article 12-31-2013

Royce Enterprise Select Fund Manager Commentary

It might not be obvious by looking only at its calendar-year return, but we were not entirely pleased with the 2013 performance of Royce Enterprise Select Fund. The Fund turned in a solid performance on an absolute level, but it fell short of its small- and mid-cap benchmark. The Fund rose 28.7% in 2013, lagging the Russell 2500 Index, which increased 36.8% for the same period.

Enterprise Select trailed in three of the year’s four quarters. So while the Fund took part in the year’s dynamic bull market, its participation was limited, which, considering our disciplined value approach, was not a disappointment in itself—only the degree to which it finished behind the Russell 2500 left us frustrated. We were pleased, however, that the Fund outpaced its benchmark in the year’s most challenging quarter. The first two quarters of 2013 were similar to the comparable periods in the three preceding years. During the bullish first quarter, the Fund gained 8.3% and fell behind the streaking Russell 2500, which advanced 12.9%. When markets turned more volatile in the second quarter—giving us the year’s only hint of a correction—the Fund advanced 2.9%, edging past its benchmark, which rose 2.3%. Challenges for China, unrest in developing nations such as Turkey and Brazil, a sharp rise in the 10-year Treasury rate during May and June, and word from the Fed that it would slow the pace of bond purchases at the end of 2013 all worried investors, primarily during April and June. However, unlike in 2011 and 2012, the domestic equity markets ultimately handled this news well in 2013. Perhaps the most convincing sign that in 2013 investors were able to shrug off potentially disturbing macro developments in 2013 was the strong showing for stocks in the third quarter, a period in which the Fund gained 7.7% compared to a 9.1% increase for its benchmark. The fourth quarter was only slightly less bullish—mid-December proving somewhat volatile—but returns remained solidly positive. The Fund was up 7.2% in the year’s last three months compared to 8.7% for the Russell 2500.

We launched the Fund in September 2007, just two months after a historic peak for U.S. small-caps and near the onset of the Financial Crisis of 2008-09. The Fund has thus seen its fair share of market volatility. We remain encouraged, the relative disappointment of 2013 notwithstanding, that our vigilance with regard to risk and consistent focus on what we think are quality companies with high internal rates of return and strong balance sheets can help Enterprise Select’s relative results going forward. The Fund was even with the Russell 2500 for the since inception (9/28/07) period ended December 31, 2013, each gaining 8.0%.

All but one of the Fund’s nine equity sectors finished the year in the black. Industrials led by a considerable margin while Consumer Discretionary and Information Technology also posted strong net gains. The electronic equipment, instruments & components group and professional services companies (from the Industrials sector) were the top contributing industries in 2013. Methode Electronics, the Fund’s top net gainer, manufactures electronic components primarily for the automotive industry. It also makes components for non-automotive uses. Over the years, Methode has undergone a transformation from a commodity component vendor to a patented, highly engineered product company, particularly in automotive components. This transformation was helped by the recovery of the auto industry. The resulting improvement in margins helped its share price to rev up in 2013, leading us to take gains. Hard disk drive maker Western Digital is one of two firms that dominate disk drive production worldwide. Its core business, which involves solutions for the collection, storage, management, and protection of digital content, has long interested us. The company made several savvy acquisitions in 2013, including Virident, sTec, and VeloBit. These moves made Western a stronger player in both the hard disk drive and flash technology markets, in addition to its growing presence in cloud storage technology. Although we reduced our position, it was the Fund’s fifteenth-largest holding at year-end.

Net losses at the position level were comparably minor. Myriad Genetics detracted most from performance for the period. The company performs molecular diagnostic tests, specializing in genetic testing for cancer (it’s also a market leader in the breast cancer gene tests). The company faced several headwinds in 2013: 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 its patents on certain genetic testing processes. While we think that the quality of its predictive tests remains the industry’s gold standard, reimbursement issues remained unresolved entering 2014, which influenced the decision to sell our shares in October. We also parted ways with specialty chemicals and performance materials company Cabot Corporation in the spring following an earnings miss.


GOOD IDEAS THAT WORKED
Top Contributors to 2013 Performance
1

Methode Electronics 1.55%
Western Digital 1.48
Towers Watson & Company Cl. A 1.39
ManpowerGroup 1.33
Thor Industries 1.20
1 Includes dividends

GOOD IDEAS AT THE TIME
Top Detractors from 2013 Performance1

Myriad Genetics -0.57%
Cabot Corporation -0.32
Ascena Retail Group -0.12
Pan American Silver -0.12
Pason Systems -0.07
1 Net of dividends

Average Annual Total Returns as of Quarter-End 12/31/13 (%)

  QTR YTD 1YR 3YR 5YR Since
Inception
Inception
Date
Enterprise Select 7.16 28.68 28.68 14.43 16.68 8.01 9/28/2007
Russell 2500 8.66 36.80 36.80 16.28 21.77 8.00 N/A

Annual Operating Expenses: Gross 3.86% Net 1.24%

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

Important Disclosure Information

All performance information in this Report 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. Gross operating expenses reflect the Fund’s total gross annual operating expenses and include management fees and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, other than interest expense on borrowings, at or below 1.24% through April 30, 2015 and at or below 1.99% through April 30, 2023. Regarding the two “Good Ideas” tables shown above, the sum of all contributors to, and all detractors from, performance for all securities in the portfolio would approximate the Fund’s performance for 2013.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2013, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds' portfolios and Royce's investment intentions with respect to those securities reflect Royce's opinions as of December 31, 2013 and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Royce-managed portfolio 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. The Fund invests primarily in small-cap and mid-cap companies, which may involve considerably more risk than investing in larger-cap stocks. The Fund also invests primarily in a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may sell securities short which involves selling a security it does not own in anticipation that the security's price will decline. Short sales present unlimited risk on an individual stock basis since the Fund may be required to buy the security sold short at a time when the security has appreciated in value. 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 2500 Index measures the performance of the 2,500 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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