article 12-31-2013

Royce Pennsylvania Mutual Fund Manager Commentary

We were mostly pleased with the performance of our flagship, Royce Pennsylvania Mutual Fund, in 2013. The Fund achieved a strong absolute return for the calendar year, rising 35.3%. Of course, we would have preferred a better relative showing, as Pennsylvania Mutual underperformed its small-cap benchmark, the Russell 2000 Index, which rose 38.8% in 2013. However, in the current context of equity returns, we were very satisfied. The last three years saw higher returns from fast-growing, lower-quality companies, often carrying ample leverage on their balance sheets, which even in an era of easy money and zero interest rates strikes us as a dubious practice. In this challenging environment, the Fund acquitted itself nicely on an absolute basis.

The year began with a strong first quarter for stocks, particularly small-caps. It marked the fourth consecutive year in which the markets began the year with a fast start. After beating its benchmark in the second half of 2012 (+10.2% versus +7.2%), the Fund fell behind the Russell 2000 in the first quarter of 2013, up 10.2% versus 12.4%. Taper talk brought a wave of volatility in the second quarter, tamping down returns to the low single digits. The Fund rose 1.3% versus 3.1% for the Russell 2000 for this period. The third quarter quickly resumed the red-hot pace of the first, with returns for most small-cap indexes rising into double digits. The Russell 2000 gained 10.2% while Pennsylvania Mutual climbed 10.7%. The fourth quarter saw a less frenetic pace and a bit more volatility, though it was not as rocky as the second quarter. More important, the Fund again beat the Russell 2000, up 9.5% versus 8.7%, giving the Fund two straight years of outperformance for the second half of the calendar year.

This second-half performance edge in 2013 can be traced to an earlier date in the year—the low for 10-year Treasury yields that occurred on May 2. With rates mostly on the rise since this low, the Fund narrowly beat the Russell 2000 from May 2 through December 31, 2013, up 25.9% compared to 25.0%. The Fund also outperformed its benchmark for the five-, 10-, 15-, 20-, 25-, 30-, and 35-year periods ended December 31, 2013. Pennsylvania Mutual's average annual total return for the 40-year period ended December 31, 2013 was 14.5%, a long-term record in which we take great pride.

In June 2013, we received the first substantial announcement that the pace of the Fed's accommodative QE programs would be slowed. The news at first sent the markets into a tailspin while quickly catapulting the term "taper" into daily usage. After their initially bearish reaction, the domestic equity markets adjusted quite well by the end of the year. When the third-quarter GDP estimate was revised upward in December, the news further helped to reassure nervous investors that the economy was sturdy enough to begin standing on its own feet (something that we have been convinced of for at least a year). The slow but steady tick down in the unemployment rate, as well as December's budget deal, also aided in the impression that the U.S. economy was moving out of its slow and uncertain growth phase and into a more historically typical pace of growth. We see this as welcome news for many portfolio holdings, especially those in cyclical areas such as Energy and Materials, many of which have not participated fully, if at all, in the bull phase that took up nearly all of 2013.

In 2013, nine of the Fund's 11 sectors finished the period with net gains, an unsurprising development in such a bullish climate. While notable contributions came from the Information Technology, Consumer Discretionary, and Financials sectors, Industrials led the way by a comfortable margin. The sector's net gains came from a number of industry groups, most notably machinery companies, which was the top performing group for the calendar year. Solid net gains also came from the sector's professional services, aerospace & defense, building products, and electrical equipment groups. The first of these was home to one of the Fund's top performers. Towers Watson & Company provides human resource, financial consulting, and other related services. Its price rose more or less steadily throughout the year. In May the firm's management raised adjusted EPS (earnings per share) guidance for fiscal 2013 while the stock also gained from the opening of Obamacare insurance exchanges in October. It then raised its dividend in November. We have liked its core business and steady earnings for several years having first bought shares in the Fund's portfolio in 2006. We began to take gains in August 2013.

Nu Skin Enterprises develops and distributes personal care skin products worldwide. After enjoying a strong first half, its share price gained additional momentum in the year's last six months. In October, the company announced stronger-than-anticipated third-quarter earnings and raised its full-year guidance for 2013, driven by the success of a limited-time offer for its new weight management system. We began to reduce our position in March. We also sold some shares of NETGEAR, though we still held a good-sized position at year-end, confident that it would benefit from a potential pick-up in its global business in 2014. We also reduced our stake in clothing retailer American Eagle Outfitters, though we still think it is capable of surviving increased competition in the malls and declining sales owing to its strong niche in the teen clothing market.

Top Contributors to 2013 Performance

Nu Skin Enterprises Cl. A 0.64%
Towers Watson & Company Cl. A 0.53
Oil States International 0.53
AAON 0.48
Helmerich & Payne 0.47
1 Includes dividends

Top Detractors from 2013 Performance

American Eagle Outfitters -0.16%
Seabridge Gold -0.16
Acacia Research -0.15
Agnico Eagle Mines -0.14
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR 20YR 30YR 40YR
Pennsylvania Mutual 9.54 35.25 35.25 14.09 20.18 10.06 11.22 11.32 11.69 14.52
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 8.42 9.27 9.82 N/A

Annual Operating Expenses: 0.90%

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. 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 investment in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of PMF’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. 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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