article 12-31-2013

Royce International Smaller-Companies Fund Manager Commentary

In many cases, companies outside the U.S. saw substantially lower returns overall than their domestic counterparts in 2013, which in large part accounts for the underwhelming calendar-year performance for Royce International Smaller-Companies Fund. The Fund was up 12.7% in 2013, trailing its benchmark, the Russell Global ex-U.S. Small Cap Index, which increased 17.2% for the same period. Non-U.S. equities not only posted lower returns in 2013—they also added the dubious distinction of being generally more volatile than their U.S. counterparts. (In addition, it was also a difficult year for many of the foreign currencies to which portfolio holdings had exposure, including the Japanese yen, South African rand, Indian rupee, and Turkish lira, all of which weakened versus the U.S. dollar.)

The first quarter of 2013 was bullish across much of the globe, though results for non-U.S. companies were generally lower. The Fund’s participation in the rally was limited, with International Smaller-Cos gaining 3.2% in the first quarter versus 6.5% for its benchmark. This was in stark contrast with the Fund’s strong absolute and relative results in 2012, which featured a second-half advantage when the Fund advanced 14.3% versus 13.5% for the Russell Global ex-U.S. Small Cap.

While the domestic markets righted themselves in time for most U.S. indexes to finish the more volatile second quarter slightly in the black, many indexes elsewhere were negative—some dramatically—over the same period. International investors had to cope with a larger number of macro challenges. The Fund held investments headquartered in Brazil, which declined by about a third in U.S. dollar terms in the first half. It also held positions in Turkey, which like Brazil suffered declining markets, a battered currency, and protests. During the spring and early summer months, China was attempting to deal with a slowing economy, credit and banking issues, and its overheated real estate market. Japan was trying to galvanize its economy with monetary stimulus, uncertainty was prevalent throughout several emerging markets nations, and there were ongoing, still unresolved issues in the eurozone. All of these situations made the pullback in share prices unsurprising. International Smaller-Cos slipped 3.8% in the second quarter while its benchmark declined 4.5%. We were pleased to see the Fund better preserve its value during this difficult period.

While none of these situations were resolved in the third quarter, most had settled down enough for many international markets to heat up again. As it did in the first quarter, the Fund enjoyed more modest participation in the bull phase, gaining 7.9% compared to 10.7% for the Russell Global ex-U.S. Small Cap Index. Curiously, and somewhat symmetrically, the Fund then once again outpaced its benchmark when the markets grew more volatile in the fourth quarter, up 5.3% versus 4.0% for the Russell Global ex-U.S. Small Cap Index. While the Fund’s shorter-term results have not been as strong as we would ideally prefer, we were pleased that the Fund outperformed the Russell ex-U.S. Global Small Cap Index for the since inception (6/30/08) periods ended December 31, 2013. In October, we made changes to the Fund’s portfolio management: Charles Royce rotated off the Fund; David Nadel now serves as the Fund’s portfolio manager, assisted by Dilip P. Badlani and Mark Rayner. David began to manage the Fund in 2011 and served as assistant portfolio manager from 2009-2011. Dilip and Mark became the Fund’s assistant portfolio managers in October 2013.

Seven of the Fund’s nine sectors posted net gains for the period, led by Health Care companies. Recordati, a top-ten holding at year-end, is a pharmaceutical business based in Milan with a growing global reach. Steadily increasing growth and earnings helped its share price to rise, as did its acquisition in October of Tunisian pharmaceutical business Opalia Pharma. This move was consistent with the company’s expanding global footprint, which saw previous growth from high-demand markets such as Russia, Turkey, and Eastern Europe. Clinigen Group is a U.K.-based specialty pharmaceuticals and pharmaceutical services business serving patients, the medical community, and the healthcare industry. Its share price rose based on the impressive growth in its global business and consequent earnings improvement. We sold our shares between May and October.

A slumping share price led us to more than triple our position in Daphne International Holdings during 2013. Daphne is a Chinese footwear maker and retailer, which sells Aerosole shoes in China. Its strong management and market position gave us confidence in the company’s long-term potential, though we recognize that this investment is likely to require patience. The overall slowdown in the Chinese economy has taken its toll on Daphne’s business as lower levels of consumer spending in particular caused sales and revenues to decline. The bulk of the Fund’s largest remaining net losses at the position level came from holdings in the metals & mining industry, part of the Materials sector that posted a sizable net loss in 2013. Metals & mining companies accounted for four of the Fund’s five, and six of its ten, largest detractors for the period. The businesses that were involved in precious metals mining could not shake the negative impact on revenue and stock prices of the respective 36% and 28% drops in silver and gold prices in 2013.


GOOD IDEAS THAT WORKED
Top Contributors to 2013 Performance
1

Recordati 0.73%
Clinigen Group 0.68
Kakaku.com 0.64
Boiron 0.63
Pacific Textiles Holdings 0.62
1 Includes dividends

GOOD IDEAS AT THE TIME
Top Detractors from 2013 Performance1

Daphne International Holdings -0.95%
Hochschild Mining -0.83
Koza Altin Isletmeleri -0.44
Maharashtra Seamless -0.43
Medusa Mining -0.38
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR Since
Inception
Inception
Date
International Smaller-Cos 5.72 12.73 12.73 3.03 15.76 7.02 6/30/2008
Russell Glo x US SC 4.05 17.21 17.21 4.24 17.83 4.47 N/A

Annual Operating Expenses: Gross 2.15% Net 1.71%

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 2% redemption fee payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current monthend performance may be higher or lower than performance quoted and may be obtained here. Gross operating expenses reflect total gross annual operating expenses 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 any applicable Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. 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 its fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, other than acquired fund fees and expenses, at or below 1.69% through April 30, 2014 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 may invest a significant portion of its assets in foreign companies, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (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 invests primarily in micro-cap, small-cap, and/or 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.) 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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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