article 06-30-2014

Royce Select Fund I Manager Commentary

The sort of well-run, conservatively capitalized small-cap companies that we look for in Royce Select Fund I have often trailed their faster-growing and/or higher-yielding peers over the last few years. There have been signs of a shift over the last two years, though leadership for quality has typically been short lived. We were very pleased, then, with the strong relative and absolute results for the Fund in the first half of 2014. For the year-to-date period ended June 30, 2014, Select I gained 6.6%, more than doubling the 3.2% increase for its small-cap benchmark, the Russell 2000 Index, during the same period.

The Fund’s relative performance edge was especially welcome after it finished behind the small-cap index for two consecutive calendar years. During much of the post-financial crisis market, in particular during the years of QE (quantitative easing) and zero interest rates, many small-caps that we think possess high quality were out of favor. For the most part, these companies were not neglected or forgotten by investors—they were simply not seeing the same high level of interest as faster-growing or higher-yielding securities. These two areas typically do not interest us because the long-term financial strength that we crave in the form of strong balance sheets, positive free cash flow, and high returns on invested capital are usually in short supply. Our practice during these years has been to keep looking for what we saw as undervalued quality while we waited for the economy to resume growing at a faster pace. A livelier economic expansion should result in a much-diminished role for the Fed and more attention to business fundamentals from investors. While this shift is not yet complete, we have seen encouraging signs, most recently during the brief correction for small-caps in the first half, which lasted from the year-to-date small-cap high on March 4 through May 15. During this time, quality smallcaps outpaced their small-cap siblings.

For the first quarter, the Fundsubstantially outpaced the Russell 2000, rising 4.3% versus 1.1% for the benchmark. The down phase began before the end of the quarter, but April saw the worst of it. A robust round of buying from mid-May through the end of June brought small-cap returns back into the black for the second quarter, when the Fund advanced 2.2%. The Fund outperformed its benchmark for the one-, 10-, 15-year, and since inception (11/18/98) periods ended June 30, 2014. The Fund’s average annual total return since inception was 14.2%, a long-term record that gives us great pride.

Seven of the Fund’s eight equity sectors finished the year-to-date period in the black and net losses in the Materials sector were very modest. Energy led all of the Fund’s sector groups by a wide margin while Health Care also posted notable net gains. It was not surprising, then, that the Fund’s two best-performing industries in the first half were energy equipment & services and biotechnology while semiconductors & semiconductor equipment companies were also a source of strength. As was the case with sectors, net losses at the industry level were small. Four of the portfolio’s five best performers for the period were energy equipment & services businesses—contract driller Helmerich & Payne, contract driller and oil & gas exploration and production firm Unit Corporation, drill rig instrumentation systems maker Pason Systems and TGS NoPEC Geophysical provides geoscientific data products and services to the oil and gas industry. Each was a top-20 holding at the end of June.

The Fund’s top performer by a sizable margin was Myriad Genetics, a molecular diagnostic company that specializes in genetic testing for cancer. Its share price slipped dramatically in 2013 after the Supreme Court issued a ruling that human genes cannot be patented. It was also challenged by a reimbursement change from payers (ultimately resolved on better terms) and faced the prospect of new competition in the breast cancer gene testing market. All of this caused many investors to abandon its stock, though we were optimistic that the quality of its diagnostics database and pipeline of additional oncology tests would allow it to remain a leader in molecular testing. The stock began to revive in 2014’s first quarter. Through much of this late 2013-early 2014 timeframe, we thought management was deploying capital productively, first by buying back stock late in 2013 and then in February by acquiring Crescendo Bioscience, which diversified Myriad’s pipeline and gives it a potential billion-dollar market for disease monitoring tests (initially for rheumatoid arthritis). The company also posted strong breast cancer diagnostic test volumes, with its MyRisk panel test meeting initial sales targets. We sold some shares as its price soared in the first half, though it was RS1’s eighth-largest position at the end of the period.

We increased our position in multiline women’s fashion business Ascena Retail Group. In addition to the generally awful market for retailers, the company was 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

Myriad Genetics 1.55
Helmerich & Payne 1.05
Unit Corporation 1.02
Pason Systems 0.61
TGS-NOPEC Geophysical 0.44
1 Includes dividends

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

Ascena Retail Group -0.40
Medicines Company (The) -0.34
Silicon Graphics International -0.27
Global Power Equipment Group -0.25
ADTRAN -0.22
1 Net of dividends

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

  QTR YTD 1YR 3YR 5YR 10YR 15YR SINCE
INCEPTION
INCEPTION
DATE
 
Select I 2.24 6.61 25.86 11.24 16.60 10.75 12.68 14.16 11/18/1998
Russell 2000 2.05 3.19 23.64 14.57 20.21 8.70 8.01 8.81 N/A
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Annual Operating Expenses: 1.2%

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 performance shown above. Current month-end performance may be higher or lower than performance quoted and may be obtained here. 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, and other expenses. 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 and mid-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 sell securities short which involves selling a security it does not own in anticipation that the security's price will decline. Short sales present unlimited risk on an individual stock basis since the Fund may be required to buy the security sold short at a time when the security has appreciated in value. The Fund also invests primarily in a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 15% 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 Index 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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