Royce Small-Cap Leaders Fund Manager Commentary
article 02-25-2016

Royce Small-Cap Leaders Fund Manager Commentary

We feel confident that our emphasis on what we believe are leading small-cap companies that have strong business models and competitive positions, superior balance sheets, and attractive prospects for growth can be successful. 


Fund Performance

Royce Small-Cap Value Fund (formerly Royce 100 Fund) was down 12.5% in 2015 versus a loss 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 fell 0.1% while its benchmark gained 4.8%. A far-reaching correction hit stocks in the third quarter, when the Fund fell 13.7% versus a decline of 11.9% for the small-cap index. During the fourth quarter's recovery, the portfolio increased 1.5% versus a gain of 3.6% for the Russell 2000.

The year ended 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.

In the year's most noticeable exception to this pattern of narrow leadership—the third-quarter correction—small-cap value enjoyed a 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 emphasis on what we believe are leading small-cap companies that have strong business models and competitive positions, superior balance sheets, and attractive prospects for growth can be successful.

The Fund's average annual total return for the since inception (6/30/03) period ended December 31, 2015 was 8.5%.

What Worked... And What Didn't

Five of the Fund's eight equity sectors finished the year in negative territory, which compared favorably to the benchmark, where eight of 10 sectors declined in 2015. Consumer Discretionary, Financials, Industrials, Energy, and Materials all detracted from performance, with the first four groups posting the largest net losses.

At the industry level, three groups were notably negative—energy equipment & services, capital markets, and specialty retail. On a position level, however, a chemical company was the Fund's loss leader. Minerals Technologies provides minerals-based value-added products. Overall revenue growth has slowed in part due to tepid demand in steel and paper production— two of its key end markets. The decelerating pace of industrial growth in China also hurt during the second half of 2015 as that country has become a market of growing importance. Consistent with its history, management has maintained solid profit margins in the face of weaker sales. The company also authorized a share repurchase program in September, signaling a long-term confidence in the business which we share.

The Buckle is a mall-based casual clothing retailer whose business has been challenged by several factors, including the lack of compelling new jeans styles for women, some excess inventory, the unseasonably warm fall and winter, lower mall traffic, and rampant discounting, especially in the all-important fourth quarter. We like its long history of successful execution and shareholder-friendly capital allocations, such as the $1 per share special dividend the company paid in December in addition to its regular quarterly payout.

"We feel confident that our emphasis on what we believe are leading small-cap companies that have strong business models and competitive positions, superior balance sheets, and attractive prospects for growth can be successful."

From the Energy sector, Unit Corporation is involved in several businesses, including oil and natural gas exploration and contract drilling services. We sold our shares in the third quarter due to our higher conviction in other energy services names that we think are better positioned to generate high returns on invested capital over the long run.

The Fund's top contributor was John Bean Technologies, which sidestepped the travails that many other industrial companies faced in 2015. The company manufacturers and services food processing and airport transportation equipment. A new CEO came on board in September 2013. He strengthened the management team which in turn has executed superbly on revenue growth and profit improvements. We reduced our position as its shares rose but held enough to make it a top-20 holding at year-end. We like its enviable market position, favorable long-term growth trends, attractive acquisition opportunities, and further room for margin expansion.

On a relative basis, the Fund was hurt most by Financials—specifically our underweight in banks and overweight in capital markets—as well as an underweight in Health Care and ineffective stock picking in Consumer Discretionary. Conversely, stock picking was a relative strength in Consumer Staples.

Top Contributors to Performance
For 2015 (%)1

John Bean Technologies 1.12
ManpowerGroup  0.60
Orbotech 0.49
Sykes Enterprises 0.42
j2 Global 0.38
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Minerals Technologies -1.14
The Buckle -1.08
Unit Corporation  -0.93
Saia -0.90
Veeco Instruments -0.78
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 Through 12/31/15 (%)

Small-Cap Leaders 1.49 -12.21 3.79 3.21 5.78 8.70 6/30/2003
Russell 2000 3.59 -4.41 11.65 9.19 6.80 9.14 N/A
Annual Operating Expenses: 1.22%

* 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). Gross operating expenses reflect the Fund's gross total annual operating expenses for the Service Class 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 fees and/or reimburse operating expenses to the extent necessary to maintain the Service Class’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 1.49% through April 30, 2016. Shares of ROH’s R Class bear an annual distribution expense that is higher than that of the Service 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, Minerals Technologies was 2.1% of the Fund’s net assets, The Buckle was 2.9%, Unit Corporation was 0.0%, and John Bean Technologies was 1.9%.

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. 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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