article 12-31-2013

Royce Special Equity Fund Manager Commentary

­The first and second halves of 2013 each featured two different market climates, and we were pleased with the absolute results for Royce Special Equity Fund in both of them. The Fund advanced 29.4% for the calendar year, trailing its small-cap benchmark, the Russell 2000 Index, which was up 38.8% for the same period.

The first quarter was a bullish period that in many ways continued the trend that began following the small-cap low on June 4, 2012. However, it actually saw a return to leadership for lower-quality companies. For example, the Fund outpaced the Russell 2000 through the last six months of 2012 (+8.8% versus +7.2%) but trailed the small-cap index in 2013’s first quarter, up 8.7% compared to 12.4%. The more volatile second quarter saw improvement on a relative basis. Although small-cap results were often dominated by many of the same lower-quality issues that led in the first quarter, there was enough differentiation at the company, industry, and sector levels in the period for the Fund to narrowly outpace the small-cap index (+3.4% versus +3.1%).

The bullish phase then resumed in earnest in the third quarter and extended into the first two months of the fourth in spite of the government shutdown in October. Volatility was not a significant factor until December. Leadership remained with lower-quality stocks, but we were pleased with Special Equity’s absolute results. For the third quarter, the Fund gained 8.3% compared to a 10.2% increase for the Russell 2000. While not as volatile as the second quarter, the fourth saw a rocky December in which share prices re-started their upward movement in the last two weeks of the year. The Fund was again behind its benchmark, with the Fund up 6.3% versus 8.7% for the small-cap index. We were pleased that the Fund outperformed the Russell 2000 for the 10-, 15-year, and since inception (5/1/98) periods ended December 31, 2013. Special Equity’s average annual total return since inception was 10.3%.

­For most of the year, lower-quality stocks outperformed. Companies with low prices, smaller market caps, no earnings, no dividend, low returns on equity, and high beta outperformed. We seek to avoid these very characteristics in the names we choose, and this hurt our relative performance. In addition, areas such as Health Care and REITs, where we had little to no representation, respectively, saw rising share prices. We strongly believe that as the market goes higher, and with less stimulus provided by the Fed, investors will again seek quality names, which could benefit many portfolio holdings.

As you would expect from our disciplined approach, as share prices rose, it became easier to find things to sell than to buy. We will not abandon our methodology. If the markets continue to rise and we cannot find replacements for the issues we sold, cash will likely increase as a percentage of the portfolio. While that might reduce our performance if the market continues its bull run, it will ultimately benefit our performance when the market declines—it will give us the ability to buy attractive names without the need to sell any of our remaining attractive holdings. In 2013, we saw a few dips—the sharpest based upon “taper tantrums” and government shutdown issues—and used both to find new names as well as to add to existing ones.

Six of the Fund’s seven equity sectors finished the year with net gains while the seventh, Energy, was essentially flat for the period. Consumer Discretionary, Industrials, and Information Technology led by a wide margin. At the industry level, the electronic equipment, instruments & components group led with a net gain higher than three of the portfolio’s sectors. Molex, a maker of electronic components for products such as the iPhone, agreed to a $7.2 billion acquisition by Koch Industries in September, which helped drive results for that industry group. The electrical equipment, specialty retail, chemicals, and media industries also did well.

Four of the Fund’s top five contributors for the period were also top-four positions at the end of December. EnerSys makes industrial batteries and related products such as chargers, power equipment, and battery accessories. Mineral Technologies develops and produces performance-enhancing minerals and mineral-based and synthetic mineral products for use in the paper, steel, polymer, and other manufacturing industries. UniFirst Corporation provides workplace uniforms and protective clothing serving customer locations in the U.S., Canada, and Europe. Bed Bath & Beyond operates a nationwide chain of retail stores that sell domestics merchandise and home furnishings as well as food, giftware, health and beauty care items, and infant and toddler merchandise.

Net losses were comparatively modest. Top-20 position American Eagle Outfitters retails casual apparel, footwear, outerwear, and accessories for men and women, including jeans, khakis, and T-shirts. Leapfrog Enterprises designs and develops technology-based educational products, including educational games and learning books, that are sold through retailers, distributors, and directly to schools.

Top Contributors to 2013 Performance

Molex 3.09%
EnerSys 2.83
Minerals Technologies 2.06
UniFirst Corporation 1.74
Bed Bath & Beyond 1.65
1 Includes dividends

Top Detractors from 2013 Performance1

American Eagle Outfitters -1.07%
Leapfrog Enterprises Cl. A -0.05
Ampco-Pittsburgh -0.04
Hawkins -0.02
National Beverage -0.01
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR Since
Special Equity 6.32 29.36 29.36 14.31 18.06 9.52 11.36 10.35 5/1/1998
Russell 2000 8.72 38.82 38.82 15.67 20.08 9.07 8.42 7.15 N/A

Annual Operating Expenses: 1.13%

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 and other expenses. Shares of RSE’s Service and Consultant 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.) As of 12/31/13, the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. 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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