After mounting a strong comeback and generally outperforming its domestic peers during the last two quarters of 2013, European indexes remained fairly competitive before beginning to lose steam towards the end of the first half of 2014. We were slightly disappointed in Royce European Smaller-Companies Fund’s relative first-half results. The Fund gained 4.6% for the year-to-date period ended June 30, 2014, trailing its benchmark, the Russell Europe Small Cap Index, which advanced 5.5% for the same period.

The Russell Europe Small Cap Index narrowed the performance gap at the end of 2013, finishing the year with a 36.6% gain versus the domestic small-cap Russell 2000 Index’s 38.8% advance. While equities in the U.S. and abroad moderated in the first quarter of 2014, European markets assumed leadership. The Fund participated in this rally, rising 3.9% versus a gain of 6.5% for its benchmark. European equity performance slowed a bit in the second quarter, most notably in June as the Russell Europe Small Cap Index fell into the red while international, domestic (save micro-caps), and global markets were in the black. We were pleased that European Smaller-Cos gained 0.6% in the second quarter, outperforming its benchmark’s 1.0% decline. We were also pleased that the Fund was able to outpace the Russell Europe Small Cap Index for the since inception (12/29/06) period ended June 30, 2014.

Eight of the Fund’s 10 equity sectors finished the first half in positive territory. Health Care made the largest positive contribution to performance, leading by a sizable margin. It was followed by solid net gains for Consumer Discretionary and Industrials. Materials was the Fund’s biggest detractor from performance, though its net loss was minimal. Pharmaceuticals led at the industry level, with household durables and software also posting significant net gains. Net losses at the industry level were modest. At the country level, holdings headquartered in France, the U.K., Norway, and Italy made the most significant contributions while the portfolio’s limited exposure to companies in Cyprus, Spain, and Belgium detracted from first-half results.

Top-three position and Austria-based Semperit AG Holding manufactures specialized rubber products. In late March the company reported record revenues for fiscal 2013. It then made moves to expand its production capacity at its Kamunting, Malaysia site with the construction of a new glove factory late in the second quarter. We added to our stake in the first half. De’Longhi is an Italian company that owns a collection of consumer brands in the domestic appliance market, such as coffee makers, food processors, electric ovens, kettles, toasters, and more. Its stock performance in the first half of 2014 was largely generated in the first quarter after reporting solid earnings for 2013. It also benefited from investors’ generally increased risk appetite for Italian stocks. We sold some shares late in the first half.

F-Secure is a Finnish company that develops software for internet security and content back-up on the cloud. A combination of better-than-expected earnings as well as an announcement in May that it would be providing its services to Facebook helped its stock price to climb. We took some gains that same month. Forbo Holding is a Swiss firm with a global business in flooring and movement systems. Its shares moved higher when the firm reported an optimistic outlook for fiscal 2014. We reduced our position in the first half. We built our position in Eltek into April after first buying shares in February. This Norwegian business makes power systems and solutions for telecommunications and datacenters, power utilities, railway and metro, marine and offshore, solar, and other industries.

Individual stock net losses were modest. French firm Societé Internationale de Plantations d’Heveas produces natural rubber and operates rubber tree plantations in French-speaking Africa. Declining rubber prices had a negative effect on the stock, which prompted us to begin adding shares early in March. Globaltrans Investment GDR runs a private freight rail transportation business that was hit hard by concerns over Russia’s actions in the Ukraine, mixed macroeconomic data, and softer leasing rates. We view most of those issues as temporary, and have been adding to the position based on of its free cash flow generation and market position. Nokian Renkaat is a long established Finnish company that manufactures and sells winter tires. The stock was hit hard by geopolitical concerns in Russia, which accounts for more than half of its profits. We view this as a shorter-term stock-price weakness. The decline created an opportunity to build our stake in what we regard as a first-class business model at attractive valuations.

Average Annual Total Returns as of Quarter-End 6/30/14 (%)

Annual Operating Expenses: Gross 2.27% Net 1.7%

Current month-end performance may be obtained from our Prices and Performance page.

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