Fund Performance

Royce Special Equity Multi-Cap Fund was down 13.6% in 2015, underperforming its large-cap benchmark, the Russell 1000 Index, which was up 0.9% for the same period. For the year-to-date period ended December 31, 2015, the Fund was down 3.1% versus an advance of 1.7% for the large-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 11.2% versus the benchmark's 6.8% slide. Share prices recovered somewhat in the fourth quarter when the portfolio increased 0.9% while the Russell 1000 advanced 6.5%. The Fund's average annual total return for the identical five-year/since inception (12/31/10) period ended December 31, 2015 was 9.0%.

Altogether, we are happy to say, "Good bye and good riddance" to 2015. For the market overall, the year was a wild ride to nowhere. The S&P 500 averaged its highest number of intraday swings since 2008. Since February 2007 the cheapest stocks in the U.S. have lagged their more expensive counterparts by 2.6% annually, an eight-year and seven-month stretch of underperformance that is the longest losing streak on record going back to 1926.

Our approach was rejected by the market in favor of more expensive stocks. Indeed, it was a bad year for penny-pinchers and bargain hunters—growth stocks trounced value stocks. There have been times before when the market has not behaved in a businesslike fashion. We are used to this, having seen it several times during our career. Yet this felt different. Nonetheless, we are still in a free market, a capitalistic economy where the rules of business and economic reality ultimately prevail. We have no doubt about this.

What Worked... And What Didn't

Six of the Fund's seven equity sectors posted net losses in 2015, though none were as steep as those in Consumer Discretionary, which were more than quadrupled those of the portfolio's next-worse sector, Financials.

The bulk of the sector's losses came from the specialty retail industry, including two of the portfolio's five largest holdings: top-five holding Bed, Bath & Beyond, which operates stores that sell primarily domestics merchandise and home furnishings, and retailer The Gap, which we sold in October.

Stocks in the sector's multiline retail and media groups also fared poorly. Our only position in the first of these industries is department store retailer Nordstrom, which was our fourth-largest holding at year-end.

Within the media group, both entertainment content company Viacom and television and Internet business operator Scripps Networks Interactive disappointed. We held shares in each at the end of 2015. In Financials, the biggest detractor was Franklin Resources, which does business as Franklin Templeton Investments and provides investment advisory services to mutual fund, retirement, institutional, and separate accounts. We sold the last of our shares in December.

Relative results were substantially hampered by stock selection in Consumer Discretionary. Ineffective stock selection hurt most in three industries—specialty retail, multiline retail, and media. The portfolio's capital markets holdings in Financials also detracted, as did stock selection in Information Technology and Industrials. Low exposure to Energy was a bright spot in calendar-year relative performance.

For positive developments on an absolute basis, two top-10 positions contributed meaningfully—software giant Microsoft Corporation and auto parts maker Lear Corporation.

Current Positioning and Outlook

Consumption is doing well. 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 have increased substantially and are expected to continue to rise. 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.

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 are pleased with the high cap rates and returns on invested capital of our holdings. In our view this makes many of them feel like positive events waiting to happen.

We also believe 2015 was an outlier, a highly anomalous year for equity performance and so we see the potential for better times for disciplined contrarians like ourselves. At the end of 2015, we remained substantially overweight in Consumer Discretionary and Industrials, and had significant exposure to Information Technology. We held no positions in Consumer Staples, Energy, Financials, Telecommunication Services, or Utilities and had much lower exposure to Financials and Health Care.

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

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

Important Performance, Expense, and Disclosure Information