article 02-22-2016

Royce Premier Fund Manager Commentary

Following a difficult 2015, we expect reversals in a number of trends that should help benefit our portfolio holdings over the next few years—those companies with discernible competitive advantages, high returns on invested capital, and a sustainable, moat-like franchise.

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Fund Performance

Royce Premier Fund was down 9.9% in 2015, lagging its small-cap benchmark, the Russell 2000 Index, which declined 4.4% for the same period. For the year-to-date period ended June 30, 2015, the Fund gained 1.7% versus a 4.8% increase for its small-cap benchmark.

Markets reversed course somewhat violently in the third quarter when Premier fell 12.4% compared to a loss of 11.9% for the Russell 2000. Equities recovered a bit in the fourth quarter, and the Fund increased 1.2% versus 3.6% for the small-cap index.

The year ended, therefore, in much the same way it began—with narrow market leadership from mostly growth-oriented stocks, particularly in Health Care (though the fourth quarter also saw strength for more growth-oriented tech businesses).

The lack of breadth was an issue, with one data point, we think, being especially telling: In 2015 the Russell 2000 lost 10.1% on an equal-weighted basis.

During the year's most noticeable exception to this pattern of narrow leadership—the third-quarter correction—small-cap value enjoyed an all-too-brief period of leadership. This short-lived phase was nonetheless encouraging to us—we suspect that contracting access to credit, lower equity returns, and reversion to the mean should all help to boost active approaches.

We feel confident that our focus on companies with discernible competitive advantages, high returns on invested capital, and a sustainable, moat-like franchise can do well in such a climate.

We were also pleased that Premier outperformed the Russell 2000 for the 15-, 20-year, and since inception (12/31/91) periods ended December 31, 2015. The Fund's average annual total return since inception was 11.0%. We remain proud of the portfolio's long-term record.

What Worked... And What Didn't

Six of the Fund’s eight equity sectors posted net losses in 2015, with the largest coming from Industrials followed by Energy and Consumer Discretionary. On an industry basis, two groups detracted meaningfully—energy equipment & services and machinery.

Both were substantially overweight vis-à-vis the Russell 2000. The first was home to Unit Corporation, a long-time Royce favorite. The company is something of an anomaly in the energy industry because it runs multiple businesses, including oil and natural gas exploration and contract drilling of onshore oil and natural gas wells. Most energy companies focus on only one of these activities. We opted to sell our shares in Premier based on our own growing preference in the portfolio for companies involved in single lines of business.

Slotted in Consumer Discretionary, Sotheby’s auctions fine art, antiques, and collectibles, along with brokering luxury residential real estate. A company we have owned a number of times dating back to 1992, we like its market share in a highly specialized niche. Declining revenues and earnings kept investors from bidding up its shares in 2015, but we were content to hold a position at year-end.

We also held a good-sized stake in footwear retailer Wolverine Worldwide, which owns a suite of brands such as Merrell, Keds, and Hush Puppies. Sales and earnings have been disappointing, but we think the strength of its well-established names can help it regain its footing.

"We suspect that contracting access to credit, lower equity returns, and reversion to the mean should all help to boost active approaches. We feel confident that our focus on companies with discernible competitive advantages, high returns on invested capital, and a sustainable, moat-like franchise can do well in such a climate."

We held shares of mall-based casual clothing retailer The Buckle. Facing declining mall traffic and sluggish sales, the company has been executing well through a challenging period for retailers.

Kennametal, from the machinery group, makes tools and tooling systems, focusing on the metalworking, mining, oil, and energy industries, all of which faced inhospitable industry conditions in 2015. Seeing the potential for steadier long-term growth elsewhere, we sold our shares.

As it was in the first half of the year, the Fund's top contributor in 2015 was Cal-Maine Foods, the largest producer of eggs in the U.S. Egg prices more than doubled in anticipation of supply constraints caused by a serious outbreak of avian flu in the Midwest. This happened as quick-service restaurants were also broadening their breakfast offerings. We took gains as its price soared.

On a sector basis, poor stock selection in Information Technology, an overweight in Industrials, and an underweight in Health Care combined to detract most from calendar-year relative performance. For Information Technology, stock selection within the electronic equipment, instruments & components and semiconductors & semiconductor equipment industries proved troublesome.

In Industrials, the primary problem was an overweight in machinery stocks, many of which experienced sizable declines due to concerns about slowing global growth. Stock picking was a notable relative advantage, on the other hand, in the Materials and Consumer Staples sectors.


Top Contributors to Performance
For 2015 (%)1

Cal-Maine Foods 0.60
Fair Isaac 0.48
Pool Corporation  0.41
Stella-Jones 0.38
Jack Henry & Associates 0.36
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Unit Corporation -0.94
Sotheby's -0.73
Kennametal -0.73
Wolverine World Wide -0.72
The Buckle -0.65
2 Net of dividends

Current Positioning and Outlook

We expect reversals in a number of trends that should help benefit a number of 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 as of Quarter-End 6/30/15 (%)

  QTR 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Premier 1.19 -9.90 -9.90 4.49 4.74 6.45 10.49 11.03 12/31/91
Russell 2000 3.59 -4.41 -4.41 11.65 9.19 6.80 8.03 9.23 N/A
Annual Operating Expenses: 1.10%

* 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 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 and other expenses. Shares of RPR’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.

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. The Fund also generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than 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.) 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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