article 12-31-2016

Royce International Premier Fund Manager Commentary

Lead Portfolio Manager David Nadel and Portfolio Manager Mark Rayner believe the narrow sector leadership within international small-cap during 2016 created potential opportunities that fueled their optimism. 


Fund Performance

Royce International Premier Fund declined 1.1% in 2016, trailing its benchmark, the Russell Global ex-U.S. Small Cap Index, which rose 5.0% for the same period. This was a disappointing result, though it was not entirely unexpected in light of the Fund’s performance in 2015 (+16.2%), which was stellar on both an absolute and relative basis. In contrast to their domestic cousins, investors in non-U.S. small-caps generally showed more favor to commodity-based international small-cap companies than they did to the kind of high-quality businesses we seek.

During the first half of 2016, International Premier was up 0.8% versus a 1.0% gain the non-U.S. small-cap index. The second half gave us a tale of two quarters. Both the Fund (+5.1%) and its benchmark (+7.9%) showed more life in the third quarter as many stocks bounced back or stabilized following Brexit-bred volatility.

During the fourth quarter, however, most international small-caps declined. The Fund fell 6.6% in the year’s final quarter compared to a 3.6% loss for the Russell Global ex-U.S. Small Cap. Much of this can be traced to currency effects. The rising U.S. dollar was particularly strong against the British pound, which declined significantly in the wake of the Brexit vote. We felt better about the Fund's longer-term results. International Premier outperformed its benchmark for the three-, five-year, and since inception (12/31/10) periods ended December 31, 2016.

What Worked... And What Didn't

Four of the portfolio's nine equity sectors finished 2016 in the red. Consumer Discretionary and Energy made the largest negative impact while the leading contributors were Information Technology and Financials. The leading detractors at the industry level were pharmaceuticals (Health Care), oil, gas & consumable fuels (Energy), and aerospace & defense (Industrials) while the top-contributing industries were health care providers & services (Health Care), electronic equipment, instruments & components (Information Technology), and consumer finance (Financials).

Many non-U.S. small-caps have also been trading at sizable discounts to international GDP while also offering generous dividend yields. In addition, a large gap can be seen not just in multiples, but also in margins—international equities trade at much lower multiples that are themselves based on lower profit margins.

The portfolio's top detractor at the position level was Virbac, a French firm that makes vaccines, antibiotics, and other veterinary medications. Its shares suffered mostly from the negative results of a 2014 FDA investigation of its U.S. plant in St. Louis that were released earlier this year. In December 2016, however, the FDA rescinded the warning letter, leaving the status of Virbac's U.S. operations where they were at the beginning of the year, which allowed its shares to begin to recover.

Gaztransport Et Technigaz is a French engineering company that specializes in cargo containment systems and land storage for liquefied natural gas carriers. Its shares looked less attractive when the Fair Trade Commission of South Korea—a major hub of its business—announced it would investigate whether or not the company was in violation of fair trade laws, which led us to sell our shares in the first quarter.

OdontoPrev made the largest positive impact at the position level. The company specializes in dental benefits and technology in Brazil, which has one of the largest dentistry markets in the world. Its business was aided by strong earnings and increased membership, as well as the recovery of Brazil's stock market and currency during the first half. During the summer, it was also helped by the view that a favorable regulatory ruling might free up cash flow to further increase the company’s already-generous dividend.

The stock of Swiss private equity business—and top-10 position—Partners Group Holding climbed through the year, boosted by ongoing growth in assets under management, which have grown each year since the firm's IPO in 2006. Partners Group Holding has garnered a strong track record in more opaque asset classes, which we think makes it very well positioned to continue growing.

Relative to the Russell Global ex-U.S. Small Cap, the Materials sector made the largest negative impact in large part due to our lack of exposure to metals & mining and poor stock picks in the sector's containers & packaging industry. Ineffective stock selection created a negative impact for commercial services & supplies (Industrials) while our very low weighting in Energy made that sector a detractor as well. On the positive side, relative results were helped most by successful stock selection in Information Technology. The portfolio derived more modest benefits from stock picking in the otherwise disappointing Health Care sector and its appreciably lower weighting in Consumer Discretionary. Based on geography, the portfolio's overweights in the U.K. and France created substantial relative performance drags.

Top Contributors to Performance
For 2016 (%)1

OdontoPrev 1.24
Partners Group Holding 0.74
LEM Holding 0.54
Meitec Corporation 0.52
Carl Zeiss Meditec 0.51
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Virbac  -0.74
Gaztransport Et Technigaz -0.68
Santan Pharmaceutical -0.65
Bajaj Finance -0.64
Senior -0.60
2 Net of dividends

Current Positioning and Outlook

The narrow sector leadership within international small-cap during 2016 (similar to what afflicted domestic small-caps in 2015) hurt performance but at the same time created potential opportunities, fueling our optimism. Some of these are among our highest-confidence selections in some time, as a number of these stocks entered 2017 near multi-year lows, especially when denominated in U.S. dollars.

Many non-U.S. small-caps have also been trading at sizable discounts to international GDP while also offering generous dividend yields. In addition, a large gap can be seen not just in multiples, but also in margins—international equities trade at much lower multiples that are themselves based on lower profit margins.

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

International Premier -6.59 -1.06 1.82 9.03 N/A N/A 4.24 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 2.35 Net 1.44

* 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 total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, and other 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 its 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 1.44% through April 30, 2017 and at or below 1.99% through April 30, 2026.

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, OdontoPrev was 2.3% of the Fund's net assets, Partners Group Holding was 0.0%, LEM Holding was 1.5%, Meitec Corporation was 3.1%, Carl Zeiss Meditec was 1.8%, Virbac was 2.4%, Gaztransport Et Technigaz was 0.0%, Santen Pharmaceutical was 2.5%, Bajaj Finance was 2.5%, and Senior 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. 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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