article 12-31-2014

Royce European Smaller-Companies Fund Manager Commentary

Fund Performance

Royce European Smaller-Companies Fund was down 14.9% in 2014, lagging its benchmark, the Russell Europe Small Cap Index, which fell 8.5% for the same period. The Fund's relative and absolute challenges were largely due to a poor second half. After generally outperforming their domestic counterparts in the last six months of 2013, European equities continued to build momentum. By the end of 2014's first quarter many European stocks remained ahead of their U.S. peers. European equity performance then began to slow in the second quarter, with returns falling into the red while other international and U.S. markets stayed in positive territory. Though we were pleased with the Fund's relative performance in the second quarter (+0.6% versus -1.0% for the Russell Europe Small Cap), European Smaller-Cos was shy of the benchmark's returns in the first half of 2014. For the six-month period ended June 30, 2014, the Fund gained 4.6% compared to 5.5% for its benchmark.

Losses continued to mount in July, when stocks across the globe corrected (with the exception of U.S. large-caps). European shares were among the most adversely affected, and European Smaller-Cos was no exception. For the third quarter the Fund fell 11.2%, trailing the Russell Europe Small Cap, which declined 10.7%. Portfolio holdings headquartered in France, the U.K., Norway, and Germany hurt most. The fourth quarter was equally unkind. U.S. small-caps rallied off a mid-October low, but many non-U.S. companies continued to struggle. Holdings headquartered in the U.K. had an outsized negative effect, while those in Cyprus and Germany also suffered large net losses in the fourth quarter. However, we were somewhat encouraged that our investments headquartered in Denmark were able to bounce back in the year's final three months, as was the case with third-quarter detractors Austria and Turkey. Still, the Fund's fourth-quarter performance on both a relative and absolute basis was dispiriting. For the quarter, European Smaller-Cos was down 8.3% versus the European benchmark's 2.9% loss. The Fund outpaced the Russell Europe Small Cap for the since inception (12/29/06) period ended December 31, 2014.

What Worked... And What Didn't

All but one of the Fund's nine equity sectors posted net losses in 2014, and the net gain for Health Care was decidedly modest. A collapse in oil prices helped to make Energy the Fund's top detractor for the calendar year after it posted generous net gains for the Fund in the first half. Industrials and Information Technology were also major trouble spots at year end. Globaltrans Investment GDR is a leading private freight rail transportation group with operations in Russia, the CIS (the Commonwealth of Independent States, including Ukraine), and the Baltics. Affected by tensions in Ukraine and the weakening ruble, Globaltrans lost about 70% of its value by year end. With more than 85% of freight transported by rail in Russia, we believe the company can improve its competitive position in the next couple of years. We added shares throughout the year. The second-half collapse in energy prices and pressure on other commodities thus took an enormous toll on results for both the second half and full year. Being overweight in Energy versus the Russell Europe Small Cap also hampered relative results. We are well aware of the near-term stresses on energy prices, which include surging supply from U.S. shale plays and weaker European and emerging market economies (the latter having been a key source of incremental demand). However, we have also been pleased with the way that most of the portfolio's energy names have been executing. We have mostly chosen to hold positions in the belief that lower energy prices will ultimately spur demand and thus eventually start the next up cycle in commodity prices. EnQuest is a London-based oil and gas development and production company, and Fred. Olsen Energy is an offshore driller with activities in the mid- and deep-water floating drilling segment based in Oslo, Norway. The share prices of both companies suffered badly in the second half. The strengthening U.S. dollar was also a factor in the performance of European holdings.

Shares of London-based design and engineering consultancy firm Hyder Consulting jumped early in the second half after being the center of a bidding war between Tokyo-based Nippon Koei and Dutch firm Arcadis. Following the announcement in late July that Hyder had reached an agreement with Arcadis, we sold our stake. Eltek, a Norwegian business which makes power systems and solutions for telecommunications and datacenters, power utilities, and other industries, was also the target of a take-out. In mid-December the company announced that Netherlands-based Deltronics, a subsidiary of Taiwanese company Delta Electronics, would be acquiring all its shares through a voluntary cash offer. We sold our stake on the news.


Top Contributors to Performance
For 2014 (%)
1

Hyder Consulting 0.67
Eltek 0.51
Forbo Holding 0.33
Boiron 0.33
F-Secure 0.31
1 Includes dividends

Top Detractors from Performance
For 2014 (%)
1

Globaltrans Investment GDR -1.56
EnQuest -1.44
Fred. Olsen Energy -1.36
Nokian Renkaat -1.07
LPKF Laser & Electronics -1.00
1 Net of dividends

Current Positioning and Outlook

At year end, European Smaller-Cos was overweight in economically sensitive cyclical sectors such as Information Technology, Materials, and Energy. The Fund was also overweight in Health Care. As bottom-up stock pickers who focus on fundamentals, we are finding attractive valuations in the U.K., France, and Germany and continue to seek companies that we believe can remain competitive in the challenging European market.

Average Annual Total Returns as of Quarter-End 12/31/14 (%)

  QTR* 1 YR 3 YR 5 YR SINCE INCEPT. DATE
European Smaller-Cos -8.29 -14.86 8.40 6.53 2.06 12/29/2006
Russell Euro SC -2.90 -8.50 17.23 8.24 1.14 N/A
Annual Operating Expenses: Gross 2.27% Net 1.7%

* Not Annualized

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

Important Performance, Expense, and Disclosure Information

All performance information in this piece 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 30 days of purchase may be subject to a 2% 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 total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and 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 its fees and/or reimburse operating expenses to the extent necessary to maintain the Fund'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 1.69% through April 30, 2015 and at or below 1.99% through April 30, 2024. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Regarding the "Top Contributors" and "Top Detractors" 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 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 December 31, 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 December 31, 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 companies that are headquartered in Europe. Securities of foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, currency or other developments that are unique to a particular country or region (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund invests primarily in small-cap and/or 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 12/31/14 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund's overall value to decline to a greater degree. 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 Europe Small Cap Index is an unmanaged, capitalization-weighted index of European small-cap stocks. Index returns include net reinvested dividends and/or interest income.The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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