article 06-30-2016

2016 Semiannual Manager Commentary for Royce Pennsylvania Mutual Fund

While the corporate earnings picture is a phenomenon we continue to watch quite carefully, we are cautiously optimistic about Penn’s near- and long-term prospects, basing our belief primarily on two factors—the growing performance advantage of small-cap value versus growth and the relatively attractive valuation and earnings picture for many cyclical stocks. Going forward, we remain confident that earnings, profitability, and low leverage will matter more and more to investors through what we expect should be a long-running cycle.

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Fund Performance

For the year-to-date period ended June 30, 2016, Royce Pennsylvania Mutual Fund handily outperformed its small-cap benchmark, the Russell 2000 Index, up 7.6% versus 2.2%.

In the midst of considerable uncertainty and volatility, the first half was generally a good time for both value approaches and active small-cap management, including the more eclectic core approach that we use in Penn, which focuses on fundamentals such as low leverage and high ROIC (returns on invested capital) while also seeking companies with what we think are excellent long-term growth prospects. 

The year started, of course, on a sharply bearish note, with stocks declining precipitously into mid-February before rebounding through much of the late winter and spring. Small-caps felt the brunt of the downturn, and we were pleased to see Penn show down market resilience, as it often has throughout its long history.

The Fund significantly outperformed the Russell 2000 in the first quarter, up 6.2% versus a loss of 1.5% for the small-cap index as investors began to gravitate to cyclical businesses with earnings and other fundamental attributes.

The second quarter was mostly a period of gradual recovery that favored more defensive areas, such as REITs and utilities. Some of the growth stocks that had been hurt in the winter sell-off also rebounded, while cyclical areas within Materials, Industrials, and Energy continued to do well, in sharp contrast to what we experienced in 2015.

The wave of volatility that hit the markets in the wake of the Brexit vote wound up doing little to impede this low-key bullish phase. Having very little exposure to defensive stocks, Penn understandably lost some ground to the Russell 2000 during the second quarter, gaining 1.3% versus 3.8% for its benchmark.

We were pleased that Penn outperformed the Russell 2000 for the one-, 15-, 20-, 25-, 30-, and 35-year periods ended June 30, 2016. The Fund's average annual total return for the 40-year period ended June 30, 2016 was 13.0%, all under the management of Chuck Royce.

What Worked... And What Didn't

Each of the Fund's nine equity sectors finished 2016's first half with net gains. The resurgent Industrials sector led by a sizable margin while meaningful net contributions also came from Information Technology, Materials, and Consumer Discretionary.

Four industry groups from three different sectors dominated performance—electronic equipment, instruments & components (Information Technology), metals & mining (Materials), machinery, and commercial services & supplies (both from Industrials). Net losses at the industry level, where the leading detractors were capital markets (Financials) and professional services (Industrials), were comparatively modest.

Long-time holding Drew Industries, which supplies components for manufactured homes and recreational vehicles, was Penn's top contributor in the first half and its largest holding at the end of June. In addition to posting impressive net sales and continuing to increase content per RV, the company has made three acquisitions so far in 2016, which it sees as adding ample potential profitability. Investors seemed to concur.

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.

"In many cases, it appears that the market has just begun to reward steady earnings and high profitability and is only gradually recognizing how low valuations had become for many cyclicals. Going forward, we remain confident that earnings, profitability, and low leverage will matter more and more to investors through what we expect should be a long-running cycle."

The stock price of Newport Corporation climbed by more than 50% in February after the company, which specializes in photonics technology, agreed to be acquired by MKS Instruments, prompting us to begin selling our position.

As for those holdings that detracted from performance, we chose to hold our shares in The Advisory Board Company, which provides best practice research and analysis to the health care industry, after its decelerating core healthcare business and warnings of lower revenues sank its shares. We like its niche business and long-term prospects in an industry still undergoing large-scale changes.

We opted to sell our position in Liberty Tax, a tax preparation services company, after another earnings disappointment.

On a relative basis, the Fund benefited most from both its underweight and effective stock selection in Health Care, its overweight and stock selection in Industrials, and strong stock picking in Information Technology and Consumer Discretionary. It was hurt somewhat by not holding any Utilities and REITs, two of the strongest sectors in the Russell 2000 in the first half, as well as from its larger exposure to capital markets in the Financials sector.


Top Contributors to Performance
For 2016 (%)1

Drew Industries 0.44
Franco-Nevada Corporation 0.43
Newport Corporation 0.43
Ritchie Bros. Auctioneers 0.42
Coherent 0.35
1 Includes dividends

Top Detractors from Performance
For 2016(%)2

The Advisory Board -0.28
Liberty Tax Cl. A -0.26
MTS Systems -0.19
comScore -0.19
Diebold -0.16
2 Net of dividends

Current Positioning and Outlook

While the corporate earnings picture is a phenomenon we continue to watch quite carefully, we are cautiously optimistic about Penn's near- and long-term prospects, basing our belief primarily on two factors—the growing performance advantage of small-cap value versus growth and the relatively attractive valuation and earnings picture for many cyclical stocks.

We continue to believe that an extended period of slow growth should be enough to keep profitable cyclicals climbing, especially after factoring in the ways in which low expectations and—for some industries—oversold conditions depressed the stock prices of so many small-caps that we see as attractive—that is, solidly profitable—businesses.

In many cases, it appears that the market has just begun to reward steady earnings and high profitability and is only gradually recognizing how low valuations had become for many cyclicals.

Going forward, we remain confident that earnings, profitability, and low leverage will matter more and more to investors through what we expect should be a long-running cycle.

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

  QTR YTD 1YR 3YR 5YR 10YR 20YR 40YR
Pennsylvania Mutual 1.31 7.61 -4.76 4.69 5.58 5.57 9.80 13.02
Russell 2000 3.79 2.22 -6.73 7.09 8.35 6.20 7.61 N/A
Annual Operating Expenses: 0.93%

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 investment in mutual funds, hedge funds, private equity funds, and other investment companies. Shares of PMF’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 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, Drew Industries was 1.4% of the Fund’s net assets, Franco-Nevada Corporation was 0.8%, Newport Corporation was 0.0%, The Advisory Board Company was 0.6%, and Liberty Tax was 0.0%.

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 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 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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