article 02-22-2016

Royce Pennsylvania Mutual Fund Manager Commentary

Our own research and regular meetings with 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.

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Fund Performance

Royce Pennsylvania Mutual Fund fell 11.4% in 2015, compared to a decline of 4.4% for its small-cap benchmark, the Russell 2000 Index, for the same period. For the year-to-date period ended June 30, 2015, the Fund gained 0.1% versus 4.8% for the Russell 2000.

The equity markets then experienced a sweeping correction in the third quarter—the steepest decline for U.S. stocks in four years. The Fund fell 13.0% versus a decline of 11.9% for the benchmark. The fourth quarter saw a recovery that benefited small-cap growth companies more than their value siblings. For the fourth quarter, the Fund was up 1.7% while the small-cap index rose 3.6%.

For a sense of how challenging the year was for small-cap stocks (and the active managers who pick them), consider that the Russell 2000 lost 10.1% on an equal-weighted basis in 2015. This shows just how hard it was to find stocks that grew appreciably by year-end, especially in the more economically sensitive, cyclical areas of the market that have been our primary focus over the last few years. In this climate, we continued to focus on companies that in our analyses showed a combination of attractive valuation, balance sheet strength, and/or promising growth prospects.

We were also pleased that Pennsylvania Mutual outperformed the Russell 2000 for the 15-, 20-, 25-, 30-, and 35-year periods ended December 31, 2015. The Fund’s average annual total return for the 40-year period ended December 31, 2015 was 13.7%, all under the management of Chuck Royce.

What Worked... And What Didn't

Industrials, where we were substantially overweight at the end of 2015, detracted most on an absolute basis in 2015. It also hurt relative performance, but our disadvantage resulted from greater exposure to the sector—stock selection was a net positive versus the benchmark.

On an industry level, the largest net losses in Industrials came from machinery stocks, which was also a significant overweight. Long-time holding Kennametal makes tools and tooling systems, focusing on the metalworking, mining, oil, and energy industries, all of which faced sluggish industry conditions in 2015.

However, the Fund’s top contributor John Bean Technologies, also came from the machinery group. The company provides technology solutions primarily to the food processing and air transportation industries and benefited from healthy earnings growth in 2015.

Consumer Discretionary was also a sore spot, hurt most by net losses in the specialty retail category, where another long-time holding, casual clothing retailer The Buckle, was a loss leader, as was America’s Car-Mart, which sells and finances used cars and trucks. The Buckle was hurt by declining mall traffic and a long (and mostly successful) history of not discounting its merchandise. We like how the company coped with the increasingly challenging situation for retailers in 2015.

America’s Car-Mart faced lighter volumes that were mostly the result of increased competition. We held shares of each at the end of 2015.

The ongoing decline of oil and natural gas prices also kept energy services businesses in the red for the year. A holding for more than a decade, Unit Corporation detracted most in the Energy sector. The company, which operates as a contract driller and exploration & production company, among other energy-related businesses, continues to execute effectively in one of the most difficult environments for energy companies in the last 30 years. Its attractively capitalized balance sheet is also likely to be an advantage as its industry is already feeling the effects of credit constraints.

Shares of residential mortgage insurer Genworth MI Canada often track the price of oil due to the company’s large share of business in commodity-dependent western Canada. Believing that the potential losses have been more than priced in (making its shares attractively inexpensive), we increased our position in 2015, confident in the firm’s long-term potential to recover.

The biggest detractor to relative performance on a sector basis in 2015 was Information Technology, where poor stock selection in the electronic equipment, instruments & components and semiconductors & semiconductor equipment industries hurt most.

The combination of an underweight in banks, an overweight in capital markets, and poor stock selections in insurance and diversified financial services all hampered relative results in Financials. Health Care’s modest net gain in the portfolio was mitigated by our significant underweight in the sector—it detracted from results relative to the Russell 2000.

We were pleased, however, with our stock-picking strength in Energy and Materials—two highly challenged sectors in which we sought to high-grade positions in 2015.


Top Contributors to Performance
For 2015 (%)1

John Bean Technologies 0.29
Core-Mark Holding Company 0.21
Blackbaud 0.21
Stella-Jones 0.19
SEI Investments 0.18
1 Includes dividends

Top Detractors from Performance
For 2015(%)2

Unit Corporation -0.38
Kennametal -0.32
The Buckle -0.31
Genworth MI Canada -0.27
America's Car-Mart -0.26
2 Net of dividends

Current Positioning and Outlook

We expect reversals in a number of trends that should 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 20YR 40YR
Pennsylvania Mutual 1.72 -11.43 5.96 5.49 5.42 9.70 13.65
Russell 2000 3.59 -4.41 11.65 9.19 6.80 8.03 N/A
Annual Operating Expenses: 0.92%

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 Investment Class (its oldest class). Operating expenses reflect the Fund’s total annual operating expenses for the Investment Class as of the Fund’s most current prospectus and include management 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 investment in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of PMF’s Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Investment Class. 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, Kennametal was 0.01% of the Fund’s net assets, John Bean Technologies was 0.8%, The Buckle was 0.8%, America’s Car-Mart was 0.4%, Unit Corporation was 0.2%, and Genworth MI Canada was 0.9%.

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 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 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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