article 12-31-2013

Royce Special Equity Multi-Cap Fund Manager Commentary

The first and second halves of 2013 each featured two different market climates, and we were pleased with the absolute and relative results for Royce Special Equity Multi-Cap Fund in both of them. The Fund gained 36.3% for the calendar year, outpacing its benchmark, the Russell 1000 Index, which was up 33.1% for the same period.

The first quarter was a bullish period that in many ways carried on the run that began following the market lows in June 2012. Special Equity Multi-Cap was behind the Russell 1000 through the last six months of 2012 (+4.6% versus +6.4%) and continued to trail the large-cap index in 2013’s first quarter, up 10.3% compared to 11.0%. This nine-month underperformance was no surprise—lower-quality companies have mostly dominated the market over the last few years. We were pleased that the more volatile second quarter saw marked improvement on a relative basis—in addition to a strong absolute showing. Markets were roiled following the Fed’s announcement that it would likely begin tapering the pace of monthly bond purchases later in 2013. In this more uncertain environment, which also included rising interest rates, the Fund more than doubled the return of its benchmark, gaining 6.8% compared to 2.7% for the Russell 1000. Strong results from holdings in the Consumer Discretionary sector, which also made a notable contribution in the first quarter, helped make the difference.

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, which made third-quarter results all the more pleasing. For the third quarter, the Fund gained 8.3% compared to a 6.0% increase for the Russell 1000. 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 slipped behind its benchmark, with the Fund up 6.8% versus 10.2% for the large-cap index. We were pleased that the Fund outperformed the Russell 1000 for the one- and three-year/since inception (12/31/10) periods ended December 31, 2013. Special Equity Multi-Cap’s average annual total return since inception was 17.7%.

We offer a hypothesis as to why the market keeps rising despite valuation and other concerns such as national and world events that would have caused a correction in the past. We have observed that a number of U.S. companies whose operating margins, which are unaffected by lower interest rates or the benefits from lower taxes, etc., have risen on falling sales. This is occurring after, we must assume, all of the low-hanging cost savings, and probably some of the harder-toreach ones, have been harvested over these past five years. Could the market, as has happened in the past, be predicting some positive outcome that most of us have not considered? The much-spokenabout peak profit margin risk might be a myth. What if the cost structures of U.S. companies have changed such that if we see more sustainable revenue growth, companies will reap huge incremental operation margins and thus much higher-than-expected earnings? We raise this issue now only as a question for discussion. Surely some of the recent rising profitability could be a result of low inflation and thus lower or flat incoming costs to companies. However, it appears it could be more than that. If in time we see that this prediction of higher profitability becomes a reality, the now somewhat elevated P/Es were justified.

For now, despite any welcome pauses or consolidations, we believe the market is still headed higher, buoyed by similar factors that occurred in the 1990s when the combination of low inflation, accommodative monetary policy, falling commodity prices, and improving leading economic indicators were the causes. The outcome of which, if our incremental margin hypothesis proves correct, will be much higher-than-expected earnings in future years, and thus lower multiples than are currently assumed.

Each of the Fund’s seven equity sectors finished 2013 in the black. Information Technology and Industrials led by a considerable margin while Consumer Discretionary also made a notable net contribution. At the industry level, machinery companies were the leaders, sparked by Dover Corporation, Parker Hannifin, and Illinois Tool Works. The specialty retail group, electronic equipment, instruments & components companies, health care equipment & supplies stocks, and the semiconductor & semiconductor equipment industry all turned in strong net gains. Health care providers & services was the only industry group to post a net loss for the period.

The top contributing position in 2013 was Molex, a maker of electronic components for products such as the iPhone that agreed to a $7.2 billion acquisition by Koch Industries in September. The substantial better than 50% premium which Koch offered for the shares helped to drive the Fund’s impressive results in the Information Technology sector. Bed Bath & Beyond, the Fund’s fourth-largest holding at year-end, 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 at the individual position level were scant and modest. Quest Diagnostics provides diagnostic testing, information, and services. The company operates a national network of full-service laboratories and patient service centers and provides routine and esoteric medical testing. It was Special Equity Multi-Cap’s twelfth-largest holding at year-end. We sold our position in department store operator Kohl’s Corporation in mid-January of 2013.

Top Contributors to 2013 Performance

Molex Cl. A 3.59%
Bed Bath & Beyond 2.01
Dover Corporation 1.89
Microsoft Corporation 1.82
Parker Hannifin 1.77
1 Includes dividends

Top Detractors from 2013 Performance1

Quest Diagnostics -0.23%
Kohl's Corporation -0.06
Jacobs Engineering Group -0.01
Fluor Corporation -0.01
United Technologies 0.11
1 Net of dividends

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

  QTR YTD 1YR 3YR Since
Special Equity Multi-Cap 6.81 36.26 36.26 17.70 17.70 12/31/2010
Russell 1000 10.23 33.11 33.11 16.30 16.30 N/A

Annual Operating Expenses: Gross 1.36% Net 1.24%

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 Service Class (its oldest class). Gross operating expenses reflect gross total annual operating expenses for the Service Class 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 the 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 reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Service Classes’s net annual operating expenses, other than acquired fund fees and expenses, at or below 1.24% through April 30, 2014. 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 mid-cap and large-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) In addition, 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. 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 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest 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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