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.

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.

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 (%)

* Not Annualized

Current month-end performance may be obtained at our Prices and Performance page.

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