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.

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 (%)

* Not Annualized

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

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