Royce Special Equity Fund Manager Commentary
article 02-22-2016

Royce Special Equity Fund Manager Commentary

Altogether, Charlie Dreifus and Steven McBoyle are happy to say, “Goodbye and good riddance” to 2015—the first calendar year since Charlie joined Royce in 1998 during which the Fund underperformed the small-cap index when the latter had a negative return. They think 2016 should be more hospitable to careful and contrarian stock pickers.


Fund Performance

Royce Special Equity Fund was down 12.4% in 2015, underperforming 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 was down 0.5% versus an advance of 4.8% for the small-cap index, which was disproportionately led by non-earning, lowest ROE quintile, and non-yielding companies—none of which meet the standards we’ve established for our classic value approach. 

During the widespread downturn that shook the markets in the third quarter, the Fund lost only slightly less than the Russell 2000, down 11.3% versus the benchmark’s 11.9% slide. Share prices recovered somewhat in the fourth quarter but the portfolio was down 0.6% while the Russell 2000 increased 3.6%.

Altogether, we are happy to say, “Good bye and good riddance” to 2015—the first calendar year since we joined Royce in 1998 during which the Fund underperformed the small-cap index when the latter had a negative return. It was also a more difficult year for small-caps than the benchmark’s return might show—on an equal-weighted basis, the Russell 2000 was down 10.1% in 2015.

We were pleased, though, that the Fund beat the Russell 2000 for the 10-, 15-year, and since inception (5/01/98) periods ended December 31, 2015. Special Equity’s average annual total return since inception was 8.4%.

What Worked... And What Didn't

Six of the Fund’s eight equity sectors posted net losses in 2015, which was better than the index, where eight of 10 sectors were in the red. No portfolio sector had net losses as steep as those in Consumer Discretionary, which more than doubled those of the portfolio’s next-worst, Industrials.

The bulk of the losses came from the specialty retail industry, in which we held a number of positions, including three of the portfolio’s five largest holdings: Bed, Bath & Beyond, which operates stores that sell primarily domestics merchandise and home furnishings, casual clothing retailer The Buckle, and The Finish Line, which sells brand name athletic and leisure footwear, activewear, and accessories. We held large stakes in each at the end of 2015. Consumption is doing all right.

A new phrase—secular rejuvenation—is being used to describe the improving consumer situation in the U.S. Real incomes, as well as expectations, have risen, and perhaps most important household formations increased and are expected to rise again in 2016. Prospects for the 2016 economy also got a boost late in December when Congress increased spending and cut business taxes, a common occurrence ahead of elections. These actions could add 0.7% to U.S. GDP in 2016.

"Against the backdrop of tepid demand for equities, particularly from individual investors who have endured two major market declines in the past 15 years, wide-scale multiple expansion looks unlikely. In our view, this highlights the case for the kind of bottom up, granular security selection that has always distinguished our disciplined and contrarian approach."

Industrials also posted a substantial net loss, keyed in part by net losses for L.B. Foster Company, which manufactures, fabricates, and distributes rail and trackwork piling, highway products, earth wall systems, and tubular products for the rail, mining, and construction industries. We sold the last of our shares in October.

The Fund’s largest holding at year end, UniFirst Corporation also detracted from results. The company provides workplace uniforms and protective clothing in the U.S. and Canada. A large and diverse sector, Industrials was also home to the portfolio’s top contributor in 2015, long-time holding National Presto Industries. The company runs a diverse number of manufacturing businesses, including defense products, housewares and small appliances, and absorbent products.

Net losses in Information Technology came from the electronic equipment, instruments & components and were spread among several holdings, including AVX Corporation (our second-largest holding at year-end), Park Electrochemical, and Anixter International.

Relative results were hampered primarily by both our overweight and stock selection in Consumer Discretionary, with ineffective choices and a substantially larger weighting in specialty retail hurting most. Stock selection was the chief culprit in Information Technology while the portfolio’s significant underweight in both Financials and Health Care also detracted meaningfully from relative performance in 2015.

By contrast, stock selection in Consumer Staples and Materials were bright spots while low exposure to Energy also helped in the calendar year period. The first of these sectors included one of the portfolio’s top net gainers for 2015, independent leaf tobacco merchant Universal Corporation.

Both absolute and relative success for Materials came from Neenah Paper, a global manufacturer of premium, performance-based papers and specialty products with manufacturing operations in the U.S. and Germany. Semiconductor test product maker and services business Teradyne also helped on both an absolute and relative basis.

Top Contributors to Performance
For 2015 (%)1

National Presto Industries  0.64
Universal Corporation 0.50
Teradyne 0.25
Neenah Paper  0.23
Scholastic Corporation  0.14
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Bed Bath & Beyond -2.42
L.B. Foster Company  -1.24
The Buckle -1.18
The Finish Line Cl. A -1.14
UniFirst Corporation  -1.09
2 Net of dividends

Portfolio Positioning and Outlook

2015 offered a potent reminder of how humbling this business can be. We have always ordered pencils with erasers to account for our mistakes knowing that our process does not work in all markets—it is not the Rosetta Stone.

However, against the backdrop of tepid demand for equities, particularly from individual investors who have endured two major market declines in the past 15 years, wide-scale multiple expansion looks unlikely. In our view, this highlights the case for the kind of bottom up, granular security selection that has always distinguished our disciplined and contrarian approach.

We remained overweight at the end of 2015 in Consumer Discretionary, Industrials, and Materials while maintaining significantly lower exposure to Financials and Health Care.

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

Special Equity -0.62 -12.36 4.65 5.76 6.91 10.10 8.38 05/01/98
Russell 2000 3.59 -4.41 11.65 9.19 6.80 7.28 6.33 N/A
Annual Operating Expenses: 1.12%

* 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 at 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 RSE’s Service and Consultant Classes bear an annual distribution expense that is not borne by the Investment Class.

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, Bed Bath & Beyond was 5.7% of the Fund’s net assets, The Finish Line was 3.0%, The Buckle was 1.8%, L.B. Foster was 0.0%, UniFirst Corporation was 9.7%, National Presto Industries was 2.6%, AVX Corporation was 7.0%, Park Electrochemical was 1.8%, and Anixter International was 0.7%.

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.) As of 12/31/15, 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. 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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