article 01-08-2015

Will Active Stock Picking Be More Relevant in 2015?

While active managers continued to struggle in 2014, we remain confident in our approach, which emphasizes discipline, patience, and absolute results. Portfolio Manager and Principal Charlie Dreifus discusses the performance of his small-cap portfolio, what sectors and industries he found most interesting at the end of 2014, conditions in place that may lead to a more robust M&A market in 2015, the state of the U.S. economy, and why he believes the value of active stock picking will increase in importance.

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What is your take on the 2014 performance for Royce Special Equity Fund?

Since the market bottom in March 2009, relative returns for Royce Special Equity Fund have lagged those of the Russell 2000 Index. That trend continued in 2014. However, the Fund also delivered a strong absolute return (+196.6%) from that bottom five years ago through the end of 2014. That outcome was consistent with the portfolio's long-term results—it has often outperformed in more bearish markets while trailing in stronger periods. Yet even in bull markets, I think the portfolio can do well if the advance is led by higher-quality, reasonably priced, and more profitable types of companies. Consistent with that, I continue to seek to invest in companies that I think can consistently raise their dividends and provide an attractive total return. Looking ahead, I'm still confident that the Fund can show solid relative and absolute performance.

What sectors and industries were most interesting to you at the end of 2014?

Consumer Discretionary stocks remain an important area of interest. Many of these stocks were largely abandoned earlier in the year, but the decline in energy prices has helped to spur a rebound for some companies in my portfolio. Bed Bath & Beyond (Nasdaq: BBBY), for example, bounced back significantly in the fourth quarter, and in my view still has room to grow. At the end of December, I held it in both Royce Special Equity and Special Equity Multi-Cap Funds. I like the long-term prospects for many businesses in the sector. Both Special Equity mutual fund portfolios were overweight Consumer Discretionary versus the Russell 2000 and Russell 1000 at the end of the year. I've also seen other holdings benefit from lower energy prices. I think it's important to remember that the decline in oil prices affects more than just gasoline prices—heating and other energy-related costs are also falling. Of course, the steep drop in the price of oil has also created opportunities in the Energy sector, though in the fourth quarter, I was more active in that sector in Special Equity Multi-Cap than in the small-cap portfolio.

Do you anticipate more M&A activity in 2015?

Yes. I think that more M&A activity is ahead and that a number of Special Equity's small-cap portfolio holdings could receive some attention based on their attractiveness to potential buyers. The forces that I can see leading to a more robust M&A market include record-low interest rates, many companies being over capitalized (some with sizeable cash balances), activist investing putting deals into play, and the fact that acquiring companies' shares have tended to advance immediately of late.

Do you think U.S. companies can remain profitable in the intermediate term?

Here in the U.S., we continue to enjoy the relatively unique situation of falling trade and budget deficits, both of which could continue for a while. The U.S. economy now seems positioned for a slower and longer recovery than we have historically experienced. If this long and slow recovery is indeed in store for the U.S., then cumulative revenue gains will increasingly cause more companies to exhibit higher incremental margins, as we have predicted. The surprise might very well be how much higher (rather than the peaking that is the consensus view) margins can go. Despite facing the conundrum of remaining quite bullish based on the prospects for the U.S. economy, my discipline made me a seller as prices were rising in the second half of 2014, resulting in fewer names in the portfolio.

A simple but important thought: Historically, quality stocks (as measured by high returns on invested capital) have tended to outperform as credit spreads have grown. I believe we are setting ourselves up for precisely this type of move.

How do you see stock pickers faring in 2015?

Market correlations continue to fall, which suggest that the value of stock picking will continue to increase in importance. Inflows into equities (beyond what has been seen recently from individual investors) will likely be funded by the well above historical allocations in bond funds. This could accelerate if yields rise and bond prices fall. 2014 was a tough year for active management. According to a recent report in Barron's, less than 15% of active managers were ahead of their benchmarks through the end of November 2014. Yet the S&P 500 Index was up 13.7% for the calendar year and did not record a drop for four consecutive days, the longest stretch in any calendar year. We believe our long-term disciplined process can be as effective as it has ever been; it only needs a market where it can demonstrate this. A simple but important thought: Historically, quality stocks (as measured by high returns on invested capital) have tended to outperform as credit spreads have grown. I believe we are setting ourselves up for precisely this type of move.

Royce Special Equity Fund [RYSEX]
Average Annual Total Returns as of Quarter-End 12/31/14 (%)

  QTR* 1 YR 3 YR 5 YR 10 YR 15 YR SINCE INCEPT. DATE
Special Equity 8.60 1.09 14.69 12.55 8.22 12.19 9.77 5/1/1998
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 7.01 N/A
Annual Operating Expenses: 1.13%

*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 the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Important Disclosure Information

Charlie Dreifus is a Portfolio Manager and Principal of Royce & Associates, LLC, investment advisor to The Royce Funds. He serves as portfolio manager for Royce Special Equity Fund and Royce Special Equity Multi-Cap Fund. The thoughts and opinions expressed in the piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

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. Royce Special Equity Fund invests primarily in small-cap stocks, and Royce Special Equity Multi-Cap Fund invests primarily in mid-cap and large-cap stocks. Investments in securities of small- and mid-cap stocks may involve considerably more risk than investments in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Funds invest a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Funds' overall value to decline to a greater degree. Royce Special Equity Multi-Cap Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), 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 Russell 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Percentage of Fund Holdings as of 12/31/14 (%)

  Bed Bath & Beyond
Special Equity 6.41
Special Equity Multi-Cap 6.09

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.

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