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.

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 (%)

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

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