article 06-30-2015

Royce Special Equity Multi-Cap Fund Manager Commentary

If, as we expect, the market becomes more challenging and quality minded, not only will returns be lower, but we will also see down markets. In that kind of environment, we expect to do better.

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Fund Performance

For the year-to-date period ended June 30, 2015, Royce Special Equity Multi-Cap Fund was down 3.1% versus a 1.7% increase for its benchmark, the Russell 1000 Index, for the same period. Most equities floundered into the new year, and we were disappointed to see the portfolio lose more than its benchmark in January, when prices were tumbling. The Fund was then unable to narrow the gap when share prices improved in February and March. For the first quarter, Special Equity Multi-Cap fell 0.6% while the Russell 1000 gained 1.6%. The quarter that followed offered little better on a relative basis, with June particularly difficult. A modest net loss for the Fund grew more severe with the impact that the Greek default had on the second-to-last day of the month. The end result was a second-quarter loss of 2.6% for the Fund compared to a modest increase of 0.1% for the Russell 1000.

In general, the benchmark's first-half performance was propelled by Health Care (led by biotech). More generally, the broader market's positive results for the semiannual period came disproportionately from non-earning, lowest ROE quintile, and non-yielding companies, which was not a good lineup for our classic value approach to be competing with. As of June 30, 2015, it had been more 1,350 days since the S&P 500 had experienced a drop of 10% or more. Since our investment approach is designed to seek a relative performance advantage during extended down markets, this has certainly been a strong headwind for the portfolio. The Fund's average annual total return since inception (12/31/10) was 12.9%.

What Worked... And What Didn't

Holdings in the Consumer Discretionary sector had an outsized negative effect on first-half performance—on both a relative and absolute basis. Five of the portfolio's 10 most significant detractors came from the sector, including media companies—a particular trouble spot in the first half—Viacom and Scripps Networks Interactive, household goods retailer Bed Bath & Beyond, and auto parts distributor Genuine Parts. The portfolio's underweights in Health Care and Financials also detracted from results vis-à-vis the Russell 1000, as did certain holdings in Information Technology. The Fund's largest net loss at the position level came from Franklin Resources, which does business as Franklin Templeton Investments. The firm provides investment advisory services to mutual fund, retirement, institutional, and separate accounts.

ManpowerGroup was a bright spot in the first half. Several positive developments have helped the company of late: Demand has spiked for temporary staffing in Europe, its largest revenue geography, and its high-margin permanent placement segment has grown. The firm also raised its dividend by 63% and announced two staffing acquisitions that expanded or solidified its status in Europe and the Australasia region. We were also pleased to see solid growth from auto parts maker Lear Corporation, diagnostic testing, information, and services business Quest Diagnostics (which we sold in the first half), and Apple.


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

ManpowerGroup 1.34
Lear Corporation 0.78
Quest Diagnostics 0.57
Apple 0.46
Rockwell Automation 0.07
1 Includes dividends

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

Franklin Resources -0.53
Viacom Cl. B -0.53
Bed Bath & Beyond -0.49
Scripps Networks Interactive
Cl. A
-0.48
Genuine Parts -0.48
2 Net of dividends

Current Positioning and Outlook

Much has been written about the widely held belief that profit levels and/or rates are unsustainable. One such argument looks to corporate profits as a percentage of GDP. In our opinion this is not an appropriate measure as that ratio has many non-operating factors included, such as taxes, interest expense, etc. When one looks deeper one can see, as we do in our accounting work, significant improvement in operating margins despite tepid sales advances. This suggests to us latent higher profit levels when revenues advance enough to kick in. American businesses have become a lot leaner and meaner. Breakeven points have been lowered. Even in an economy with only modest but continued progress, we will indeed reach a level of production that will allow those incremental margins to manifest themselves. We do not see any imminent collapse in profitability as long as the "Goldilocks" model of the economy being "just right" is operative.

If, as we expect, the market becomes more challenging and quality minded, not only will returns be lower, but we will also see down markets. In that kind of environment, we expect to do better. Owning what we believe are great companies bought at reasonable valuations—most of which have increased dividends annually— continues to excite us. It's important to note that in low-growth periods such as the 1940s and 1970s dividends accounted for as much as 75% of the total return for stocks.

Perhaps the best signal that many of the globe's potential trouble spots at the end of June—China, Greece, Puerto Rico, and the seemingly ever-present possibility of terror attacks, to name four examples—seem unlikely to cause harm to the U.S. economy is that consumer confidence remained elevated in sharp contrast to investor sentiment. We believe investors will become more bullish. Taking a full market cycle view, particularly from this level, we feel very comfortable with the portfolio. At the end of the first half, the Fund was substantially overweight in the Consumer Discretionary and Industrials sectors and slightly overweight in Information Technology.

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

  QTR* YTD* 1 YR 3 YR SINCE INCEPT. DATE
Special Equity Multi-Cap -2.58 -3.14 0.48 14.71 12.90 12/31/2010
Russell 1000 0.11 1.71 7.37 17.73 14.13 N/A
Annual Operating Expenses: Gross 1.34% Net 1.24%

* 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). Gross operating expenses reflect gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service 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 investments in mutual funds, hedge funds, private equity funds, and other investment companies. Net operating expenses reflect contractual fee waivers and/or reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Service Classes’s net annual operating expenses, (excluding brokerage commissions, taxes, interest litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business), at or below 1.24% through April 30, 2016. 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 mid-cap and large-cap stocks. The Fund's investments in mid-cap stock may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund generally invests 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. 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 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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