article 12-31-2013

Royce Select Fund I Manager Commentary

By the end of 2013, we were still a bit vexed by the performance of Royce Select Fund I, its strong absolute result notwithstanding. Still, the Fund’s 2013 showing was not entirely surprising considering its disciplined value approach, which has historically produced better relative results in flat or down markets than in the almost uninterrupted bull run of 2013. The Fund gained 26.0% for the calendar year, trailing its small-cap benchmark, the Russell 2000 Index, which was up 38.8% for the same period.

The Fund’s strong second half of 2012, a period in which it beat its benchmark (+10.6% versus +7.2%), inspired our confidence that the kind of stocks that we favor—those with strong balance sheets, high returns on invested capital, and the ability to generate free cash flow, many in cyclical sectors—were poised for a solid run of market leadership after lagging more defensive areas of the market over the last few years. This was not the case, however, as 2013 saw a resurgence from those same defensive areas. And while the performance of several Fund holdings in cyclical sectors picked up nicely in the second half of 2013, their improved performance was not enough to vault the Fund past its benchmark for the calendar year.

As was the case in the previous three calendar years, the opening quarter of 2013 was highly bullish, especially for micro-, small-, and midcap stocks. The Fund performed solidly on an absolute basis in this period, though it lagged the Russell 2000. The Fund was up 7.3% compared to 12.4% for the small-cap index in the first quarter. Select I then fell further behind its benchmark in the far more volatile second quarter, which was disappointing—our disciplined approach has historically helped the Fund to weather down and/or volatile periods more effectively, typically by losing less than its benchmark. In the second quarter, however, Select I fell 0.5% versus a 3.1% gain for the Russell 2000. We were pleased to see the Fund rebound in the third quarter, which was a more bullish phase like the first quarter. Investors had plenty to digest between the end of March and early July: rising interest rates—the 10-year Treasury yield hit a 2013 low on May 2—less-than-encouraging news out of China and other important developing economies, and the Fed’s initially vague promise in June that it would begin to taper its monthly bond-buying program by some amount at some point later in the year. Indeed, investors were uncommonly sanguine through much of 2013. Good contrarians that we are, this new-found serenity was cause for a bit of worry on our part, though we were pleased with third-quarter results on an absolute basis—the Fund advanced 8.6% versus 10.2% for the Russell 2000. The Fund’s fourth-quarter results were strong on both an absolute and relative basis, with the Fund even with the small-cap index, both increasing 8.7%. The Fund also held a performance advantage over its benchmark for longer-term periods, outpacing the Russell 2000 for the 10-year, 15-year, and since inception (11/18/98) periods ended December 31, 2013. The Fund’s average annual total return since inception was 14.2%.

Each of the Fund’s equity sectors contributed to performance in 2013, led by Industrials and Information Technology. Net losses at the industry and position level were modest. Major Drilling Group International provides contract drilling services for the metals industry. Slumping demand for gold drilling services, which accounts for about 50% of the firm’s revenues, and other minerals such as iron ore sped its stock-price decline, as did the drop in commodities prices. In some cases miners cancelled or scaled back their exploration plans, which resulted in excess contract drilling capacity and pricing pressure. After buying shares in the first quarter, we reduced our position between May and October. Intrepid Potash mines and markets potash for fertilizer. The breakup of one of the two key global potash marketing consortia—it remained to be seen at year-end whether the breakup was permanent or temporary—was a major driver
in the more than 25% drop in potash prices in 2013. Another significant factor was the 2013 bumper crop in corn and wheat here in the U.S., which increased the likelihood of lower fertilizer application in 2014 as farmers face lower farm income and may plant less acreage. We finished selling our position in August.

Helmerich & Payne provides contract drilling of oil and gas wells in the Gulf of Mexico and South America and also operates land and platform rigs. The company continued to leverage its technological leadership in the drilling rig business into market share gains as E&P (exploration & production) companies upgrade their fleets to improve drilling efficiencies and lower their total well costs. Based in Houston, Oil States International provides products and services to oil and gas companies. Its share price skyrocketed at the end of April on news that activist shareholders were asking the company’s management to create a REIT from its oilfield accommodation business. We think that management unlocked significant shareholder value through its decision to spin off its accommodations business, sell its energy pipe distribution segment, and increase its share repurchase program. We took gains throughout the year.


GOOD IDEAS THAT WORKED
Top Contributors to 2013 Performance
1

Helmerich & Payne 1.42%
Oil States International 1.22
Jazz Pharmaceuticals 1.03
Lazard Cl. A 0.94
Minderals Technologies 0.90
1 Includes dividends

GOOD IDEAS AT THE TIME
Top Detractors from 2013 Performance1

Intrepid Potash -0.55%
Major Drilling Group International -0.53
TGS-NOPEC Geophysical -0.46
Myriad Genetics -0.39
American Eagle Outfitters -0.24
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR Since
Inception
Inception
Date
Select I 8.74 25.99 25.99 11.35 17.89 10.99 13.72 14.18 11/18/1998
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 8.42 8.89 N/A

Annual Operating Expenses: 1.15%

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 performance shown above. 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. 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 micro-cap, small-cap, and 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.) 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 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 invest up to 15% 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 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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