Royce International Small-Cap Fund Manager Commentary
article 02-24-2016

Royce International Small-Cap Fund Manager Commentary

Europe and Japan have seen underlying improvements in their respective economies, though growth has so far been modest. While these markets rallied in 2015, we still see a large number of mispriced opportunities in the small-cap space.


Fund Performance

Royce International Small-Cap Fund was down 1.7% in 2015, underperforming its benchmark, the Russell Global ex-U.S. Small Cap Index, which was up 0.5% for the same period. For the year-to-date period ended June 30, 2015, the Fund advanced 4.5% compared to a 7.7% increase for its benchmark.

During the far-reaching correction that rocked markets in the third quarter International Small-Cap fell 9.4% while the Russell Global ex-U.S. Small Cap fell 11.2%. Equities rebounded over much of the year's last three months. For the fourth quarter as a whole, the Fund rose 3.8% while its benchmark was up 5.1%. The Fund outperformed the Russell Global ex-U.S. Small Cap for the since inception (6/30/08) period ended December 31, 2015.

What Worked... And What Didn't

Five of the Fund's nine equity sectors posted net gains in the calendar year, with Financials making the most significant contribution, followed by Health Care. At the industry level, two of the three best-performing groups came from Financials—capital markets and diversified financial services.

The health care equipment & supplies industry also made a notable net contribution. Two holdings posted net gains that were well ahead of our other successes. Also the portfolio's top contributor in the first half, Value Partners Group is a Hong Kong-based firm that has focused on Asian markets for more than two decades. Its shares often closely parallel movements in the Hong Kong and Shanghai markets. Each climbed precipitously into May before cooling off with the bear market for Chinese stocks. Increasingly discouraging news out of China led us to take gains and reduce our position by more than half between late April and July, which helped it keep its place as the Fund's best performer in 2015 in spite of a steep correction for its shares in the second half of the year.

"Europe and Japan have seen underlying improvements in their respective economies, though growth has so far been modest. While these markets rallied in 2015, we still see a large number of mispriced opportunities in the small-cap space."

A nearly opposite pattern governed the portfolio's next-best performer—Swiss financial advisory company VZ Holding, which works with individual and corporate clients in Switzerland and Germany. Its shares stumbled early in 2015 after the Swiss National Bank's surprise decision in mid-January to delink from the euro, which created rapid appreciation for the Swiss franc. The firm, however, is a domestic business that has historically been largely unaffected by currency movements, something that may have helped its shares recover when the company reported impressive 2014 results in March 2015. The mostly steady rise in its stock price prompted us to sell the last of our shares in December.

The Fund's leading detractors on a sector basis were Information Technology, Consumer Discretionary, and Industrials. With the exception of machinery stocks (from the Industrials sector) net losses at the industry level were modest.

Two of the Fund's three largest net losers on a company basis are machinery businesses. Brazil's Kepler Weber makes food storage equipment including grain silos, conveyors, and animal feed mills. Ongoing weakness in the Brazilian economy, combined with a global commodity price decline, led us to sell our shares in April.

China's Haitian International Holdings manufactures plastic injection molding machines and related parts for the automotive, construction, healthcare, and other industries. Sales growth was challenged by the slowing of momentum in China, though revenues and profits were solid. We were content to hold a decent-sized position at year-end. We also held a small position in Chinese retailer New World Department Store China, whose business has suffered with the deceleration of the mainland economy.

On a relative basis, stock selection in the Consumer Discretionary and Information Technology sectors hurt most. In the first sector holdings in auto components, specialty retail, and multiline retail had the largest relative negative effect while in the second, we were hurt by ineffective stock selection in software.

Conversely, stock picking in the Financials sector was a significant strength that was most notable in the capital markets and real estate management & development industries.

Top Contributors to Performance
For 2015 (%)1

Value Partners Group 1.27
VZ Holding  1.05
Relo Holdings 0.61
Xtep International Holdings 0.61
Blosensors International Group 0.45
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

New World Department Store China -0.59
Haitian International Holdings -0.58
Kepler Weber -0.46
Television Broadcasts -0.45
Shriram Transport Finance  -0.43
2 Net of dividends

Current Positioning and Outlook

Europe and Japan have seen underlying improvements in their respective economies, though growth has so far been modest. While these markets rallied in 2015, we still see a large number of mispriced opportunities in the small-cap space. Canadian stocks sold off dramatically in 2015, which was largely the result of the steep decline in oil prices, though it did not spare our related holdings in technology, manufacturing, and services.

Along with plummeting share prices, the greatly weakened Canadian dollar has presented what we see as a large number of opportunities. The overall environment in developing markets remains challenging as growth rates in these countries have cooled considerably. While there may be a little bit more downside in these markets, we think they should recover nicely once they bottom, as they have done historically.

Hong Kong, Canada, and Germany were the portfolio’s largest overweights by country at year-end, though Japan accounted for the largest percentage of net assets. On a sector basis, we had greater exposure to Financials and Consumer Discretionary (the Fund's two largest sectors) with comparable exposure to Industrials and Information Technology. We were also underweight in Materials, Consumer Staples, Health Care, and Energy at year-end.

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

International Small-Cap 3.74 -1.64 -1.64 1.03 0.01 N/A N/A 3.86 06/30/08
Russell Glo x US SC 5.11 0.50 0.50 4.32 1.87 4.40 N/A 2.82 N/A
Annual Operating Expenses: Gross 4.92% Net 1.19

*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. 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, Value Partners Group was 1.1% of the Fund’s net assets, VZ Holding was 0.0%, Kepler Weber was 0.0%, Haitian International Holdings was 1.0%, and New World Department Store China was 0.4%.

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, currency 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.) In addition, as of 6/30/15 the Fund invested 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 invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (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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