article 06-30-2016

2016 Semiannual Manager Commentary for Royce Dividend Value Fund

Portfolio Managers Chuck Royce and Jay Kaplan continue to see the most attractive values in cyclically sensitive areas, particularly those involved in capital markets and industrial activity. They also believe that asset managers, investment banks, and niche vendors are potentially profitable investments because of their high returns on invested capital and ability to differentiate themselves. In addition, their often complex business models and the companies' cyclical earnings patterns also often lead to them being misunderstood—and thus mispriced—by investors, which can create opportunities.

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Fund Performance

Royce Dividend Value Fund advanced 4.4% for the year-to-date period ended June 30, 2016, doubling the 2.2% return for its benchmark, the Russell 2000 Index, for the same period.

While the year began with an alarming correction that reached into mid-February, the Fund bounced back strongly after a period of underperformance with one of its strongest relative quarterly showings in a number of years, gaining 5.0% versus a loss of 1.5% for the small-cap index in the first quarter.

In this highly volatile period, the portfolio benefited from the long-awaited shift in the small-cap market towards companies with current earnings, below-average risk profiles, and lower valuations, which all fit well with the Fund's strategy.

The second quarter featured an environment that was both more mixed and more challenging for the Fund. While many of the cyclical businesses in sectors as diverse as Industrials, Information Technology, and Materials continued to do well, they ceded overall leadership to defensive areas such as REITs, utilities, and staples.

More pointedly, the Fund suffered most from its significantly higher exposure to capital markets companies, many of which demonstrated little or no recovery in the wake of Brexit. The upshot was a step back for the portfolio, which finished the second quarter with a modest decline of 0.6% while the Russell 2000 rose 3.8%.

We were nonetheless pleased by the Fund's strong first half overall and believe that leadership for small-cap value, which stretches back to the most recent peak for the Russell 2000 on June 23, 2015, should be long lasting. We were also happy that Dividend Value outpaced its benchmark for the one-, 10-year and since inception (5/3/04) periods ended June 30, 2016.

What Worked... And What Didn't

Nine of the Fund's 10 equity sectors finished the first half with net gains—as was also the case for the Russell 2000. Leading the portfolio by a comfortable margin was Materials, followed by strong net gains for Industrials and Financials. The net loss for Telecommunications Services, by contrast was small.

Metals & mining (from Materials) was the leading industry group, followed by machinery and air freight & logistics, both from the Industrials sector. Materials was also home to the Fund's top three contributors for the semiannual period.

Reliance Steel & Aluminum benefited from a sharp rise in steel and other base metals prices. Strong demand from the auto and aerospace sectors, as well as incremental improvement in commercial construction, continues to underpin solid volume trends, while distributor inventories are lean, with extended mill lead times for some products.

Franco-Nevada Corporation is a Toronto-based business that owns royalties and streams in gold mining and other commodity and natural resource investments. The company benefited from a surge in gold prices and paid down debt during the first half while also increasing its dividend and offering upward earnings revisions.

Worthington Industries is a global diversified metals manufacturing company. It was able to keep earnings positive in spite of sales declines earlier in the year and then reaped the benefit of record fiscal fourth quarter earnings per share. We held good-sized positions in all three companies at the end of June.

"We believe that asset managers, investment banks, and niche vendors are potentially profitable investments because of their high returns on invested capital and ability to differentiate themselves. In addition, their often complex business models and the companies' cyclical earnings patterns also often lead to them being misunderstood—and thus mispriced—by investors, which can create opportunities for us."

We have long liked the core businesses of investment processing, management, and operations solutions specialist, SEI Investments. The portfolio's biggest detractor in the first half, it continued to execute well but saw its stock price hurt by market volatility, though its shares were recovering at the end of June.

Staffing and workforce solutions specialist ManpowerGroup saw its shares plummet in the wake of Brexit. Its inability to share in the subsequent recovery was largely related to the company's significant exposure to the European labor market. We chose to hold our shares in the belief that the market overreacted to what remains a business with impressive revenues, positive earnings, and a steady dividend. It was the Fund's seventeenth largest holding at the end of June.

Relative to its benchmark, the Fund was helped most by both its underweight in Health Care and better stock picking in that sector's pharmaceuticals industry. Our larger weighting in Materials, especially in the aforementioned metals & mining group, also boosted outperformance.

Conversely, the portfolio's slight exposure to Utilities and stock selection in Financials hampered relative results.


Top Contributors to Performance
For 2016(%)1

Reliance Steel & Aluminum  0.68
Franco-Nevada Corporation 0.57
Worthington Industries 0.50
Ritchie Bros. Auctioneers 0.37
Helmerich & Payne  0.30
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

SEI Investments -0.46
ManpowerGroup -0.35
Inmarsat -0.26
Diebold -0.25
KBR -0.21
2 Net of dividends

Current Positioning and Outlook

Portfolio positioning remained largely unchanged at the end of June. We continue to see the most attractive values in cyclically sensitive areas, particularly those involved in capital markets and industrial activity, as our large weightings in Financials and Industrials demonstrate.

Moreover, with Treasury Bond yields at historic lows and interest-rate sensitve stock valuations looking rich, we are comfortable with the portfolio's lack of exposure to defensive areas—the Fund rarely holds REITs and has little exposure to Utilities and Telecommunication Services companies.

Our much larger weighting in capital markets is based on our belief that asset managers, investment banks, and niche vendors are potentially profitable investments because of their high returns on invested capital and ability to differentiate themselves.

In addition, their often complex business models and the companies' cyclical earnings patterns often lead to them being misunderstood—and thus mispriced—by investors, which we believe can create opportunities for us.

Average Annual Total Returns Through 6/30/16 (%)

  QTR YTD 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Dividend Value -0.57 4.54 -3.86 4.59 6.34 7.02 N/A 8.05 05/03/04
Russell 2000 3.79 2.22 -6.73 7.09 8.35 6.20 7.61 7.46 N/A
Annual Operating Expenses: 1.14%

* 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 gross 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 the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies. 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 2016.

The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at June 30, 2016, 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 June 30, 2016 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 6/30/16, Reliance Steel & Aluminum was 2.0% of the Fund’s net assets, Franco-Nevada Corporation was 1.1%, Worthington Industries was 1.6%, SEI Investments was 1.0%, and Manpower Group was 1.3%.

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.) 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 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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