article 12-31-2016

Royce International Micro-Cap Fund Manager Commentary

Portfolio Managers Jim Harvey and Dilip Badlani continue to find attractive opportunities in international micro-cap companies as valuations in many parts of the world remain compelling to them.


Fund Performance

Royce International Micro-Cap Fund advanced 6.3% in 2016, outperforming its benchmark, the Russell Global ex-U.S. Small Cap Index, which was up 5.0% for the same period. We were pleased that this solid performance came in the context of sector results that were choppier than those of domestic micro-caps, with the benchmark's two cyclical, commodity-based sectors, Energy and Materials, doing best, followed by strong results for defensive Utilities. This stood in sharp contrast to the U.S. small- and micro-cap markets, in which cyclical leadership was more pronounced.

During the first half of the calendar year, the Fund gained 0.2% versus 1.0% for its benchmark. The second half was more of a tale of two quarters. The third quarter saw International Micro-Cap advance 9.2% versus 7.9% for the benchmark as many stocks rebounded following the Brexit vote.

During the fourth quarter, however, most international small- and micro-caps declined. The Fund fell 2.8% compared to a decline of 3.6% for the Russell Global ex-U.S. Small Cap. A lot of this was due to currency effects as the growing strength of the U.S. dollar affected holdings based in the U.K., where the British pound declined significantly in 2016.

What Worked... And What Didn't

Five of the portfolio's nine equity sectors made contributions to 2016 performance, led by Information Technology and Consumer Discretionary. Detractors made a far lower impact and were led by Energy (the best-performing sector in the benchmark) and Consumer Staples.

The leading industries by contribution were media (Consumer Discretionary), semiconductors & semiconductor equipment (Information Technology), and metals & mining (Materials). As with sectors, detracting industries had much less of an effect on results, with oil, gas & consumable fuels (Energy), commercial services & supplies, and building products (both from Industrials) the leaders.

We continue to find attractive opportunities in international microcap companies as valuations in many parts of the world remain compelling to us. With three times as many small- and micro-cap companies headquartered outside the U.S., we continue to see ample opportunity to uncover well-run, underfollowed micro-cap companies trading at attractive valuations.

The Fund's top contributor at the position level was Brazil’s T4F Entretenimento. The company operates at multiple levels of the entertainment industry, including venue operation, ticketing, food & beverage, merchandise sales, and corporate sponsorships. T4F participated in a strong rally that saw Brazilian small-caps rise approximately 60% in 2016. After a few difficult years in which profitability suffered from heightened competition, T4F increased its profits for the second consecutive year. We reduced our stake as its shares climbed.

Manappuram Finance, one of India's leading Non-Bank Financial Companies (NBFC), has been enjoying robust market conditions for its specialized lending focus which offers loans against gold collateral. A stable gold market coupled with healthy demand helped Manappuram to continue its mid-double-digit growth rate. We sold the last of our shares in October.

Imdex is an Australian company with a global business providing drilling fluids and leading downhole instrumentation to the mining, water well, and civil engineering industries. A summer earnings announcement showed stable profitability and offered a more favorable outlook boosted by the company shedding an unprofitable business segment. The combination helped to send shares soaring between June and year-end.

Turning to detractors, Banca Sistema is an Italian bank specializing in financing and managing trade receivables owed by the Italian Public Administrations. Despite its unique business model and attractive growth profile, it was initially caught up in the widespread downdraft for Italian banks, considered one of the more vulnerable areas of European finance in the aftermath of Brexit. However, the company continued to execute effectively and delivered strong earnings growth. We think that it is well positioned to take advantage of the large opportunity set in front of it.

We also held shares of Ardmore Shipping, which owns and operates shipping tankers, primarily for chemicals. With shipping index volumes bouncing along all-time lows during the first half of the year, its stock was not spared. However, the fact that it was trading at about half its book value or lower through most of the second half made it worth holding as we await a recovery for its industry. Zealand Pharma is a Danish biotechnology company whose share price decline was mostly driven by the sell-off in its industry. Seeing what we thought was better value elsewhere, we sold the last of our shares in May.

Companies headquartered in Canada and Australia had the largest positive impact on performance while those based in the U.K. and Italy detracted most. Relative to its benchmark, the Fund had significant stock selection advantages in Consumer Discretionary, especially in the media industry, and Information Technology. Conversely poor stock picks in oil, gas & consumable fuels hurt relative performance, as did our substantial underweight in the Materials sector.

Top Contributors to Performance
For 2016 (%)1

T4F Entretenimento 1.00
Manappuram Finance 0.89
Imdex 0.59
Morneau Shepell 0.56
I.T 0.46
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Banca Sistema -0.65
Ardmore Shipping -0.46
Zealand Pharma -0.45
GCA -0.37
Pendragon -0.34
2 Net of dividends

Current Positioning and Outlook

We continue to find attractive opportunities in international microcap companies as valuations in many parts of the world remain compelling to us. With three times as many small- and micro-cap companies headquartered outside the U.S., we continue to see ample opportunity to uncover well-run, underfollowed micro-cap companies trading at attractive valuations.

Of our four largest sectors at yearend—three were overweighted versus the benchmark, Information Technology, Industrials, and Consumer Discretionary.

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

International Micro-Cap -2.84 6.33 0.92 6.79 N/A N/A 1.45 12/31/10
Russell Glo x US SC -3.61 5.04 0.57 7.22 2.65 5.95 2.39 N/A
Annual Operating Expenses: Gross 3.11% Net 1.64

*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 2% 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 Gross operating expenses reflect the Fund's total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Fund's net annual operating expenses (excluding brokerage commissions, taxes, interest, litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business) at or below 1.64% through April 30, 2016 and at or below 1.99% through April 30, 2025. 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, T4F Entretenimento was 0.7% of the Fund's net assets, Manappuram Finance was 0.0%, Imdex was 0.4%, Morneau Shepell was 0.0%, I.T was 0.9%, Banca Sistema was 1.1%, Ardmore Shipping was 0.6%, Zealand Pharma was 0.0%, GCA was 0.4%, and Pendragon was 0.7%.

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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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