article 06-30-2014

Royce Smaller-Companies Growth Fund Manager Commentary

In a market that could not quite figure out if it was interested more in fast growth or high quality during the first half, Royce Smaller-Companies Growth Fund (formerly Royce Value Plus Fund), which looks for elements of both, acquitted itself quite nicely. The Fund gained 4.1% for the year-to-date period ended June 30, 2014, ahead of the 3.2% gain for its small-cap benchmark, the Russell 2000 Index, for the same period.

The Fund remains unique among our portfolio offerings. Its approach differs from most traditional value approaches, including those used in many Royce-managed portfolios, because growth prospects are usually not a critical factor in the stock-selection process. In fact, they may not be a factor at all. However, this approach also contrasts with most growth approaches because we continue to look closely at a company’s valuation as part of the security analysis process, a process that is generally an afterthought, if it is considered at all, in many growth funds. In essence a growth-oriented approach with a value overlay, it stood the Fund in mostly good stead in a market that had trouble establishing a clear direction through much of the year’s first six months.

The first quarter was a much more low-key bull phase than what stocks experienced through much of the red-hot 2013. Smaller-Companies Growth gained 3.4% in the year’s opening quarter, outpacing the small-cap index, which picked up 1.1% for the same period. The year-to-date high for the Russell 2000 came on March 4. While small-caps rallied through the last two weeks of May and through much of June, they could not push past that late winter summit. The Fund struggled a bit on a relative basis through the correction that lasted from March 4 through May 15, though its strength in the first quarter and June rally allowed it to stay ahead of the benchmark for the year-to-date period. The Fund was up 0.6% in the second quarter. While the Fund has not yet pulled ahead of the small-cap index for recent longer-term and market cycle periods, we were pleased with its first-half performance. (Market cycle results can be found here.) The Fund outperformed the Russell 2000 for the since inception (6/14/01) period ended June 30, 2014. The Fund’s average annual total return since inception was 12.7%.

As might be expected in a solid performance period, net losses at the sector, industry, and position level were fairly modest. Three sectors detracted from performance—Information Technology, Consumer Discretionary, and Financials. A sliding share price led us to increase our stake in SciQuest during the first half. The company provides procurements and spending management software on a subscription basis. SciQuest provides automated purchasing primarily to universities, hospitals, and local and state governments, though it has expanded its focus to include more commercial sectors. Its earnings pattern has been erratic, almost consistently inconsistent, and some recent misses drove investors to sell, though we like the growth potential of its core business and expect earnings to improve. It was the Fund’s eleventh-largest position at the end of June. The Fund’s twelfth-largest contributor in 2013, California-based Cerus Corporation makes the INTERCEPT blood system, a pathogen inactivation technology. Already selling INTERCEPT in Europe, the company has submitted its application for FDA approval for distribution here in the U.S., which could arrive as early as this fall. After doing fine in 2013, the company’s stock performance was more challenged in the first half.

Other Health Care holdings enjoyed better times, with four of the top five contributors in the first half calling the sector home. Furiex Pharmaceuticals first saw strong results in phase III clinical trials for an IBS treatment before being acquired at a healthy premium, the announcement of which in April prompted us to sell our shares. In February the stock price of InterMune soared on news of positive phase III trial results for a drug that treats IPF (idiopathic pulmonary fibrosis), a chronic and ultimately fatal condition that leads to a decline in lung function. Top-10 holding Actelion rose during the first quarter around the launch of a PAH (pulmonary arterial hypertension) drug. It is the dominant player in this pharmaceutical niche.

Myriad Genetics made a significant leap for us in the first half. After detracting most from 2013 results, it was the Fund's second-best contributor for the semiannual period. The company faced several headwinds last year: reimbursement change concerns from payers, a Supreme Court decision in June that held that human genes cannot be patented, and new competition in the breast cancer gene testing market. This led its stock to fall, though the company retained some of its patents on certain genetic testing processes. Its shares then came back strong in the first half. The reimbursement issues were resolved at a rate that was more favorable than many investors were expecting, the firm has demonstrated an impressive rate of growth, while competition, especially in the breast cancer genetic screening area, has not materialized to the degree many were anticipating. It was the Fund’s second-largest position at the end of June.

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

Furiex Pharmaceuticals 1.44
Myriad Genetics 1.23
InterMune 0.97
U.S. Silica Holdings 0.71
Actelion 0.61
1 Includes dividends

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

SciQuest -0.68
Cerus Corporation -0.46
TearLab Corporation -0.34
Medicines Company (The) -0.31
Tractor Supply -0.29
1 Net of dividends

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

Smaller-Companies Growth 0.63 4.08 22.74 11.19 15.84 8.42 12.69 6/14/2001
Russell 2000 2.05 3.19 23.64 14.57 20.21 8.70 8.39 N/A
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Annual Operating Expenses: 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. All performance and risk information reflects results of the Service Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Service Class as of the Fund’s most current prospectus and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of RVP’s Consultant and R Classes bear an annual distribution expense that is higher than that of the Service 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 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.) In addition, as of 6/30/14 the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund’s overall value to decline to a greater degree. 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 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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