article 02-22-2016

Royce International Premier Fund Manager Commentary

Even in the aftermath of a strong year, we think valuations for many non-U.S. small-caps remain attractive in large part because they underperformed over much of the last five years. We also see currency as a positive. So while U.S. dollar strength has created a performance headwind, U.S. dollar-based investors have substantially more purchasing power than they did when we launched the Fund five years ago because, unlike some of our peers, we do not hedge currency.

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Fund Performance

Royce International Premier Fund enjoyed a strong year on both an absolute and relative basis. The Fund advanced 16.2% in 2015, substantially ahead of its benchmark, the Russell Global ex-U.S. Small Cap Index, which advanced 0.5% for the same period. The portfolio’s advantage was wire to wire. For the year-to-date period ended June 30, 2015 the Fund gained 13.7%, outperforming its benchmark, which was up 7.7%.

During the widespread global correction in the third quarter International Premier was down 5.8% versus a decline of 11.2% for the Russell Global ex-U.S. Small Cap. The Fund then increased 8.5% for the fourth quarter while its benchmark rose 5.1%.

The portfolio’s terrific results in 2015 helped it establish a relative advantage over longer-term periods. International Premier outpaced the Russell Global ex-U.S. Small Cap for the three-year and identical five-year/since inception (12/31/10) periods ended December 31, 2015.

What Worked... And What Didn't

Seven of the Fund’s eight equity sectors finished 2015 in the black. The most significant net gains came from Industrials and Health Care, followed by Financials and Information Technology. At the industry level, health care equipment & supplies, commercial services & supplies, and pharmaceuticals made large positive impacts.

Net losses at the sector and industry level were decidedly modest. Energy was the lone sector in negative territory while the chemicals, aerospace & defense, and real estate management & development groups detracted most on the industry level.

The share price of Swiss financial advisory business VZ Holding rose through most of the year. VZ exceeded earnings estimates twice in 2015, extending a record of profitable growth going back 14 years to its founding. The company’s ability to drive growth via recurring revenues and substantial barriers to entry—bundled in a highly profitable and relatively low-risk structure—exemplifies the qualities we seek in all of our holdings. VZ was one of seven positions at year-end headquartered in Switzerland, a country that houses an impressive concentration of what we think are premier companies.

“We have high confidence in our holdings given their prospects to grow a-cyclically, generate cash, self-fund, and maintain or improve market share. Further, the countries on which our strategy focuses—the U.K., Japan, Switzerland, and other European nations north of the Alps—have a high concentration of what we see as well-managed, high-quality businesses with ample room for growth.”

The rise in Bajaj Finance’s share price was similar, building through much of the year without any dramatic advances. In our estimate one of the best-managed, and certainly one of the fastest-growing non-bank finance companies in India, Bajaj is located in a market which is home to the fastest-growing middle class among the major emerging markets. Strong performance from its consumer unit was a major factor in both growth in assets under management and better-than-expected earnings. A nascent credit market, India should see greater credit penetration, which should benefit Bajaj. Both were top-10 positions at year-end.

The share price of London-based AVEVA Group, by contrast, shot upward in July, following a somewhat complicated deal with France’s Schneider Electric to purchase 54% of the company, which produces CAD-CAM software used in the production of large-scale infrastructure, via an asset swap. We exited our position after this announcement, as we thought AVEVA’s shares were fully valued.

Far and away the biggest detractor for 2015 was Brazil’s TOTVS, which supplies enterprise resource planning (ERP) software. Bucking the trend of that nation’s economic and political challenges, TOTVS exploited its coveted brand and 70% market share to execute in Brazil’s fledgling software market, where only 13% of IT spending goes to software (compared to 26% in the U.S.) However, foreign currency posed a challenge for us as unhedged investors as the Brazilian real lost 47% of its value against the U.S. dollar in 2015, overwhelming the company’s more modest 13% share-price decline in local currency.

Senior is a manufacturing company specializing in the aerospace, defense, land-vehicle, and energy markets with operations in 14 countries. Earnings and margins were challenged a bit, though revenues and cash flows remained brisk. We built our position throughout the year.

On a relative scale, Industrials, Health Care, and Financials gave the portfolio large—and quite substantial— advantages over the benchmark, in each case keyed by strong stock selection. This was especially the case in the commercial services & supplies and marine industry groups in Industrials. In Health Care, pharmaceuticals was strongest while in Financials consumer finance and capital markets had the biggest relative advantages. The Fund was slightly disadvantaged by our underweight in the Consumer Staples sector.


Top Contributors to Performance
For 2015 (%)1

VZ Holding 1.69
Bajaj Finance 1.63
AVEVA Group 1.34
Latchways 1.31
Nokian Renkaat 1.23
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

TOTVS -0.90
Senior -0.46
Rotork -0.45
LPS Brasil Consultoria de Imoveis -0.45
Fidessa Group -0.43
2 Net of dividends

Current Positioning and Outlook

We have high confidence in our holdings given their prospects to grow a-cyclically, generate cash, self-fund, and maintain or improve market share. Further, the countries on which our strategy focuses—the U.K., Japan, Switzerland, and other European nations north of the Alps—have a high concentration of what we see as well-managed, high-quality businesses with ample room for growth.

Valuations remain attractive in large part because many non-U.S. stocks underperformed over much of the last five years. We also see currency as a positive. So while U.S. dollar strength has created a performance headwind, U.S. dollar-based investors have substantially more purchasing power than they did when we launched the Fund five years ago because, unlike some of our peers, we do not hedge currency.

At year-end we had relatively greater exposure to the U.K., Switzerland, Germany, and France while at the sector level we had larger weightings in Industrials, Information Technology, and Health Care.

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

  QTR 1YR 3YR 5YR SINCE
INCEPT.
DATE
International Premier 8.52 16.22 8.07 5.33 5.33 12/31/10
Russell Glo x US SC 5.11 0.50 4.32 1.87 1.87 N/A
Annual Operating Expenses: Gross 2.68% Net 1.44

* 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 2% 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 total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, and other expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive its fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’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 1.54% through April 30, 2016 and at or below 1.99% through April 30, 2025. 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, VZ Holding was 2.2% of the Fund’s net assets, Bajaj Finance Limited was 2.5%, AVEVA Group was 0.0%, TOTVS was 2.2%, and Senior was 1.7%.

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 may invest a significant portion of its assets in foreign companies which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also 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 one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" 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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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