article 02-22-2016

Royce Dividend Value Fund Manager Commentary

Portfolio Managers Chuck Royce and Jay Kaplan suspect that the protracted leadership of growth over value stocks is likely to reverse in 2016 and that companies with better balance sheets will do well in an environment of elevated corporate bond spreads. They also expect the combined effects of these reversals to put the market’s focus squarely on the attributes they emphasize, which look overdue for recovery to them.

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Fund Performance

Royce Dividend Value Fund fell 5.7% in 2015, underperforming its small-cap benchmark, the Russell 2000 Index, which was down 4.4% for the same period. The Fund advanced 2.6% for the year-to-date period ended June 30, 2015 compared to a 4.8% gain for the small-cap index.

During most of the first half, small-cap market leadership was tightly clustered around biotech and pharmaceuticals companies, leaving behind the kind of steadily profitable, conservatively capitalized small- and mid-cap dividend-payers that we prefer.

This began to shift somewhat in the second quarter, when the Fund outpaced the Russell 2000, before it reversed even more dramatically in the third quarter’s correction when Dividend Value was down 10.2% compared to a decline of 11.9% for the benchmark. When small-caps rebounded in the fourth quarter, however, sentiment swung back to growth, primarily to Health Care and more growth-oriented technology. The Fund gained 2.4% for the fourth quarter versus a 3.6% increase for the index.

It was undoubtedly a difficult year. Taking great pride in the Fund’s long history of both low volatility and sterling down market returns, we found the year’s results particularly tough to digest. Yet the context is critical.

First, 2015 was a more difficult year for small-caps than the benchmark’s return might show—on an equal-weighted basis, the Russell 2000 was down 10.1%. More important, the Fund trailed its benchmark when returns were positive and outpaced it when small-caps reversed—consistent with its history. For example, from the 2015 small-cap high on June 23 through year-end, the Fund lost 10.6% versus a slide of 11.6% for the Russell 2000.

We were pleased with the portfolio’s longer-term results. Dividend Value outperformed the Russell 2000 for the 10-year and since inception (5/3/04) periods ended December 31, 2015.

What Worked... And What Didn't

Six of the Fund’s 10 equity sectors finished the year in the red. Financials, Consumer Discretionary, Materials, and Energy detracted most. At the industry level, four groups posted meaningful net losses—capital markets, specialty retail, metals & mining, and energy equipment & services. It did not help our relative performance that we had much greater exposure to each of these groups than could be found in the Russell 2000. 

“We expect reversals in a number of trends that should help benefit many portfolio holdings over the next few years… We also expect the combined effects of these reversals to put the market’s focus squarely on the attributes we emphasize, which we think are overdue for recovery.”

Health Care was the portfolio’s top contributor in 2015, but the positive effects of our stock picking in the pharmaceuticals industry were outweighed by our significant underweight in the sector as a whole versus the benchmark.

Consumer Staples, on the other hand, contributed on both an absolute and relative basis, attributable mostly to terrific results for Hormel Foods, the portfolio’s top contributor in 2015. The company manufactures and markets consumer-branded meat and food products under a variety of branded names. We liked its low debt and strong brands and were pleased to see robust earnings growth attract investors to its stock. It was a top-10 position at the end of 2015.

From the Industrials sector, John Bean Technologies was also another top-10 holding and contributor. It operates two divergent businesses—food-processing equipment, which has driven its impressive run of revenue and earnings growth, and airport operations equipment.

Two companies in the metals & mining group posted the Fund’s largest net losses at the position level in 2015. Allegheny Technologies produces specialty materials, including titanium, titanium alloys, and nickel-based alloys. Losses have been driven by weakness in the energy market and increased competition in the firm’s flat-rolled products segment. Slackening demand for its stainless and some electrical steel products led the firm to slash its dividend and shutter some operations in Pennsylvania during December. Confident in a recovery for industrial activity, we held shares at year-end.

Long-time holding Carpenter Technology makes specialty alloys and performance engineered products. The second of these businesses was hurt by exposure to the energy markets in 2015 while the second did comparatively better. Both Carpenter and Allegheny could benefit from increased defense spending in 2016.

Financials and Information Technology detracted most on a relative basis in 2015. Our overweight in capital markets, an underweight in banks, and poor stock selection in the diversified financial services and thrifts & mortgage finance categories detracted most in Financials.

For Information Technology, the issues were both an underweight and disappointing stock selection in the software industry. In contrast, stock selection in Industrials and Consumer Staples were strongest on a relative basis.


Top Contributors to Performance
For 2015(%)1

Hormel Foods 0.43
John Bean Technologies 0.39
SEI Investments 0.32
Symetra Financial  0.31
Diamond Hill Investment Group 0.30
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Allegheny Technologies -0.61
Carpenter Technology -0.42
Coronation Fund Managers  -0.42
The Buckle -0.39
Genworth MI Canada  -0.36
2 Net of dividends

Current Positioning and Outlook

We expect reversals in a number of trends that should help benefit many portfolio holdings over the next few years. Our own research and regular meetings with confident management teams have made us comfortable with a contrarian, pro-cyclical bias for the portfolio.

Moreover, we suspect that the protracted leadership of growth over value stocks is likely to reverse in 2016 and that companies with better balance sheets will do well in an environment of elevated corporate bond spreads. We also expect the combined effects of these reversals to put the market’s focus squarely on the attributes we emphasize, which we think are overdue for recovery.

Average Annual Total Returns Through 12/31/15 (%)

  QTR 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE
Dividend Value 2.40 -5.72 6.45 6.13 7.08 7.81 05/03/04
Russell 2000 3.59 -4.41 11.65 9.19 6.80 7.58 N/A
Annual Operating Expenses: 1.55%

* 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 gross 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, 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. 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 December 31, 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 December 31, 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.

As of 12/31/15, Hormel Foods was 1.4% of the Fund’s net assets, John Bean Technologies was 1.4%, Allegheny Technologies was 0.4%, and Carpenter Technology was 0.7%.

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. (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 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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