article 06-30-2015

Royce Pennsylvania Mutual Fund Manager Commentary

Due to the considerable potential earnings power we believe many of our holdings in more cyclical, less defensive sectors possess, our primary focus remained with Industrials, Information Technology, Consumer Discretionary, Energy, and Materials.

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Fund Performance

Royce Pennsylvania Mutual Fund gained 0.1% for the year-to-date period ended June 30, 2015 versus a gain of 4.8% for its small-cap benchmark, the Russell 2000 Index, for the same period. The Fund began 2015 with a historically uncharacteristic underperformance during a bearish January, which helped to seal up a relative disadvantage for the first quarter (+1.2% versus +4.3%). The Fund then beat the small-cap index in the April downturn before trailing in May and June. The second-to-last day of June was particularly harrowing, as the Fund saw a quarterly gain morph into a loss. For the second quarter, Pennsylvania Mutual fell 1.1% compared to a 0.4% advance for the Russell 2000.

Recent relative performance challenges have served to mask somewhat the fact that the Fund's five-year average annual total return for the period ended June 30, 2015 was 13.4%, a mark that was higher than both its own and its benchmark's respective five-year historical rolling averages of 10.7% and 7.4%. This says something to us about the historically atypical market of the last five years. Still, we remain committed to our risk-conscious, fundamentally rooted approaches and remain confident about the Fund's long-term prospects. Pennsylvania Mutual outperformed the Russell 2000 for the 15-, 20-, 25-, 30-, and 35-year periods ended June 30, 2015. The Fund's average annual total return for the 40-year period—all under the management of Chuck Royce—was 13.8%.

What Worked... And What Didn't

The Fund was underweight Health Care at the end of June, though this sector was Pennsylvania Mutual's top performer in the first half. However, the portfolio's net gains were paltry compared to those for Health Care businesses in the Russell 2000, which were led by biotech stocks. Net contributions for Pennsylvania Mutual came instead from companies clustered mostly in two industry groups—health care providers & services and life sciences tools & services. Other sectors in the black at the end of June included Financials, Consumer Staples, and Consumer Discretionary. Although four sectors—Energy, Materials, Industrials, and Information Technology—posted net losses for the first half, only the first of these registered more than a modest decline. The Energy sector's largest detractor was Unit Corporation, which we have held in the portfolio for more than 10 years. Unit operates as a contract driller and exploration and production company, among other energy-related businesses. Last year's significant decline in commodity prices drove its share price down. While a nascent recovery for oil prices and its own ongoing effective operations were helping its shares to come back a bit earlier in 2015, a first-quarter loss announced in May brought its stock back down. We held a decent-sized position at the end of the first half.

The Fund's largest detractor was MBIA, which provides financial guarantee insurance to public finance markets in the U.S. and internationally. Its position as an insurer of municipal bonds issued by Puerto Rico led its shares to drop significantly in late June as the island commonwealth's precarious financial condition grew more troubling. We held a small position at the end of June. Top-10 position Genesco also detracted. The company is a specialty retailer that sells footwear, headwear, sports apparel, and accessories. While we like its core businesses, execution has been an issue of late, particularly the yet-to-materialize turnaround for Lids hat and Lids Locker Room shops, which exerted enough pressure on margins to help create an earnings miss announced late in May.

In contrast, two companies from the Financials sector made the largest positive contribution to first-half performance. Shares of Ohiobased investment management firm Diamond Hill Investment Group climbed over much of the last few years, boosted most recently by strong earnings and growing revenues. SEI Investments, the Fund's eleventh-largest holding at June 30, is another asset manager that also provides technology solutions. The firm enjoyed double-digit growth in assets under management and administration, the result of both capital market appreciation and new client wins. We have always liked asset management businesses and think that more widespread economic growth coupled with an expanding global need for expertise in wealth management bode well for the industry as a whole.


Top Contributors to Performance
Year-to-Date Through 6/30/15 (%)1

Diamond Hill Investment Group 0.19
SEI Investments 0.15
Blackbaud 0.14
ManpowerGroup 0.13
Drew Industries 0.12
1 Includes dividends

Top Detractors from Performance
Year-to-Date Through 6/30/15 (%)2

MBIA -0.18
Unit Corporation -0.13
Genesco -0.13
Balchem Corporation -0.12
PICO Holdings -0.12
2 Net of dividends

Current Positioning and Outlook

In the context of a small-cap market recently led by biotech stocks and at other times dominated by similarly fast-growing, non-earning companies, the Fund's results in the first half were not entirely surprising. Due to the considerable potential earnings power we believe many of our holdings in more cyclical, less defensive sectors possess, our primary focus remained with Industrials, Information Technology, Consumer Discretionary, Energy, and Materials. If the U.S. economy continues to accelerate—and we believe it will—the inherent operating leverage in these positions should propel earnings, especially in the event of increased CAPEX spending. And while the demand for profitable and fundamentally sound small-cap companies has not yet materialized to the degree that we had anticipated, we have seen signs of a shift—one that we expect will look more dramatic as the economy picks up its pace.

Average Annual Total Returns as of Quarter-End 6/30/15 (%)

  QTR* YTD* 1YR 3YR 5YR 10YR 15YR 20YR 30YR 40YR
Pennsylvania Mutual -1.06 0.08 -2.61 13.98 13.40 7.71 10.28 10.75 11.06 13.83
Russell 2000 0.42 4.75 6.49 17.81 17.08 8.40 7.50 9.15 9.83 N/A
Annual Operating Expenses: 0.92%

* 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 year-to-date performance for 2015.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at June 30, 2015, 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 June 30, 2015 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.

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