article 02-22-2016

Royce Smaller-Companies Growth Fund Manager Commentary

Losing less than the benchmark in a volatile down year was notable for this growth at a reasonable price portfolio, which had successes with Health Care holdings in several industries, as well as contributions from software companies, banks and electrical equipment stocks. 

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Royce Smaller-Companies Growth Fund was down 1.8% in 2015, ahead of its small-cap benchmark, the Russell 2000 Index, which declined 4.4% for the same period. Negative results are never welcome, but in our view losing less than the benchmark in a volatile down year was notable for a portfolio emphasizing growth at a reasonable price. The second half was difficult, however.

The Fund increased 8.9% for the year-to-date period ended June 30, 2015, ahead of the small-cap index, which rose 4.8% for the same period. Stocks then corrected steeply in the third quarter, when Smaller-Companies Growth dropped 11.1%, losing slightly less than the Russell 2000, which slid 11.9%. The fourth quarter saw a rebound for many equities, with small-cap growth taking back leadership from value. The Fund fell behind its benchmark in the period, advancing 1.4% versus a 3.6% increase for the Russell 2000.

In addition to its calendar-year advantage, the Fund also outperformed the Russell 2000 for the since inception (6/14/01) period ended December 31, 2015. Smaller-Companies Growth Fund’s average annual total return since inception was 11.2%.

What Worked... And What Didn't

First-half dominance and a fourth-quarter recovery made Health Care the top-performing sector for the Russell 2000 in 2015. It was also the Fund’s top contributor on both an absolute and relative basis— by a comfortable margin. Net gains from holdings in three industry groups—biotech, life sciences tools & services, and health care equipment & supplies—helped to drive results in 2015.

“Health Care was the Fund’s top contributor on both an absolute and relative basis— by a comfortable margin. Net gains from holdings in three industry groups—biotech, life sciences tools & services, and health care equipment & supplies—helped to drive results in 2015.”

On an individual position basis, two of the portfolio’s top-five performers (and four of its top-10) came from the sector. The leading position was Anacor Pharmaceuticals (as it was for 2015’s first half). Its shares appreciated early in 2015 with the successful launch of its first commercial product, Kerydin, a topical antifungal medication. The market also liked the positive results from two pivotal Phase 3 studies of Crisaborole, a topical treatment for atopic dermatitis. We trimmed our shares as its price rose, though we held a good-sized stake at year-end.

We acted in a similar fashion with Cambrex Corporation, another top contributor. Cambrex is a life sciences company that provides active pharmaceutical ingredients (“APIs”) for the pharmaceuticals industry. Pharmaceuticals companies typically outsource around 50% of their API business, and Cambrex has one of the best reputations in this attractive niche. Its shares first began to grow noticeably healthy in February after the company reported terrific results for the fourth quarter and fiscal 2015.

Elsewhere in the portfolio, shares of Paylocity Holding Corporation rallied after the company reported strong revenue growth for the first quarter and raised guidance for the full year. We continue to see ample growth potential for this cloud-based software provider specializing in payroll and human resources. As the price of Acuity Brands climbed, we chose to reduce our position in the company, which makes specialty LED lighting and control systems.

Four sectors detracted from results in 2015—Consumer Discretionary, Energy, Consumer Staples, and Materials. The first hurt most, courtesy of two stocks for which our expectations had been high. The Container Store Group operates specialty retail stores that offer storage and organizational products. It was subject to the same woes that affected many retailers—sluggish sales and choosy shoppers—but also executed poorly on promotions and other key operations.

After enduring a series of share price declines, we were reevaluating our position at the end of 2015. We were more sanguine about the “reboot” potential for Boot Barn Holdings, increasing our position in the year’s second half. The company sells western and work gear and is so far surviving a very challenging period for its industry by hanging onto market share. Historically a big seller in energy-rich areas of the U.S., we like its long-term prospects—consistent with our cautiously optimistic outlook for the U.S. consumer.

We sold our position in Sierra Wireless, which provides wireless data communications equipment, after rethinking our exposure to component makers and choosing to give greater emphasis to services providers in the burgeoning M2M (machine-to-machine) area.

In addition to Health Care providing a significant relative edge, Industrials also made a sizable relative contribution, keyed by strong results for our selections in machinery stocks. In Consumer Discretionary the portfolio was hurt mostly by stock selection and less so by the sector’s substantial overweight while ineffective stock selection was the major factor in underperformance for Consumer Staples.


Top Contributors to Performance
For 2015 (%)1

Anacor Pharmaceuticals 1.99
Cambrex Corporation 1.19
Paylocity Holding Corporation  0.99
Acuity Brands 0.96
Manhattan Associates 0.60
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Container Store Group (The) -2.33
Sierra Wireless -0.95
Boot Barn Holdings -0.83
United Natural Foods -0.60
SunOpta -0.55
2 Net of dividends

Current Positioning and Outlook

We expect economic growth to continue at the same bumpy, slow-growth way that characterized 2015. Portfolio positioning has therefore not changed dramatically. We scaled back on a number of Health Care companies in the second half, mostly in biotech and, to a lesser degree, in pharmaceuticals as it became clear that these areas were pressured. However, we still see ample growth potential in areas such as drug development, medical devices, specialty pharma, and genetic testing.

We expect spending on technology to increase in 2016, which gives us confidence in the fundamentals for a number of industries. We also see opportunities in Financials, particularly in banks, which should be helped by the recent rate increase.

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

  QTR 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE
Smaller-Companies Growth 1.39 -1.82 10.57 7.00 5.59 11.16 06/14/01
Russell 2000 3.59 -4.41 11.65 9.19 6.80 7.28 N/A
Annual Operating Expenses: 1.45%

* 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). Operating expenses reflect the Fund’s total annual operating expenses for the Service Class as of the Fund’s most current prospectus and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of RVP’s Consultant and R Classes 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, Anacor Pharmaceuticals was 1.1% of the Fund’s net assets, Cambrex Corporation was 1.6%, Paylocity Holding Corporation was 2.8%, Acuity Brands was 2.0%, The Container Store Group was 2.2%, Boot Barn Holdings was 1.6%, and Sierra Wireless was 0.0%.

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 and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (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 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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