article 06-30-2014

Royce Pennsylvania Mutual Fund Manager Commentary

Our flagship, Royce Pennsylvania Mutual Fund, was up 2.0% for the year-to-date period ended June 30, 2014, finishing the first half behind its small-cap benchmark, the Russell 2000 Index, which gained 3.2% for the same period. This was somewhat disappointing because the market has at times been more hospitable to disciplined and active investment approaches over the last 14 months, dating back to the May 2, 2013 low for the 10-Year Treasury. This occasional strength could be seen in the Fund’s results from the second half of 2013, when it outperformed its benchmark.

Unlike the previous four years, 2014 got off to a slow, though still positive, start. This was not terribly surprising in the context of a highly bullish 2013, a year that saw no major corrections and enjoyed a particularly dynamic second half. The result was a nondescript opening quarter in which the Fund was up 0.3% versus a gain of 1.1% for the Russell 2000. The second quarter seemed similarly uninspired, though it was more volatile. Equities failed to establish any clear direction as the economy continued to grow slowly and a stillunresolved 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. The same could be said for volatility, which has been low. Smallcaps reached a first-half high on March 4, declining 9.1% through May 15. This was as close to a correction as stocks have come so far in 2014. Markets began to rally in May and continued doing so through the end of June. For the second quarter, Pennsylvania Mutual rose 1.7% while the Russell 2000 was up 2.0%.

We have been very pleased to see valueoriented styles such as our own gradually narrow the performance gap over the last several months with their respective benchmarks and the passively managed portfolios and ETFs that mirror the indexes. While the Fund’s first-half results did not show this growing strength to the degree that we would like, results over the one-year period ended June 30, 2014 were more encouraging. We therefore remain resolute about the Fund’s approach and optimistic about its long-term prospects. We were also happy that its longer-term performance advantages remained in place. The Fund outpaced the Russell 2000 for the one-, 10-, 15-, 20-, 25-, 30-, and 35-year periods ended June 30, 2014. The Fund’s average annual total return for the 40-year period—all under the management of Chuck Royce—was 15.2%. We take great pride in this four-decade result.

Although net losses were relatively light, the portfolio held a number of detractors clustered in the Industrials sector, a cyclical area that has seen some recovery in the small-cap market and where the Fund was overweight in the first half compared to the Russell 2000. Global supply chain logistics services and solutions company UTi Worldwide suffered from weaker freight-forwarding volumes and pricing. Combined with delays collecting receivables due to the implementation of a major new IT system in the U.S., this caused the company to violate its debt covenants, forcing an expensive and dilutive recapitalization. Liking its chances for a turnaround, we built our position in the first half. KBR, a Houstonbased engineering and construction firm with global operations, saw its fiscal 2014 outlook reduced by cancellations and losses on some engineering and construction bids, as well as on pushed out start dates for certain LNG (liquefied natural gas) projects. We also liked its prospects for reversing its fortunes and added shares as its price slipped.

As for those sectors that made a positive contribution in the first half, Energy stocks led by a wide margin, followed by solid net gains for Materials, Health Care, and Financials. Holdings in the Energy sector accounted for three of Pennsylvania Mutual’s five, five of its 10, and eight of its 20 top contributors. Helmerich & Payne, Unit Corporation, and Pason Systems are all long-term holdings. Along with other strong performers in the sector, they benefited from a revival of interest in energy stocks. Helmerich & Payne saw growth in demand for new rigs, confirming that its technologically superior offerings are driving market share gains for companies eager to reduce drilling costs by upgrading to its more efficient rigs. Unit Corporation operates as a contract driller and exploration and production company, among other energy-related businesses. Double-digit production growth, the introduction of a new advanced drilling rig, and continued strong performance from its midstream operations all helped to draw investors to its stock.

Along with Industrials, Consumer Discretionary also had a small net loss in the first half. We increased our position in multiline women’s fashion business Ascena Retail Group as it endured a generally awful market for retail businesses. The company was more specifically challenged by depressed holiday results that did not improve as the year went on, particularly at Justice, a brand in the promotion-driven teen fashion space. The company is aiming for better results in the second half with revamped products for, and reduced inventory lead times at, Justice, increasing profitability from their plus-size brands, and cost reduction realizations.


GOOD IDEAS THAT WORKED
Top Contributors to Performance
Year-to-Date through 6/30/14
1

Helmerich & Payne 0.33
Unit Corporation 0.29
Pason Systems 0.22
Myriad Genetics 0.19
Westlake Chemical 0.18
1 Includes dividends

GOOD IDEAS AT THE TIME
Top Detractors from Performance
Year-to-Date through 6/30/14
1

UTi Worldwide -0.17
Ascena Retail Group -0.14
Advisory Board (The) -0.12
KBR -0.12
Barrett Business Services -0.11
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR 20YR 30YR 40YR  
Pennsylvania Mutual 1.69 2.04 23.70 12.25 18.77 9.41 11.00 11.61 11.93 15.18
Russell 2000 2.05 3.19 23.64 14.57 20.21 8.70 8.01 9.81 10.30 N/A
Please swipe to view the complete data

Annual Operating Expenses: 0.93%

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, 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 investment in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of PMF’s Service, Consultant, R, and K 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 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 small-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’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), 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 2000 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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