article 02-22-2016

Royce Heritage Fund Manager Commentary

The Fund remains oriented toward quality, with a focus on finding companies with durable moats, high returns on invested capital, and the capacity to reinvest into the business. Throughout 2015 we made progress both toward reducing the overall number of names and increasing the Fund's domestic focus. 

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Fund Performance

Royce Heritage Fund was down 6.5% in 2015, trailing its small-cap benchmark, the Russell 2000 Index, which fell 4.4% for the same period. The Fund advanced 1.1% for the year-to-date period ended June 30, 2015 compared to a gain of 4.8% for the small-cap index.

The equity markets then experienced a widespread correction in the third quarter, when Heritage lost 10.4% while the Russell 2000 declined 11.9%. Stocks rebounded somewhat in the fourth quarter, with the Fund increasing 3.2% while its benchmark was up 3.6%.

Throughout the year, small-cap was characterized by narrow market leadership from mostly growth stocks, particularly in Health Care (though the fourth quarter also saw strength for similarly oriented tech businesses). This lack of breadth can best be seen by the equal-weighted calendar-year return for the Russell 2000, which was -10.1%.

We were pleased that Heritage celebrated 20 years of history in December 2015 and outpaced its benchmark over longer-term periods. The Fund outperformed the Russell 2000 for the 15-, 20-year, and since inception (12/27/95) periods ended December 31, 2015. Heritage's average annual total return since inception was 12.1%. We are quite proud of the Fund's long-term record.

What Worked... And What Didn't

Six of the Fund's nine equity sectors finished the year with net losses, which compared favorably to the benchmark, where eight of 10 were in the red for 2015. The largest detractors in Heritage were Financials, Industrials, and Materials, though net losses at the sector level were mostly modest. At the industry level, four groups posted notable net losses— machinery, capital markets, chemicals, and electronic equipment, instruments & components.

Minerals Technologies, the Fund's biggest detractor by a large margin, is a value-added, minerals-based product company. Revenue growth disappointed throughout the year as the company's end markets—paper production and metals refractories—came under considerable stress.

Throughout this period, the company has executed well in protecting operating margins largely via continued operational improvements at the recently acquired Amcol Corporation. The company continues to generate substantial cash flow and in September authorized a share repurchase program and became active buyers of the stock. It was the Fund's fifteenth-largest holding at year-end—our confidence premised on the company's ability to continue generating substantial cash flow.

Genesee & Wyoming owns and operates short line and regional freight railroads and provides related rail services through its subsidiaries. A newer position, its business was slowed primarily by a number of factors related to lower shipping traffic for steam coal, agricultural products, oil and frac sand, and metals. Liking its core business and potential to recover, we added shares in the fourth quarter.

We chose to reduce our stake in KKR, which topped a longish list of detractors in the capital markets group, after the company saw a reversal in carried interest income, performance fees, and investment income. A similar trajectory led us to exit our position in investment business Medley Management.

"The Fund remains oriented toward quality, with a focus on finding companies with durable moats, high returns on invested capital, and the capacity to reinvest into the business. The compounding effect is the dynamic we most covet. Valuation is critical to this process, though our preference is to identify potential value creation as much as it is to spot what we think is a compelling bargain."

The same industry was also home to the Fund's top contributor, Value Partners Group, a Hong Kong-based asset manager. Its stock often closely parallels movements in Hong Kong's and China's markets, which climbed precipitously into May before cooling off in June with the decline in Chinese stocks. We sold the bulk of our shares before the end of July and exited completely by year-end.

On a relative basis, the Fund was hurt most by Financials, Information Technology, and Health Care. In the first of these sectors, an underweight in banks, an overweight in capital markets, and ineffective stock selection in diversified financial services all hurt relative results. Stock selection was an issue in Information Technology while it was a strength in Health Care, but our low exposure to the top-contributing biotech industry was a factor in underperformance.

Conversely, stock selection drove better results for our holdings in three sectors— Industrials, Consumer Discretionary, and Materials. Finally, the Fund also benefited from its large cash position at year-end.


Top Contributors to Performance
For 2015 (%)1

Value Partners Group 0.43
Innospec 0.29
Cal-Maine Foods 0.29
SEI Investments 0.27
Fiserv 0.25
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Minerals Technologies  -0.74
KKR & Co. L.P.  -0.48
Genesee & Wyoming Cl. A -0.47
Medley Management Cl. A -0.39
Anixter International  -0.38
2 Net of dividends

Current Positioning and Outlook

The Fund remains oriented toward quality, with a focus on finding companies with durable moats, high returns on invested capital, and the capacity to reinvest into the business. The compounding effect is the dynamic we most covet. Valuation is critical to this process, though our preference is to identify potential value creation as much as it is to spot what we think is a compelling bargain.

Throughout 2015 we made progress both toward reducing the overall number of names and increasing the Fund’s domestic focus. In 2016, we expect to continue refining the portfolio towards a more concentrated, increasingly domestic strategy. We are concerned about the deflationary effects from weakened commodities and the Internet, in tandem with the industrial recession, on the U.S. consumer.

For this reason and others, we continue to believe the market will discount these incremental risks, market volatility will increase, and investors will become more discriminating. In such an environment, it follows that returns will be lower, and for that reason, among others, we believe our bottom-up, quality-oriented process should defend better. At the end of the year, the Fund was overweight in Industrials, Consumer Discretionary, and Materials, underweight Health Care and Financials, and had almost no exposure to Energy.

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

  QTR* 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Heritage 3.17 -6.33 -6.33 5.50 4.11 6.54 12.18 12.19 12/27/95
Russell 2000 3.59 -4.41 -4.41 11.65 9.19 6.80 8.03 8.06 N/A
Annual Operating Expenses: 1.17%

*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 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. Shares of RHF’s Consultant and R Classes bear an annual distribution expense that is higher than that of the Service Class. 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, Minerals Technologies was 1.5% of net assets, Genesee & Wyoming was 1.1%, KKR & Co. L.P. was 0.6%, Medley Management was 0.0%, and Value Partners Group was 0.0%.

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 generally invests a significant portion of its assets 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 35% 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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