Fund Performance

Royce Small-Cap Leaders Fund gained 25.5% in 2016, outperforming its small-cap benchmark, the Russell 2000 Index, which was up 21.3% for the same period. The Fund benefited from a series of key reversals in 2016, including positive returns for small-cap stocks, a leadership rotation back to value, and significantly improved results for many cyclical businesses.

Each contributed to strength for companies with positive earnings, better balance sheets, and higher profitability—the sort of companies that are our primary focus in the portfolio. Small-Cap Leaders outpaced its benchmark during the first half of 2016, up 6.0% versus 2.2% for the Russell 2000. When growth stocks rebounded in the third quarter, Small-Cap Leaders ceded a bit of ground, advancing 6.1% compared to 9.0% for the small-cap index. The Fund then rebounded soundly in the fourth quarter, up 11.7% versus 8.8% for the Russell 2000.

What Worked... And What Didn't

Each of the portfolio's nine equity sectors finished 2016 in the black. The two areas that made highly outsized contributions to 2016 performance, Information Technology and Industrials, were also our two largest at year-end. Additional solid contributions also came from Consumer Discretionary and Materials while Real Estate, in which we had a very low weighting, made only a modest contribution.

Two groups in Information Technology led at the industry level—semiconductors & semiconductor equipment and electronic equipment, instruments & components. They were followed by two from Industrials, machinery and road & rail. Net losses at the industry level were comparatively much less impactful, with biotechnology (Health Care), capital markets (Financials), and professional services (Industrials) detracting most.

The Fund's top-contributing holding was Saia, a less-than-truckload (relatively small freight) trucker. The company's decision to focus on profitable pricing rather than chasing volume at any cost allowed it to deliver strong performance despite a challenging trucking market in 2016. We reduced our stake as its price rose. Mentor Graphics designs and manufactures electronic design automation software. In November, Siemens agreed to buy it at a roughly 29% premium, which led us to begin selling our shares.

Minerals Technologies produces performance-enhancing minerals, mineral-based, and synthetic mineral products. Its stock appreciated through much of the year before spiking post-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. We see it as poised for accelerating earnings growth in a more vibrant economy and added shares in 2016.

Clothing retailer The Buckle was the Fund's top detractor in 2016. The company faced a difficult retail environment while also enduring its own misses on women’s fashion and its (ultimately positive) strategy of reducing price points, particularly in its all-important denim category. Its same-store-sales were negative. However, its trailing 12-month operating margin, while low for The Buckle historically, remains among the best in its industry. If reducing pricing and other actions reinvigorate sales growth, the earnings acceleration should be impressive.

TrueBlue's stock was bruised after this temporary labor provider lost a huge share of its business when Amazon, its largest customer, chose to bring all of its warehouse staffing in house. Temporary staffing growth also turned negative, even excluding the loss of Amazon. A strong fourth quarter erased a portion of the stock’s decline for the year. We held a small position at year-end.

Artisan Partners Asset Management suffered ongoing net outflows due to performance challenges in certain strategies and investors' concerns about the sustainability of its healthy annual dividend. Liking its potential to rebound in a market more conducive to active management, we bought shares through much of the year’s second half.

Outperformance in 2016 was driven by stock-selection strength in Information Technology and Industrials as well as by our significant underweight in the lagging Health Care sector. Conversely, the Fund's underweighting in banks and ineffective stock selection in capital markets led it to trail in Financials, making that sector the portfolio's leading relative detractor. The Fund's cash position also affected relative results as did poor stock selection and our underweight in Real Estate.

Current Positioning and Outlook

We continue to own companies with durable, high-ROIC business models trading at attractive valuations in pro-cyclical sectors, including Industrials (companies with significant operating leverage that should produce faster absolute and relative earnings growth when revenue growth picks up) and Consumer Discretionary (favorable employment trends, wage gains, and low energy prices are supportive of increased personal consumption expenditures). Within Financials, select asset managers and financial advisory firms have priced in a fair amount of negative expectations, though in the near term the stocks tend to rise and fall with capital market gyrations.

As 2016 marked the reversal of what had been a multi-year relative performance run for small-cap growth, defensives, and non-earners, a run for cyclicals, earners, and value in small-cap may have a way to go. Our high-quality company focus could continue to do well in this environment if this situation continues.

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

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

Important Performance and Disclosure Information