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.

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 (%)

* Not Annualized

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

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