article 12-31-2014

Royce Small-Cap Value Fund Manager Commentary

Fund Performance

Royce Small-Cap Value Fund (formerly Royce Value Fund) finished 2014 with a slight loss of 0.02%, well behind its small-cap benchmark, the Russell 2000 Index, which advanced 4.9% for the same period. Making things more frustrating was that Value was slightly ahead of the small-cap index in the first half, up 3.4% versus 3.2%. This capped a smooth start to 2014 that followed the red-hot pace of returns in 2013. Yet this did not last, at least not for small-caps. Shortly after establishing a high on July 3, returns for the Russell 2000 began to slip. This made for a dismal third quarter in which the Fund fell 5.6%, losing less than its benchmark, which declined 7.4%. At this stage, the Fund remained ahead of the small-cap index for the nine-month period ended September 30, 2014.

The Fund forfeited its relative advantage, then, in the otherwise pleasant fourth quarter. Small-caps remained volatile through the year's final three months, but returns were generally positive. This was more true in some cases, however, than in others. The Russell 2000 managed a gain in each of the year's last three months while Halloween marked the final month with a positive return for Small-Cap Value. For the fourth quarter, the Fund rose 2.4% versus 9.7% for the Russell 2000. Longer-term returns offered something better on a relative (as well as absolute) basis. Small-Cap Value outpaced the small-cap index for the 10-year and since inception (6/14/01) periods ended December 31, 2014. The Fund's average annual total return since inception was 10.8%.

What Worked... And What Didn't

Three of the Fund's equity sectors finished the year in the red—Energy, Consumer Staples, and Materials. After finishing the first half as the Fund's best-performing sector, energy stocks were crushed by the precipitous collapse in oil prices. Atwood Oceanics is an offshore drilling contractor that specializes in deep-water drilling, an area that earlier in the year was suffering from an oversupply problem that hurt pricing for both rigs and drill ships. Atwood's rigs that are currently under customer contracts make its prospects for 2015 look fairly solid, but 2016's outlook is murky. The decline in commodity prices also led the company to push out delivery dates for two large new drill ships for which it does not yet have contracts. We think it can benefit from a recovery in oil prices, but the timing on that is obviously impossible to predict. While keeping in mind the daunting short- and intermediate-term prospects for the industry, we were also constructive about the long-term prospects for Unit Corporation, which operates primarily as a contract drilling company that is also involved in exploration and production and engages in midstream activities. These related segments make it an outlier in an otherwise rigidly specialized industry, though we like its unique business model as well as its long history of strong operating results. Outside of Energy, Nu Skin Enterprises settled some issues with the Chinese government by paying fines and improving training, restructuring its debt covenants, and reversing a cash flow problem. This was all good news, but we think the firm also needs improved sales in China to spur a comeback.

The sectors that contributed most to 2014 results were Information Technology (by a sizable margin), Financials, Health Care, Industrials, and Consumer Discretionary. Net gains in the first of these groups were particularly strong in the semiconductors & semiconductor equipment group and communications equipment industry, where Brocade Communications Systems, which provides switching solutions for storage area networks (SAN), was the standout. Knight Transportation, from the Industrials sector, is a short-to medium-haul truckload carrier of general commodities that we regard as a very well-run business. Consolidation and labor tightening in its industry aided the stronger players, and Knight's stock price accelerated.

The Fund's top-performing position was Chemed Corporation, which operates two very different businesses—hospice care provider Vitas and plumbing and drain cleaning service company Roto- Rooter—and is slotted in Health Care. Its shares appeared to benefit most from a "no news is good news" scenario regarding Vitas. In 2013 this business became the target of a Justice Department investigation into Medicare enrollment and billing rates. Vitas offers more critical care than is typical in the hospice industry, which might have helped to trigger an inquiry. However, margins for critical care are not much higher than for other elements of hospice care, and the firm is one of the few able to deliver it on a nationwide basis. The absence of news around the investigation seemed to reassure investors who flocked to the stock. We like the consistency and brand value of Roto-Rooter and Vitas's status as one of the few hospice providers with coast-to-coast reach.

Top Contributors to Performance
For 2014 (%)

Chemed Corporation 0.90
Knight Transportation 0.73
Brocade Communications Systems 0.66
DSW Cl. A 0.60
G-III Apparel Group 0.56
1 Includes dividends

Top Detractors from Performance
For 2014 (%)

Nu Skin Enterprises Cl. A -1.96
Atwood Oceanics -1.45
Ascena Retail Group -1.35
Unit Corporation -0.88
GameStop Corporation Cl. A -0.74
1 Net of dividends

Current Positioning and Outlook

At the end of 2014, the Fund remained heavily overweight in the Consumer Discretionary and Information Technology sectors, which reflected our confidence for strong growth potential in these areas. Biotech was an area that we again avoided. These companies, which have been among small-cap's best performers over the last couple of years, also tend to have no earnings. We expect interest rates to remain low and for the economy to keep growing. In our view stocks should benefit from earnings growth, and we have carefully positioned the portfolio for this kind of environment.

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

Small-Cap Value 2.41 -0.02 11.85 10.12 8.15 10.84 6/14/2001
Russell 2000 9.73 4.89 19.21 15.55 7.77 8.20 N/A
Annual Operating Expenses: 1.48%

* 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 Service Class (its oldest class). Operating expenses reflect the Fund's total annual operating expenses for the Service Class as of the Fund's most current prospectus and include management fees, 12b-1 distribution and service fees, and other expenses. Shares of Value's Consultant and R Classes bear an annual distribution expense that is higher than that of the Service 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 and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. 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.(Please see "Primary Risks for Fund Investors" in the prospectus.) 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 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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