article 06-30-2014

Royce Micro-Cap Discovery Fund Manager Commentary

Royce Micro-Cap Discovery Fund was flat for the year-to-date period ended June 30, 2014 compared to a 1.6% gain for its benchmark, the Russell Microcap Index, for the same period.

Micro-cap stocks have been among the equity market’s best-performing asset classes over the last several years. For example, the Russell Microcap outpaced its small-cap peers (as represented by the Russell 2000 Index) in four of the last five calendar year periods and their large-cap counterparts (as represented by the Russell 1000 Index) in three of the previous five. In addition, 2013 was the second-best calendar-year result for the Russell Microcap since its inception on June 30, 2000. A slackening of the pace of returns was therefore not unexpected, and this is exactly what took place in the first half of 2014. Equities failed to establish any clear direction as the economy continued to grow slowly and a still unresolved debate went on about whether or not stocks are overvalued or still have some room to run. This argument has so far been a low-intensity dispute, at least insofar as it has affected share prices.

For the first quarter Micro-Cap Discovery advanced 0.4%. 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. Volatility, which has been quite low throughout the last 18 months, returned briefly to the small-cap market in early March and persisted through mid-May, making the second quarter a relatively more unsettled period. Equities rallied through the end of May and all of June, undoing the bearish effect. For the second quarter the Fund fell slightly, down 0.4%, losing less than its benchmark, which declined 1.4% for the same period.

To enhance the detection of potential portfolio candidates, the Fund’s portfolio managers combine a proprietary quantitative screening model—first developed by George Necakov more than a decade ago—with traditional fundamental analysis to aid them in their effort to find companies that exhibit these characteristics. There are several key pieces to the Fund's proprietary model: First, relative sector valuations are an important element in understanding outperformance patterns. The model’s output is sector adjusted so that companies are evaluated relative to their sector peers. Second, the model has historically been more effective in discriminating between over and undervalued companies as one moves down the market cap scale, which explains the Fund’s emphasis on micro-cap stocks. Finally, the efficacy of each of the three attributes can vary depending on what stage we are in within a particular economic cycle. While we believe the model is effective at generating a list of micro-cap investment candidates, fundamental scrutiny adds a level of refinement that does not exist in purely quantitative approaches.

Six of the Fund’s nine equity sectors finished the first half with net gains, with Industrials leading by a large margin. Within the sector, the best-performing industries were machinery companies and professional services stocks. Two holdings in the machinery group were among the portfolio’s five top contributors. Standex International makes a variety of products, including food merchandising and display cases, reusable and expendable space launch vehicles, and magnetic components and connectors. Its shares rose when the company reported record results for its fiscal third quarter with all five operating groups reporting increased year-over-year sales and operating income as well as an optimistic outlook. We sold our shares of Lydall in the second quarter as its price climbed. The company manufactures engineered specialty papers, automotive heat shields, acoustical barriers, and medical filtration and bioprocessing components for original equipment manufacturers. VASCO Data Security International was the Fund’s best-performing position in the first half. The company specializes in bank security and develops security systems to secure and manage access to user digital assets. Its stock made two significant upticks in the first half. In February, its shares rose on better-than-expected fourth quarter of 2013 earnings and a strong outlook for fiscal 2014. Increased revenues and ongoing earnings strength saw the shares getting another major boost late in April. We reduced our position in June.

We parted ways with Liquidity Services in the first half, though we reinitiated a position in July. The company runs online auctions for wholesale, surplus, and salvage assets. We also sold our shares of Big 5 Sporting Goods, an owner and operator of sporting goods stores in the Western U.S. Each posted larger losses in the first half than we were prepared to live with.

Top Contributors to Performance
Year-to-Date through 6/30/14

VASCO Data Security International 0.61
Standex International 0.60
Lydall 0.59
VSE Corporation 0.56
Comtech Telecommunications 0.51
1 Includes dividends

Top Detractors from Performance
Year-to-Date through 6/30/14

Liquidity Services -0.56
Big 5 Sporting Goods -0.50
Village Super Market Cl. A -0.44
Actuate Corporation -0.39
Employers Holdings -0.37
1 Net of dividends

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

Micro-Cap Discovery -0.43 N/A 20.54 9.92 13.46 5.30 6.69 10/3/2003
Russell Microcap -1.41 1.56 24.98 15.94 20.03 6.67 7.73 N/A
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Annual Operating Expenses: Gross 2.5% Net 1.49%

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. Gross operating expenses reflect the Fund’s gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service fees, and other expenses. Net operating expenses reflect contractual fee waivers and/or expense 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 Class’s net annual operating expenses, (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business), at or below 1.49% through April 30, 2015 and at or below 1.99% through April 30, 2024. 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 year-to-date performance for 2014.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at June 30, 2014, 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 June 30, 2014 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 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 invest up to 25% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, 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 Microcap Index includes 1,000 of the smallest securities in the small-cap Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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