article 12-31-2014

Royce Pennsylvania Mutual Fund Manager Commentary

Fund Performance

Our flagship, Royce Pennsylvania Mutual Fund, lost 0.7% in 2014, trailing its small-cap benchmark, the Russell 2000 Index, which gained 4.9% for the same period. This result was made more disappointing coming after a promising first half in which the Fund rose 2.0%. The quietly bullish first half of the year, however, gave way to a far more volatile period for small-cap companies in the second. The Fund lost more ground to its benchmark in the bearish third quarter (-7.6% versus -7.4%), an unpleasant surprise considering the Fund’s long-term record of better relative results in down market periods. Increased volatility within small-cap extended into the fourth quarter, which was, however, a solidly bullish period thanks in large part to a dynamic rally to close out the year in December. The Fund stayed behind the small-cap index in the year’s final quarter, climbing 5.3% versus a 9.7% advance for its benchmark.

Over the last few years, the Fund has struggled on a relative basis, even when (as in 2010 and 2013) absolute results were more than respectable. The lingering combination of higher-than-average small-cap returns and lower volatility has clearly had an impact on the Fund’s results vis-à-vis the benchmark in much of the market cycle since the bottom on March 9, 2009. It is also worth pointing out, however, that the respective five-year average annual total returns for both our flagship (+12.8%) and the Russell 2000 (+15.5%) were higher than their respective historical rolling monthly five-year averages of 9.8% and 7.6%. We remain committed to our risk-conscious approach and are optimistic about the Fund’s long-term prospects. The Fund outpaced the Russell 2000 for the 10-, 15-, 20-, 25-, 30-, and 35-year periods ended December 31, 2014. The Fund's average annual total return for the 40-year period—all under the management of Chuck Royce—was 16.3%. We take great pride in this fourdecade result.

What Worked... And What Didn't

One somewhat counterintuitive result of a year replete with volatility in the small-cap market was that there were no outsized net gains or losses for the Fund at the sector, industry, or position level. The only sizable net gain came from positions in Information Technology. Net losses were concentrated mostly in the Energy and Industrials sectors, though Materials, Consumer Staples, and Telecommunication Services also detracted from 2014’s results. Industrials were a slight sore spot in the otherwise bullish first half, though it remained one of the Fund’s largest sectors at the end of the period. The woes for Houstonbased engineering and construction firm KBR continued. Earlier in the year, the firm had its fiscal 2014 outlook reduced by cancellations and losses on some engineering and construction bids, as well as on pushed-out start dates for certain LNG (liquefied natural gas) projects. Its shares fell through most of the year, with a somewhat sharp dip in December when it announced plans to restructure its operations and divest or exit some noncore segments. We held a position at year end.

Unlike Industrials, Energy was a stalwart performer in the first half before the nearly 50% decline in oil prices sent shockwaves throughout the industry and elsewhere. Unit Corporation, a top performer in the six-month period ended June 30, 2014, operates as a contract driller and exploration and production company, among other energy-related businesses. With a long history as a successful, well-run business, its rebound potential when oil prices eventually recover looked strong to us, but its short-term prospects were tougher to gauge at the end of December, when it was a top-40 position. Nu Skin Enterprises was also a top-40 holding at the end of the period. The personal care products maker and distributor endured a host of challenges in 2014, including trouble with the Chinese government early in the year and the announcement of new debt arrangements in October. Its consistently punished shares can get off the mat, we suspect, with a comeback for its business in China. Multiline women’s fashion retailer Ascena Retail Group endured sluggish sales for two of its highest profile brands—tween fashion stop Justice and plus-size specialist Lane Bryant. Unsure of its ability to navigate a still-challenging environment for retailers, we reduced our position in the second half.

A rising stock price helped to leave the Fund with a sizable position in Core-Mark Holding Company, which distributes and markets various consumer goods to convenience stores, grocery stores, drug stores, and other retail centers. Increased earnings gave investors a convenient reason to buy. Long-time holding Sapient Corporation provides integrated management consulting services, Internet commerce solutions, and systems implementation services. We sold our shares in November shortly after it was announced that French advertising company Publicis Groupe was paying a substantial premium to buy the company.

Top Contributors to Performance
For 2014 (%)

Core-Mark Holding Company 0.27
Sapient Corporation 0.25
NVR 0.18
International Rectifier 0.16
Rentrak Corporation 0.16
1 Includes dividends

Top Detractors from Performance
For 2014 (%)

Nu Skin Enterprises Cl. A -0.37
Ascena Retail Group -0.32
Unit Corporation -0.31
KBR -0.26
Kennametal -0.25
1 Net of dividends

Current Positioning and Outlook

We believe that increasing volatility and decreasing stock correlation can help stock pickers to emerge as performance leaders. Beyond minor increases or decreases, sector weightings remained largely unchanged from the end of 2013. The Fund was overweight in more economically sensitive areas such as Industrials and Information Technology, which reflected our confidence that the U.S. economy will continue to expand in 2015.

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

  QTR* 1 YR 3 YR 5 YR 10 YR 15 YR 20 YR 30 YR 40 YR
Pennsylvania Mutual 5.30 -0.70 15.45 12.80 7.97 10.74 11.32 11.55 16.28
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 9.63 10.27 N/A
Annual Operating Expenses: 0.93%

* 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 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 Investment Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investment in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of PMF’s Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Investment Class. 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 small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. 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 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.

1 Geometric Average. This weighted calculation uses each portfolio holding's market cap in a way designed to not skew the effect of very large or small holdings; instead, it aims to better identify the portfolio's center, which Royce believes offers a more accurate measure of average market cap than a simple mean or median.



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