article 12-31-2014

Royce Special Equity Fund Manager Commentary

Fund Performance

Royce Special Equity Fund suffered some relative disappointments in 2014. The Fund gained 1.1% in the calendar year, underperforming its smallcap benchmark, the Russell 2000 Index, which advanced 4.9% for the same period. In the context of a market in which many companies with no earnings, no dividend, and other lower-quality attributes continued to outperform, this was hardly surprising. In fact, the strength of low quality was particularly evident even in the first quarter, when Special Equity was down 0.8% versus a gain of 1.1% for the Russell 2000. Much of this underperformance came from specialty retailers in the Consumer Discretionary sector, and the negative impact was exacerbated by the portfolio's significant overweight versus the benchmark. However, our patience with many of these holdings would begin to be rewarded later in the year.

After underperforming again in the second quarter, the Fund finished behind the index in the first half, up 0.2% versus 3.2% for the Russell 2000. When the market became both more volatile and markedly bearish in the third quarter, the Fund had a somewhat curious experience. It lost less than the small-cap index in both the July and September downturns but underperformed in the August recovery, which gave Special Equity only a narrowly smaller loss than the Russell 2000 for the third quarter as a whole, -7.1% versus -7.4%. We were pleased to see the Fund go on to enjoy a strong rebound when small-cap prices began to recover, thanks in part to a strong showing from specialty retailers. Special Equity advanced 8.6% in the fourth quarter compared to 9.7% for its benchmark. Considering the Fund's long-term historical pattern, 2014 results were not surprising as the market continued to favor lower-quality issues that simply do not meet our exacting selection standards. We were pleased with Special Equity's longer-term results. The Fund outpaced the Russell 2000 for the 10-, 15-year, and since inception (5/1/98) periods ended December 31, 2014. Special Equity's average annual total return since inception was 9.8%.

What Worked... And What Didn't

Only two of the Fund's equity sectors—Consumer Staples and Consumer Discretionary—finished the year with net losses, which were modest. The latter group, as mentioned, received a considerable boost in the fourth-quarter rally. Information Technology led the Fund's five equity sectors that posted net gains in 2014 (Financials were flat for the year). Special Equity's three top-performing industry groups were chemicals, media, and commercial services & supplies, while the communications equipment group, semiconductors & semiconductor equipment companies, and electronic equipment, instruments & components stocks all posted solid net gains to galvanize the Information Technology sector.

The Fund's top performer and largest holding at the end of the year was UniFirst Corporation, which provides workplace uniforms and protective work wear clothing. We added shares between February and early June. Minerals Technologies, another top-performing top-10 position, is a resource- and technology-based organization that develops and produces performance-enhancing minerals as well as synthetic mineral and mineral-based products. We took gains through much of the year as its price rose. Special Equity's leading detractor was also a top-10 holding. Schweitzer-Mauduit International runs a global business from Georgia manufacturing paper and reconstituted tobacco products for the tobacco industry. After buying during the first half, we trimmed in the second, resulting in a small net decrease in the position for the year. The Finish Line ran a poor race in what was often a torturous course for retailers in 2014. The company sells men's, women's, and children's brand name athletic and leisure footwear, activewear, and accessories. It was the Fund's sixth-largest position at the end of the year.

Top Contributors to Performance
For 2014 (%)

UniFirst Corporation 0.93
Minerals Technologies 0.81
Meredith Corporation 0.65
Plantronics 0.55
Neenah Paper 0.47
1 Includes dividends

Top Detractors from Performance
For 2014 (%)

Schweitzer-Mauduit International -0.62
Finish Line (The) Cl. A -0.59
LeapFrog Enterprises Cl. A -0.54
Universal Corporation -0.52
EnerSys -0.40
1 Net of dividends

Current Positioning and Outlook

The combination of slower growth in healthcare costs on top of lower energy prices is striking—a decade ago, energy and healthcare costs were consuming nearly all of the gains in consumer discretionary income. It is possible, even likely, that profit margins will expand rather than contract, as most expect. Besides the slide in commodity prices, we continue to see the substitution of capital for labor. While having a negative outcome concerning income inequality, it bodes well for the equity market.

We still believe that more merger and acquisition activity is ahead and that our portfolio should receive its share and then some in light of both our methodology and the attractiveness of the issues. The forces behind more M&A activity include record-low interest rates, little other cost cutting opportunities, many companies being over capitalized (some with sizeable cash balances), activist investing putting deals into play, and the fact that acquiring companies shares have been advancing immediately of late. Market correlations continue to fall, which suggests that the value of stock picking will continue to increase in importance. The more concerned about the market one is, the more we think quality companies—those with high returns on equity, low debt, and stable earnings—make sense.

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

Special Equity 8.60 1.09 14.69 12.55 8.22 12.19 9.77 5/1/1998
Russell 2000 9.73 4.89 19.21 15.55 7.77 7.38 7.01 N/A
Annual Operating Expenses: 1.13%

* 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 and other expenses. Shares of Special Equity's Service and Consultant 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.) 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 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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