Royce Opportunity Fund Manager Commentary
article 12-31-2016

Royce Opportunity Fund Manager Commentary

Lead Portfolio Manager Buzz Zaino and Portfolio Manager Bill Hench have focused the portfolio on areas such as non-residential construction, industrial stocks, and technology companies. They are emphasizing turnaround situations that they think are most likely to benefit from a stronger economy.


Fund Performance

Royce Opportunity Fund gained 29.9% in 2016, well ahead of its small-cap benchmark, the Russell 2000 Index, which was up 21.3% for the same period. This was largely due to the fact that 2016 was particularly favorable to the kind of inexpensive small-cap stocks that we focus on, as measured by our primary metrics, companies with low P/B (price-to-book) and P/S (price to sales) ratios. Effective stock selection, of course, also played a significant role.

The Fund outperformed the Russell 2000 in 2016's first half, advancing 3.2% versus 2.2% for the benchmark. The third quarter saw a rebound for many growth stocks as well as inexpensive companies. Opportunity handily outpaced the Russell 2000 for the quarter, up 13.1% versus 9.0%. The Fund then gained 11.2% in the fourth quarter while the benchmark gained 8.8%.

We were pleased to see the Fund participate so fully in a period that saw value retake leadership from growth and cyclical stocks outpace defensive areas.

We were also happy with Opportunity's longer-term relative advantages. The Fund beat the Russell 2000 for the one-, 15-, 20-year, and since inception (11/19/96) periods ended December 31, 2016. (The Fund was essentially equal for the five-year period and trailed the benchmark's 10-year return by only three basis points). Opportunity's average annual total return since inception was 12.3%. We are very pleased with the Fund's long-term performance record on both an absolute and relative basis.

What Worked... And What Didn't

Nine of the portfolio's 11 equity sectors contributed to 2016's performance. Information Technology led by a sizable margin while meaningful contributions also came from Industrials, Materials, and Financials. Energy detracted modestly, Health Care even more so.

The top industries by contribution were semiconductors & semiconductor equipment, electronic equipment, instruments & components (both from Information Technology), and metals & mining (Materials). Those industries that detracted most—specialty retail (Consumer Discretionary), Internet software & services (Information Technology), and health care technology (Health Care)—had far less impact.

As is typically the case in a good year, most of the portfolio's successes in 2016 resulted from opportunities we pursued in 2015 or earlier, when valuations looked attractively low and the potential for earnings recovery was promising. As is always the case, we were prepared to wait for catalysts, usually in the form of earnings improvement, to take effect.

Kraton Corporation produces engineered polymers, styrenic block copolymers, and specialty products primarily derived from renewable sources. We first bought shares in 2013, gradually building our stake as its management engineered a turnaround. Profitability was stronger than many were anticipating in 2016, thanks in part to an acquisition of a private firm that enhanced earnings. Advanced Energy Industries makes power conversion products for semiconductors and has ample exposure to industry leaders in its growing end market, which helped to drive steady earnings increases throughout the year.

"We believe that the U.S. economy will continue to grow, and our industry focus has been on areas such as residential and non-residential construction, defense, and discrete consumer industries, where we think positive trends in employment and wage growth should ultimately prove rewarding for these companies."

The Fund's two biggest detractors struggled to execute turnarounds. Global IT consulting company CIBER divested from its stagnant European business, a move that did little to break a pattern of quarterly earnings misses, which led us to begin reducing our stake.

Monster Worldwide is a global online employment solutions company. Its shares first declined in February after it announced strong earnings on disappointing revenues. The company's inability to gain an edge in an increasingly competitive field made us dubious about its long-term prospects before it was bought by a larger competitor in August for less than what we had been paying for its shares earlier in the year.

We held a healthier view of the long-term potential for clinical software developer Allscripts Healthcare Solutions. Its earnings pattern tends to be choppy and a rumored acquisition failed to materialize, both of which hurt its stock. We think it can ultimately thrive in what we anticipate will be a growth industry.

The Fund enjoyed its most significant relative advantage in 2016 with Information Technology while our lower exposure to Health Care, which corrected through much of 2016, was also a strength. Both a larger weighting and skillful stock-picking gave us a significant edge in Materials and Industrials.

Relative detractors were less impactful and included an underweight in Financials, poor stock picking in Energy, a combination of a larger weighting and ineffective selections in Consumer Discretionary, and our cash position.

Top Contributors to Performance
For 2016 (%)1

Kraton Corporation 0.88
Advanced Energy Industries 0.77
MasTec 0.77
Commercial Metals 0.73
AK Steel Holding Corporation 0.71
1 Includes dividends

Top Detractors from Performance
For 2016(%)2

CIBER -0.51
Monster Worldwide -0.49
Allscripts Healthcare Solutions -0.43
Bankrate -0.35
Ascena Retail Group -0.34
2 Net of dividends

Current Positioning and Outlook

We anticipate headwinds to start 2017 and tailwinds in its second half. A list of the former would include higher interest rates and uncertainty around federal spending.

As for tailwinds, there is the momentum of business improvement since the election and pent-up demand from the inhibited environment of the six months prior to it. In addition, employment is strong, and consumer balance sheets are in better shape.

Finally, expansionary fiscal policy should ultimately be implemented at a reasonable pace assuming spending is restrained so as not to balloon the federal deficit. The performance of small-cap stocks depends on a growing economy and higher earnings.

We have focused the portfolio on areas such as non-residential construction, industrial stocks, and technology companies. We are emphasizing turnaround situations that we think are most likely to benefit from a stronger economy.

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

Opportunity 11.24 29.86 3.76 14.46 7.03 12.07 12.28 11/19/96
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 8.45 N/A
Annual Operating Expenses: 1.17%

* 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 Investment Class as of the Fund's most current prospectus and include management 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, Kraton Corporation was 0.5% of the Fund's net assets, Advanced Energy Industries was 0.5%, MasTec was 0.6%, Commercial Metals was 1.1%, AK Steel Holding Corporation was 0.0%, CIBER was 0.1%, Monster Worldwide was 0.0%, Allscripts Healthcare Solutions was 0.6%, Bankrate was 0.0%, and Ascena Retail Group was 0.3%.

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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