article 12-31-2014

Royce International Micro-Cap Fund Manager Commentary

Fund Performance

Royce International Micro-Cap Fund was down 2.4% in 2014, losing less than its benchmark, the Russell Global ex-U.S. Small Cap Index, which lost 3.6% for the same period. For the six-month period ended June 30, 2014, International Micro-Cap advanced 7.9% compared to the international small-cap index's 7.5% gain.

These first six months saw many smaller non-U.S. companies mount a comeback and outpace their domestic counterparts. This picture began to shift with the arrival of more volatility and mostly falling stock prices in the third quarter. The correction found stocks across the globe—with the exception of U.S. large-caps—mostly in the red. Among the most adversely affected were European equities, which had already begun to pull back slightly in the second quarter after a terrific first-quarter showing. During the third-quarter down phase, the Fund outperformed its benchmark's 6.2% decline with a loss of 3.0%. International Micro-Cap, however, was unable to add to this advantage in the last three months of the year. While U.S. small-caps rallied off a mid-October low, their non-U.S. counterparts mostly continued to struggle. In the fourth quarter International Micro-Cap was down 6.6%, trailing its benchmark, which fell 4.5%. Although holdings in South Korea, Austria, and India contributed to fourth-quarter performance, holdings headquartered in Japan, Brazil, Hong Kong, Australia, and China were significant detractors. Longer-term results on an absolute and relative basis were also not in line with our expectations.

What Worked... And What Didn't

During the second half of 2014, we were pleased to see portfolio holdings headquartered in India build on first-half net gains while those in Canada, Germany, and South Korea suffered only minor slippage. Holdings in Brazil and Hong Kong remained top detractors through the end of the year while the portfolio's holdings in Japan corrected sharply after posting solid net gains in the first half. Brazil-based T4F Entretenimento is the biggest live entertainment promoter in South America and one of the largest in the world. Brazil's weak consumer sentiment drove reductions in discretionary spending on concerts which, coupled with the pressure the World Cup put on consumers' wallets, negatively affected its stock price. We believe that the share price should react favorably as business conditions normalize and added to our position throughout the second half. Brazil's weak economy, along with a slowdown in the real estate market and economic uncertainty over the re-election of President Dilma Rousseff, all hurt the share price of Brasil Brokers Participacoes, which remained a top detractor after a rough first half. The company is one of the country's two leading real estate brokerages. We like its ability to generate cash, its generous dividend policy, and its large degree of insider ownership. Brasil Insurance Participacoes e Administracao—another top detractor from the semiannual period—is a collection of insurance brokers that have been acquired over the years. New management is working on implementing a turnaround, but in the process of deploying their plan, they had to make significant cuts to guidance to reposition the company for future growth, which hurt its stock price. We re-built our position in July, adding shares in August. The strength of the U.S. dollar also played a role in the performance of non-U.S. holdings.

Three of International Micro-Cap's top contributors to performance in the first half remained so for the full year. Ontario-based Magellan Aerospace serves the civil aerospace and defense market. Magellan has benefited from a strong aerospace and defense capital spending cycle as well as weakness in the Canadian dollar, which has increased its competitiveness versus U.S. suppliers significantly. In addition, a strong management team that is focused on margins has helped drive improvement in earnings and an increase in the overall backlog. We think the stock has the potential for additional growth, so we bought shares in August and September (after reducing our position in the second quarter). Global automotive demand coupled with automation in the industrial supply chain has driven demand for Japanese manufacturer Obara Group's products. A weakening yen has also helped its position versus foreign competitors. Australiabased TFS Corporation owns and manages sustainable sandalwood plantations. A long-tailed asset that is seeing the benefit of the work that has been put in over the past decade, the company's plantations are in harvest mode, which should help it to start generating cash flow. An off-take agreement with pharmaceutical company Galderma also helped give proof of concept for the company's sandalwood oil.


Top Contributors to Performance
For 2014 (%)
1

Magellan Aerospace 1.06
Obara Group 0.63
RIB Software 0.55
TFS Corporation 0.48
Comba Telecom Systems Holdings 0.47
1 Includes dividends

Top Detractors from Performance
For 2014 (%)
1

T4F Entretenimento -0.71
Brasil Insurance Participacoes e Administracao -0.71
Ellies Holdings -0.61
Brasil Brokers Participacoes -0.60
Freund Corporation -0.54
1 Net of dividends

Current Positioning and Outlook

Anticipating an eventual turnaround in the global economy, we were substantially overweight economically cyclical sectors such as Industrials, Consumer Discretionary, and Information Technology at the end of December. We remain bullish on the prospects for a rebound in Japan and Hong Kong—and had significantly more exposure than the benchmark to the latter nation.

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

  QTR* 1 YR 3 YR SINCE INCEPT. DATE
International Micro-Cap -6.65 -2.37 9.67 0.87 12/31/2010
Russell Glo x US SC -4.45 -3.63 10.31 2.22 N/A
Annual Operating Expenses: Gross 3.88% Net 1.71%

* 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% though 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 micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund may invest a significant portion of its assets in foreign companies which 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. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (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.) 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. (Please see "Primary Risks for Fund Investors" 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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. 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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