In 2013, Royce Heritage Fund did fine on an absolute basis but disappointed on a relative basis. During the first half of 2014, it did much the same, though it managed to slightly narrow the gap with its benchmark. The Fund rose 2.9% for the year-to-date period ended June 30, 2014, trailing its benchmark, the small-cap Russell 2000 Index, which gained 3.2% for the same period.

The first quarter, in which the Fund rose 0.5%, was positive for most equities. However, the pace of returns slowed considerably following the fast-paced bull run that lasted through most of 2013, particularly during its last seven months. A new Fed chair, miserable winter weather through much of the eastern part of the U.S., and ongoing concerns about the pace of economic growth all gave investors pause at one point or another in 2014’s opening months. There was not enough anxiety, however, to reverse the course of the upswing—it only caused the bull to slow his pace. Small-caps reached an interim high on March 4 and the ensuing correction lasted into mid-May before shares began to rally again. We were pleased that the Fund outpaced the Russell 2000 from this early March high through the end of June. (More market cycle results can be found here.)

The Fund climbed 2.4% compared to a 2.0% increase for the Russell 2000 for the second quarter. The market rewarded lower-quality companies in the first quarter and during the low-key rally that closed out the first half, while higher-quality companies (mostly in the form of profitability and/or high returns on invested capital) led during the short correction. We think investors are attempting to sort out both the present and future in an economic climate in which the Fed is gradually stepping back. To us, the economy looks poised for faster growth. We believe this should benefit disciplined active approaches such as our own that emphasize absolute returns and a long-term investment horizon.

We were pleased that the Fund stayed ahead of the Russell 2000 for longer-term periods. Heritage beat its benchmark for the 10-, 15-year, and since inception (12/27/95) periods ended June 30, 2014. The Fund’s average annual total return since inception was 13.8%, a longterm record in which we take great pride.

Effective May 1, 2014, the Fund may now invest in companies with market capitalizations up to $15 billion (up from $5 billion). This offers more potential exposure to the full range of mid-cap securities, an area of the market in which we have taken more interest over the last several years.

The precious metals mining industry suffered through a brutal 2013, with respective declines of 36% and 28% in silver and gold prices conspiring with rising operational costs to make things truly awful. Valuations for several companies dropped to levels comparable to or lower than those of the market bottom in early 2009. All of this made us very pleased to see the industry rebound strongly during the first half of 2014. Dividend-paying silver miner Pan American Silver was the standout in the group. This still short-term recovery—along with nicely positive results for chemical companies—helped to give Materials top honors among the portfolio’s sector performances in the first half of 2014. Financials, Information Technology, and Energy also posted notable net gains for the semiannual period. The topperforming industry groups were energy equipment & services and capital markets, two areas of near-perennial interest to us. Two companies with what we regard as distinct technological advantages were major contributors in the energy equipment & services group. Helmerich & Payne is a contract driller with a specialty in high-tech drilling rigs that were in increasingly high demand as drilling activity picked up. Pason Systems makes instrumentation systems for on-land and offshore rigs that relay data, which improves drilling efficiency. More drilling activity and improved daily rental rates for its rig connectivity and remote diagnostics products were keys to its first-half success, as was the favorable outlook based on its pipeline of new products. Asset manager AllianceBernstein Holding L.P., which saw improvements in both portfolio performance and assets under management, was the leader in capital markets.

UTi Worldwide is a global supply chain logistics services and solutions company. The firm suffered through a series of problems, including the violation of its debt covenants, which led to an expensive and dilutive recapitalization. We held our shares in the hopes of a rebound. We also made a modest trim to our stake in engineering and construction business KBR during the first quarter in the belief that the company can recover from cancellations and losses of projects as well as the pushed-out start dates for some of its LNG (liquefied natural gas) ventures. We sold our stake in cloud-based technology services and software business Support. com after management embarked on shifts in strategy which had us question our original investment thesis. We were content to hold shares of footwear retailer Wolverine World Wide as many retailers were faced with declining business owing to poor retail traffic that we deemed temporary in nature.

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

Annual Operating Expenses: 1.49%

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

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