article 06-30-2016

2016 Semiannual Manager Commentary for Royce Special Equity Fund

In this era of unknown unknowns, unprecedented events, and obviously heightened uncertainty, we strongly believe our contrarian, skeptical view of things can be beneficial. We see year-over-year dividend growth as a strong signal of managements' outlook in a slow-growth world. Obviously, the increases have to be internally funded. Total return and the importance of compounding remain critical in generating strong long-term results.

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Fund Performance

Royce Special Equity Fund gained 8.3% for the year-to-date period ended June 30, 2016, more than tripling the 2.2% return for its benchmark, the Russell 2000 Index, for the same period.

During the volatile first quarter, small-cap value solidified its leadership over growth, having begun to lead in the cycle that kicked off from the Russell 2000's peak on June 23, 2015. The small-cap shift benefited companies with earnings, higher ROE (return on equity), and dividends in the first quarter.

This reversal was both welcome and, in our estimation, long overdue. We were pleased to see the Fund substantially outperform its benchmark in the year's opening quarter, climbing 5.6% versus a loss of 1.5% for its benchmark.

The second quarter saw some of these trends stall or reverse, with most of the market's strength coming from REITs, Utilities, and Consumer Staples, as well as low ROE, highly levered, and/or high sales growth companies—not the kind of businesses typically found in the portfolio.

Still, Special Equity posted a modest positive return in what was an otherwise quietly bullish period aside from the major impact of the Brexit decision. For the second quarter, the Fund advanced 2.5% compared to 3.8% for the Russell 2000.

We were very pleased with Special Equity's strong first half on both an absolute and relative basis and were also happy to see the Fund maintain longer-term relative advantages. The Fund beat the Russell 2000 for the one-, 10-, 15-year, and since inception (5/01/98) periods ended June 30, 2016. Special Equity's average annual total return since inception was 8.6%.

What Worked... And What Didn't

Five of the Fund's six equity sectors posted net gains in the first half. Consumer Discretionary led by a sizable margin, followed by a strong contribution for Industrials. Materials, Consumer Staples, and Information Technology rounded out the list while Financials, the portfolio's lone detractor, posted comparatively minor net losses.

The Consumer Discretionary sector was home to both our two top-performing industry groups—specialty retail and media—as well as household durables, its biggest detractor.

The commercial services & supplies (Industrials), paper & forest products (Materials), and electronic equipment, instruments & components (Information Technology) groups also did well in the first half, while other groups with net losses, such as semiconductors & semiconductor equipment (Information Technology) and capital markets (Financials), made a much smaller impact.

The Fund's top performing contributor by a wide margin was The Children's Place, which retails value-priced apparel and accessories for newborn to 12-year-old children.

"In this era of unknown unknowns, unprecedented events, and obviously heightened uncertainty, we strongly believe our contrarian, skeptical view of things can be beneficial. We see year-over-year dividend growth as a strong signal of management’s outlook in a slow-growth world. Obviously, the increases have to be internally funded. Total return and the importance of compounding remain critical in generating strong long-term results."

Meredith Corporation, an Iowa-based diversified media company involved mainly in publishing and broadcasting, also made a strong contribution, as did South Carolina's AVX Corporation, which manufactures passive electronic components and related products.

UniFirst Corporation provides workplace uniforms and protective clothing while Neenah Paper is a global manufacturer of performance-based papers and specialty products used in a variety of applications.

As for those positions that detracted, Hooker Furniture and Haverty Furniture sell home furnishings; we added shares of each in the first half. We chose to sell our shares of Minerals Technologies, which provides specialty chemicals, early in 2016.

We also parted ways with housewares retailer Bed, Bath & Beyond (along with retailers The Buckle and The Finish Line) while making a modest trim to our position in Teradyne, which makes semiconductor test products and provides related services primarily for the military and aerospace industries.

Relative to the Russell 2000, the Fund's strengths were significantly better stock picking in Consumer Discretionary, an underweight in Health Care, effective stock picks in Materials, and an overweight and strong stock selection in Industrials. Conversely, we were hurt by having no exposure to Utilities and, within Financials, REITs—both of these interest-rate sensitive areas did well when bond yields fell.


Top Contributors to Performance
For 2016 (%)1

Children's Place 1.93
Meredith Corporation 1.11
AVX Corporation 0.92
UniFirst Corporation 0.86
Neenah Paper 0.77
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Hooker Furniture -0.39
Haverty Furniture -0.27
Minerals Technologies -0.24
Bed Bath & Beyond  -0.22
Teradyne -0.18
2 Net of dividends

Portfolio Positioning and Outlook

In the wake of Brexit, we see interest rates staying low longer and think investors will continue to favor stocks that look like bonds (based on yield and dividend growth) and/or possess attributes that remain scarce, such as stability, free cash flow generation, and good revenue profiles.

Clearly, as always, uncertainty and fear allow for opportunistic purchases, and we intend to make our share. However, we also remain mindful that the overall market is subject to additional Black Swan events, in Japan and China especially, and stocks are far from inexpensive, except perhaps in comparison to sovereign alternatives.

Small-caps, of course, are generally more U.S.-centric and therefore less exposed to the global economy. In this environment, we have seen opportunities in a number of cyclical sectors.

Three of the Fund's four largest at the end of June—Consumer Discretionary, Industrials, and Materials—were also substantially overweighted versus the Russell 2000. The exception was Information Technology, where our good-sized exposure was nonetheless lower than that of the benchmark.

In this era of unknown unknowns, unprecedented events, and obviously heightened uncertainty, we strongly believe our contrarian, skeptical view of things can be beneficial.

We see year-over-year dividend growth as a strong signal of managements' outlook in a slow-growth world. Obviously, the increases have to be internally funded.

Total return and the importance of compounding remain critical in generating strong long-term results. To try to achieve this, we use a low volatility strategy.

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

  QTR 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Special Equity 2.53 -4.58 3.36 6.81 7.24 N/A 8.62 05/01/98
Russell 2000 3.79 -6.73 7.09 8.35 6.20 7.61 6.28 N/A
Annual Operating Expenses: 1.15%

* 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 at www.roycefunds.com. 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 and other expenses. Shares of RSE’s Service and Consultant Classes bear an annual distribution expense that is not borne by the Investment Class.

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, The Children's Place was 3.9% of the Fund’s net assets, Meredith Corporation was 5.3%, AVX Corporation was 6.8%, UniFirst Corporation was 7.1%, Neenah Paper was 4.8%, Hooker Furniture was 1.6%, Haverty Furniture was 1.5%, Minerals Technologies was 0.0%, Bed, Bath & Beyond was 0.0%, The Buckle was 0.0%, The Finish Line was 0.0%, and Teradyne was 3.5%. 

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.) As of 12/31/15, the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund’s overall value to decline to a greater degree. 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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