article 12-31-2013

Royce Opportunity Fund Manager Commentary

In 2013, Royce Opportunity Fund continued to be one of the happy exceptions in a now-three-year period of challenging times for active management in the small-cap space. The Fund gained 43.5% in 2013, outpacing its small-cap benchmark, the Russell 2000 Index, which was up 38.8% for the same period. Opportunity's calendar-year result formed part of a longer-term trend of outstanding absolute and relative returns.

Small-caps made a fast start to the year, and the Fund was near the front of the field. During the bullish first quarter, the Fund gained 13.3% compared to a 12.4% increase for its benchmark. Performance was again dominated by faster-growing, defensive areas of the market, as well as by higher-yielding, but arguably lower-quality issues, all at the expense of more cyclical areas once again. This bull phase was in contrast to the second half of 2012, which saw much-improved results from higher-quality companies—that is, those with higher returns on invested capital. Yet the Fund managed very well in both market phases.

Volatility returned to the markets in the form of a bearish April that gave way to a bullish May, while June was already proving to be a volatile month when the Fed announced on the 19th that it would likely begin to taper its bond-buying program later in 2013. Along with a fast-rising rate on the 10-year Treasury, underwhelming news out of China, and growing unrest in the developing world, the global markets swooned, though most domestic indexes were recovering by the end of the month. The Fund did well in this more challenging environment. Opportunity gained 4.6% for the second quarter, ahead of the Russell 2000, which was up 3.1%.

The third quarter saw a resumption of the red-hot pace of the first. The Fed signaled that tapering would be very gradual and in any case would not be starting for a few months, and the U.S. economy continued to expand, although at a slower pace than most of us would prefer. In this more placid climate, the Fund fell behind the Russell 2000, gaining 9.4% in the third quarter while the small-cap index was up 10.2%. The market’s pace slowed a bit in the fourth quarter with more volatility in December. The Fund reasserted its edge, beating the Russell 2000 with a gain of 10.7% compared to 8.7% for the benchmark.

We were very pleased with the Fund’s sterling results over recent calendar year and market cycle periods on both an absolute and relative basis. (Market cycle results can be found here.) The Fund outperformed the Russell 2000 for the one-, five-, 10-, 15-year, and since inception (11/19/96) periods ended December 31, 2013. (And it trailed the Russell 2000 very narrowly for the three-year period, +15.3% versus +15.7%.) Opportunity’s average annual total return for the since inception period was 13.8%. We remain very proud of the Fund’s long-term record. We are also pleased that, effective October 22, 2013, Bill Hench began to serve as a portfolio manager after serving as assistant portfolio manager since 2004.

Information Technology led all sectors, closely followed by Industrials. Consumer Discretionary and Financials also made strong net contributions. The strength of tech holdings was in part the result of the sector’s substantial overweight in the Fund throughout 2013. The portfolio holds several technology businesses that we think are just beginning to recover. The Fund’s two top contributors came from the semiconductor group, though the market’s interest in each company had more to do with their respective roles in the red-hot solar energy industry. We reduced our position in both stocks as their respective share prices moved past our sell targets. SunPower Corporation manufactures high-performance solar electric equipment. SunEdison produces electronic-grade polysilicon used for electronics, solar cells, and film devices while also developing solar power projects. In spite of fears that reduced government subsidies would derail growth, the demand for solar technology shows few signs of cooling off. Many lesser-quality players have either exited the business or lost market share. Technological efficiency has improved, which has helped bring down costs, while China called for a five-fold increase in installed solar capacity in 2013.

Tower International operates a global business manufacturing metal automotive components for OEMs (original equipment manufacturers). Demand for auto parts has held up well worldwide, attracting interest to its shares. We began to take gains in May as its stock price revved up. The rising share price of Unifi also led us to sell shares through much of 2013. The North Carolina-based textile maker with operations in China reversed course after its shares were sold off in part because cotton prices were high. Their subsequent decline, along with the introduction of a polyester fabric made from recycled materials, reignited interest in its shares.

Weaker earnings hurt the Fund’s two largest detractors. Walter Energy produces metallurgical coal. Prices fell in the wake of slack demand in China. We sold our shares shortly after the company’s efforts to refinance its debt looked murky, then reinitiated a position when a new plan was announced. We chose to add to our stake in oil and gas driller Layne Christensen throughout the year based on our belief that its industry niche and efforts to improve operations would eventually help it to reverse course.

Top Contributors to 2013 Performance

SunPower Corporation 1.17%
SunEdison 0.87
Tower International 0.70
Unifi 0.67
Radian Group 0.63
1 Includes dividends

Top Detractors from 2013 Performance1

Walter Energy -0.37%
Layne Christensen -0.18
Tower Group International -0.16
GSE Holding -0.15
Coldwater Creek -0.14
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR Since
Opportunity 10.70 43.50 43.50 15.26 27.13 9.95 13.74 13.84 11/19/1996
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 8.42 8.75 N/A

Annual Operating Expenses: 1.14%

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 monthend performance may be higher or lower than performance quoted and may be obtained here. All performance and risk information reflects results of the Investment Class (its oldest class). 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, 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 investments in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of ROF’s Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Investment Class. 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 micro-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. 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 Index 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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