article 02-22-2016

Royce Total Return Fund Manager Commentary

Portfolio Managers Chuck Royce and Jay Kaplan 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. They also expect the combined effects of these reversals to put the market's focus squarely on the attributes they emphasize, which look overdue for recovery to them.

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Fund Performance

Royce Total Return Fund was down 7.2% in 2015, underperforming its small-cap benchmark, the Russell 2000 Index, which was down 4.4% for the same period. The year began with a strong run for Health Care stocks. For the year-to-date period ended June 30, 2015, the Fund advanced a modest 0.7%, lagging its small-cap benchmark, the Russell 2000 Index, which gained 4.8% for the same period.

During the sweeping correction that shook markets in the third quarter, Total Return lost less than the Russell 2000, down 9.6% versus a decline of 11.9%. When small-caps rebounded in the fourth quarter, however, sentiment swung back to growth, primarily to Health Care and more growth-oriented technology. For the quarter, Total Return advanced 1.9% versus a 3.6% gain for the small-cap index.

It was undoubtedly a difficult year. In fact, 2015 marked the first calendar year in its more-than-20 year history that Total Return lost to the small-cap index when the latter was in negative territory. Taking great pride in the Fund’s long history of both low volatility and sterling down market returns, we found the year’s results particularly tough to digest.

Yet the context is critical. The portfolio trailed its benchmark when returns were positive and outpaced it when small-caps reversed—consistent with its history. For example, from the 2015 small-cap high on June 23 through year-end, the Fund lost 10.7% versus a slide of 11.6% for the Russell 2000. In addition, the Fund maintained a relative edge for longer-term periods.

Total Return outpaced the Russell 2000 for the 15-, 20-year, and since inception (12/15/93) periods ended December 31, 2015. Its average annual total return since inception was 10.3%, a notable result that makes us quite proud.

"Taking great pride in the Fund’s long history of both low volatility and sterling down market returns, we found the year’s results particularly tough to digest. Yet the context is critical. The portfolio trailed its benchmark when returns were positive and outpaced it when small-caps reversed—consistent with its history."

What Worked... And What Didn't

Six of the Fund’s 10 equity sectors posted net losses in 2015, with three posting markedly large net losses—Industrials, Energy, and Consumer Discretionary. The first of these is a broad and diverse group that remains one of the Fund’s mainstays. Seven of the 12 industry groups in which we held positions finished the year in the red, with machinery and commercial services & supplies detracting most.

For the portfolio as a whole, however, the energy equipment & services group posted the biggest net losses on an industry basis. Many Industrial companies were challenged in 2015 by concerns over the slowing pace of global economic growth while Energy was hampered by consistently soft commodity prices that received no support from producers determined to keep pumping oil. Uncertainty over near-term global economic prospects only made it easier for investors to avoid these sectors.

Aiming to high-grade those holdings with commodity exposure, we parted ways with Tidewater, which provides marine service vessels to offshore energy companies in October. While initially pleased with the way it had been executing through this rough period for the energy business, we grew increasingly concerned about the depth of its ongoing losses and chose to sell.

The same impulse toward higher quality led us to increase our stake in longtime favorite SEACOR Holdings, which provides marine transportation equipment and logistics services primarily for energy companies. SEACOR has a history of opportunistic purchases in prior down markets and, while it too has endured losses of late, we have been pleased with the way the company has managed its business during this time.

Within Consumer Discretionary, holdings in the specialty retail category detracted most, led by two companies with which we are very familiar. The Buckle is a mall-based casual clothing retailer that struggled with reduced store traffic and consequent lower sales. Having owned shares for more than a decade, we were confident in its long-term prospects. We had a similar estimate of specialty footwear retailer DSW and department store operator Dillard’s (from the multiline retail group).

On the positive side, insurance was the portfolio’s top-performing industry, led by number-two holding and top contributor Markel Corporation. A longstanding favorite, insurance was home to the Fund’s three largest positions at year-end.

Information Technology, Health Care, and Financials detracted most on a relative basis for the year. For Information Technology, the issues were underweighting the strongly performing software industry and disappointing stock selection in the communications equipment group.

In Health Care, our underweight was a negative factor while in Financials the situation was more nuanced. We were hurt by our underweight in banks, an overweight in capital markets, and poor stock selection in diversified financial services and thrifts & mortgage finance companies. In contrast, Consumer Staples and Materials were the strongest relative contributors, driven in both cases by superior stock selection.


Top Contributors to Performance
For 2015 (%)1

Markel Corporation 0.29
A. O. Smith Corporation  0.22
SEI Investments 0.15
LSI Industries 0.15
ManpowerGroup  0.14
1 Includes dividends

Top Detractors from Performance
For 2015 (%)2

Tidewater -0.37
The Buckle -0.28
SEACOR Holdings  -0.27
DSW Cl. A  -0.24
Dillard’s Cl. A  -0.23
2 Net of dividends

Current Positioning and Outlook

We expect reversals in a number of trends that should help benefit many 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 (%)

  QTR 1YR 3YR 5YR 10YR 15YR 20YR SINCE
INCEPT.
DATE
Total Return 1.86 -7.19 7.68 7.03 5.86 8.28 9.82 10.30 12/15/93
Russell 2000 3.59 -4.41 11.65 9.19 6.80 7.28 8.03 8.56 N/A
Annual Operating Expenses: 1.19%

* 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 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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the 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 RTR’s Service, Consultant, R, and K Classes bear an annual distribution expense that is not borne by the Investment 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, Tidewater was 0.0% of the Fund’s net assets, SEACOR Holdings was 1.0%, The Buckle was 0.6%, DSW was 0.6%, Dillard’s was 0.6%, and Markel Corporation was 1.4%.

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.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. 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 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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