds, private equity funds, and other investment companies.

Important Disclosure Information

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in micro-cap, small-cap, and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets in foreign securities, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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