By doing largely what we would expect it to do, Royce Total Return Fund finished the first half of 2014 with a solid absolute result that nonetheless fell short of its benchmark. The Fund gained 2.7% for the year-to-date period ended June 30, 2014 versus a 3.2% increase for its small-cap benchmark, the Russell 2000 Index, for the same period.

For the majority of small-caps, performance in the first half was more muted than it was in 2013, which was as dynamic a year as we have seen for stocks since the initial phase of the post-financial crisis recovery in 2009. Following last year’s very bullish second half, the slackening of the pace in 2014’s first quarter was not surprising. However, we were disappointed that small- and micro-cap dividend payers did not perform better. Total Return rose 0.5% in the first quarter. 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. We were pleased to see the Fund narrowly outpace its benchmark during the second quarter, up 2.2% versus 2.0% for the small-cap index. The Fund's pronounced advantage from the 2014 small-cap high on March 4 through the end of June was key to this advantage. (More market cycle results can be found here.)

We have been pleased with the Fund’s performance in more volatile markets over the last two-plus years even as we acknowledge that returns for dividend-paying small-caps during this otherwise mostly bullish period have lagged those for small companies that do not, as well as for the small-cap benchmark as a whole. Small-cap stocks are an asset class in which volatility can be high while dividends are often ignored. We take a typically contrarian view, seeing dividends as a key link on a company’s capital allocation chain. We also see the potential attraction for the sort of conservatively capitalized, dividend-paying small-cap companies that we seek for the Fund’s portfolio going forward: As the Fed’s quantitative easing winds down and interest rates begin to rise, we expect economic growth to pick up speed with a consequent focus on fundamentals from investors.

For periods ended June 30, 2014, the long-term performance advantage remained with dividend payers in the small-cap asset class, as did lower overall volatility as measured by standard deviation. It was unsurprising, then, that Total Return outperformed the Russell 2000 for the 10-, 15-, 20-year, and since inception (12/15/93) periods ended June 30, 2014. The Fund’s average annual total return since inception was 11.6%, a long-term record that gives us great pride.

Nine of Total Return’s 11 equity sectors finished the first half in the black. Financials and Energy led all of the Fund’s sectors while Consumer Discretionary and Consumer Staples holdings as a whole detracted from first-half results. Contributions at the industry level were broad based. Machinery led by a good-sized margin, its results driven by Trinity Industries, a midcap company that was the Fund’s top-performing holding for the semiannual period. Trinity provides products and services for the energy, transportation, chemical, and construction industries in the U.S., Canada, Mexico, the U.K., Singapore, and Sweden. Liking its core business and dividend, we have owned shares since 2001. Pleased to watch its share price rise more or less steadily over the last five years, we particularly enjoyed the boosts its stock received at different points in the first half when the firm announced some canny acquisitions, record fiscal fourth-quarter and full-year 2013 earnings, an increase in its dividend, and a 2-for-1 stock split. We began to take gains in May.

Helmerich & Payne is an oil and gas contract driller that provides drilling rigs, equipment, personnel, and camps on a contract basis. It’s a long-time holding that we have owned for more than a decade in the Fund’s portfolio. Its edge lies in the superiority of its drilling fleet, which has helped the firm to remain profitable even in periods that were more challenging for the energy industry than the first half of 2014. We reduced our stake while its stock price was gushing. Improved operating results, better portfolio performances, and increased assets under management all helped the share price of investment manager AllianceBernstein Holding L.P., another long-term holding, to shine in the first half.

Individual stock losses were mostly modest. Nu Skin Enterprises was embroiled in allegations made in January by a Chinese newspaper that it was running a pyramid scheme. Although by March the firm had paid a small fine and revamped its training procedures, short-term results were challenged. We were re-evaluating our long-term outlook for this personal product manufacturer and distributor, hopeful that its global business could eventually resume its formerly healthy pace of growth. We built our position in Ascena Retail Group, a multiline women’s fashion retailer. Like many in its industry, the firm endured lousy results owing to poor holiday sales and frigid winter weather. We believe that it can rebound.

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

Annual Operating Expenses: 1.18%

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

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