article 12-31-2016

Royce Heritage Fund Manager Commentary

Portfolio Manager Steven McBoyle continues to anticipate lower returns, higher volatility, and lower correlation levels. Evidence is building that a normalization in the markets is taking place, which should make them far more discriminating. For these reasons, he believes his bottom-up, quality-oriented process has the potential to do well.


Fund Performance

Royce Heritage Fund increased 17.8% versus a gain of 21.3% for its small-cap benchmark, the Russell 2000 Index, for the same period. Despite trailing the small-cap index, we were pleased with the Fund's absolute performance. The portfolio's weighted average market cap has moved up over the last few years—it stood at $4.3 billion at year-end, $3.6 billion at the end of 2015, and $2.9 billion at the end of 2014—embracing more fully its ability to invest in both small- and mid-cap stocks that meet our exacting criteria for high quality and attractive valuation.

In this light, it is worth noting that the smid-cap Russell 2500 Index gained 17.6% in 2016 and also trailed the small-cap index. In addition, the market saw three reversals that we think bode well for the Fund and active management: Small-caps had positive returns, value recaptured leadership from growth, and cyclical stocks beat their defensive counterparts.

During the first half of 2016, Heritage advanced 5.3%, ahead of the 2.2% increase for the Russell 2000. The second half of the year was more rewarding on an absolute basis though less so on a relative scale. The Fund advanced 11.9% in the second half of 2016 compared to 18.7% for the benchmark. Turning to longer-term spans, Heritage outperformed the small-cap index for the 20-year and since inception (12/27/95) periods ended December 31, 2016. The Fund's average annual total return since inception was 12.3%.

What Worked... And What Didn't

Of the Fund's 10 equity sectors, seven finished the year with net contributions. Its two largest, Industrials and Consumer Discretionary, also made the biggest positive impact on performance. Of the three sectors that detracted—Real Estate, Health Care, and Energy—only the first had a meaningful negative impact, and the portfolio was significantly underweighted in each throughout 2016.

At the industry level, auto components (Consumer Discretionary) had by far the greatest positive effect on returns, led by top-15 holding and significant contributor LCI Industries, while chemicals (Materials) also made a notable positive impact. The effect of detracting industries was more modest, led by real estate management & development (Real Estate) and capital markets (Financials). The first industry was home to three of the Fund’s five top detracting positions.

The politically driven fourth quarter of 2016 notwithstanding, we continue to anticipate lower returns, higher volatility, and lower correlation levels. Evidence is building that a normalization in the markets is taking place, which should make them far more discriminating. For these reasons, we believe our bottom-up, quality-oriented process has the potential to do well.

The top contributor at the position level was recreational vehicle (RV) maker Thor Industries, the largest manufacturer in its industry and one of three stocks in the top five from the Consumer Discretionary sector. Thor benefited from numerous advantageous developments during the year, including its acquisition of Jayco, which bolstered Thor's leading market position in low-end towable RVs, its fastest-growing sector. Robust growth in orders from both retail and dealer sources, the growing popularity of RVs, and favorable consumer financing all helped its shares to accelerate.

Minerals Technologies produces performance-enhancing minerals, as well as mineral-based and synthetic mineral products. Its stock appreciated through much of the year before spiking after the election. We think the company has done an excellent job improving underperforming operations and maintaining margins in key divisions where organic growth has been modest due to macroeconomic factors. It also continues executing a material penetration opportunity in China of precipitated calcium carbonate (PCC) in paper production, an opportunity that remains large and has been gaining traction generating ample free cash flow.

Of those positions that detracted, we sold our shares of Signet Jewelers in June before reinitiating a position in November. The company, which operates the Jared, Kay, and Zales chains, was hurt earlier in the year by financing concerns that were followed by allegations of precious stone-swapping by its employees. Jones Lang LaSalle, which provides real estate brokerage and property management services, continues to execute well. However, a deceleration in commercial real estate transaction volumes and a material reset in capital markets fee streams caused an adjustment to certain fundamentals. We reduced our position during the year.

Relative to the Russell 2000, the Fund was hurt most by its underweight in banks and poor stock selection in capital markets, both of which led Financials to lag considerably. Stock selection challenges also had a meaningful impact in the aforementioned real estate management & development group. In addition, the Fund's large cash position affected relative results. Conversely, stock selection was a relative strength in Consumer Discretionary, thanks in large part to LCI Industries and Standard Motor Products. We also benefited from having limited exposure to Health Care, which was the only Russell 2000 sector to decline in 2016.

Top Contributors to Performance
For 2016 (%)1

Thor Industries 1.69
Minerals Technologies 1.43
LCI Industries 1.30
Copart 1.17
Standard Motor Products 1.04
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Signet Jewelers -0.67
Jones Lang LaSelle -0.47
Kennedy Wilson Europe Real Estate -0.43
Anixter International -0.35
Kennedy-Wilson Holdings -0.29
2 Net of dividends

Current Positioning and Outlook

The politically driven fourth quarter of 2016 notwithstanding, we continue to anticipate lower returns, higher volatility, and lower correlation levels. Evidence is building that a normalization in the markets is taking place, which should make them far more discriminating. For these reasons, we believe our bottom-up, quality-oriented process has the potential to do well.

During 2016 we continued to reduce the number of names in the portfolio while raising cash, particularly in the fourth quarter, by selling holdings that had exceeded their reward targets. Portfolio positioning has otherwise remained largely intact. 

Average Annual Total Returns Through 12/31/16 (%)

Heritage 4.85 17.84 2.88 9.41 5.91 11.72 12.35 12/27/95
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 8.65 N/A
Annual Operating Expenses: 1.37

*Not Annualized

Important Performance and Expense Information

All performance information 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 Operating expenses reflect the Fund’s 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.

Current month-end performance may be obtained at our Prices and Performance page.

Important Performance and Disclosure Information

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, 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 December 31, 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. 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.

As of 12/31/16, Thor Industries was 2.8% of the Fund's net assets, Minerals Technologies was 1.8%, LCI Industries was 1.7%, Copart was 2.8%, Standard Motor Products was 2.5%, Signet Jewelers was 1.4%, Jones Lang LaSalle was 1.5%, Kennedy Wilson Europe Real Estate was 1.1%, Anixter International was 0.0%, and Kennedy-Wilson Holdings 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. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" 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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