article 06-30-2016

2016 Semiannual Manager Commentary for Royce Low-Priced Stock Fund

Our approach continues to swim against the tide of highly unusual circumstances, including negative interest rates in developing countries such as Germany and Japan, Brexit, and extremely volatile commodity prices. Notwithstanding these, we remain cautiously constructive on the outlook for the U.S. economy.  

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Fund Performance

We were disappointed in first-half results for Royce Low-Priced Stock Fund. The Fund fell 2.5% for the year-to-date period ended June 30, 2016, underperforming its small-cap benchmark, the Russell 2000 Index, which gained 2.2% for the same period.

Small-cap stocks began the year with a significant decline that intensified the downward trend that began following the Russell 2000's peak on June 23, 2015. This made for a highly volatile first quarter in which we were pleased to see the Fund hold its value better than its benchmark. Low-Priced Stock lost 0.8% in the year's opening quarter versus a decline of 1.5% for the Russell 2000. 

The second quarter, however, saw the Fund unable to participate in the modest recovery for stocks of all asset classes that even the seismic shock of Brexit did little to deter, at least here in the U.S.

So while there were recoveries for defensive areas such as REITs and Utilities, rebounds for pockets of high growth, and ongoing success for certain cyclicals, the Fund did not keep pace. For the second quarter, Low-Priced Stock was down 1.7% while the Russell 2000 gained 3.8%. Needless to say, this was a frustrating end to the semiannual period.

The Fund outperformed the small-cap index for the 20-year and since inception (12/15/93) periods ended June 30, 2016. Low-Priced Stock's average annual total return since inception was 9.5%.

What Worked... And What Didn't

Although there was balance in the fact that five of the Fund's 10 equity sectors posted net losses and five posted net gains, the impact of the detractors was markedly greater, particularly for Health Care and Industrials.

At the position level, the biggest net loss was SeaChange International, which provides video on demand software to cable television and telecommunications operators. Its shares fell as its efforts to offer a similar turnkey video solution to over-the-top video providers such as Netflix are proving to be a longer-term project than we and other investors had originally anticipated, which resulted in an unexpected CEO change.

However, we like its inexpensive valuation and long-term prospects for success. We added shares in the first half. We also liked the combination of inexpensive valuation and long-term prospects for Ardmore Shipping, which operates mostly oil-based chemical tankers. Although we see the tanker market as moving from oversupplied to undersupplied, the uncertain global economic picture has made the transition less smooth than we initially suspected. 

"Our approach continues to swim against the tide of highly unusual circumstances, including negative interest rates in developing countries such as Germany and Japan, Brexit, and extremely volatile commodity prices. Notwithstanding these, we remain cautiously constructive on the outlook for the U.S. economy."

In Health Care, the largest detractor was Lipocine, a specialty pharmaceuticals business whose stock was hurt by a delay in approval of its orally induced testosterone drug. While we are unsure about the ultimate approval of this drug, we cautiously added to our position in the first half based on Lipocine's strong pipeline and the fact that it was trading close to the value of cash on its balance sheet.

We chose to hold our shares of ZAIS Group Holdings, an investment manager that focuses primarily on structured credits. Turmoil in the credit markets pushed its investment performance below various high watermarks, which had a negative effect on both profitability and near-term growth.

In January, we built our stake in BioAmber, an industrial biotechnology company that focuses on the use of renewable feedstocks. Its shares have been hurt by the kind of start-up issues that are typical with a first-of-its-kind fermentation plant. However, we see ample commercial potential for its products.

On the positive side, the two top contributors came from the metals & mining industry—the portfolio’s second-best industry group behind semiconductors & semiconductor equipment.

Alamos Gold and Pretium Resources are both precious metals exploration and production companies that had been trading at valuations well below our estimate of the intrinsic value of their respective resources. Each benefited from the sharp gain in precious metals prices during the first half. We have been trimming both positions as their shares vastly outperformed the change in the underlying asset price, thus closing some of the valuation gap we found in our original investment thesis.

Relative to the Russell 2000, results were hampered most meaningfully by ineffective stock picking in the Industrials sector, especially in professional services and construction & engineering. Stock selection was also an issue in Financials, as was our overweight in capital markets and an underweight in REITs in the same sector. Conversely, stock selection was a strength in Information Technology.


Top Contributors to Performance
For 2016 (%)1

Alamos Gold Cl. A 0.59
Pretium Resources 0.47
Newport Corporation 0.34
Cirrus Logic  0.33
J.C. Penny Company  0.33
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

SeaChange International  -0.56
Ardmore Shipping -0.48
Lipocine  -0.47
ZAIS Group Holdings Cl. A -0.45
BioAmber -0.38
2 Net of dividends

Current Positioning and Outlook

Our approach continues to swim against the tide of highly unusual circumstances, including negative interest rates in developing countries such as Germany and Japan, Brexit, and extremely volatile commodity prices. Notwithstanding these, we remain cautiously constructive on the outlook for the U.S. economy.  

This is reflected in sector overweights in Information Technology, Consumer Discretionary, and Industrials where we have been finding an intriguing overlap of relatively solid fundamentals and attractive valuations.

We also see many exciting themes, particularly in technology, that provide numerous investment opportunities for valuation-conscious small-cap investors.

Finally, we have also begun to selectively add to Health Care as that sector has significantly corrected.

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

  QTR 1YR 3YR 5YR 10YR 15YR 20YR SINCE
INCEPT.
DATE
Low-Priced Stock -1.55 -2.19 -14.61 -0.88 -3.53 2.30 8.51 9.59 12/15/93
Russell 2000 3.79 2.22 -6.73 7.09 8.35 6.20 7.61 8.47 N/A
Annual Operating Expenses: Gross 1.29% Net 1.25

*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, including management fees, 12b-1 distribution and service fees, and other expenses. Shares of RLP’s R Class bear an annual distribution expense that is higher than that of the Service 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 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 3/31/16, SeaChange International was 0.5% of net assets, Ardmore Shipping was 0.7%, Lipocine was 0.2%, ZAIS Group Holdings was 0.2%, BioAmber was 0.4%, Alamos Gold was 0.5%, and Pretium Resources was 0.6.

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 low priced small-cap stocks, which may involve considerably more risk than investing in higher-priced or 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 35% 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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