Royce Pennsylvania Mutual Fund Manager Commentary
article 12-31-2016

Royce Pennsylvania Mutual Fund Manager Commentary

Lead Portfolio Manager Chuck Royce, along with Portfolio Managers Jay Kaplan and Lauren Romeo, believe we are on the road back to a more historically normal market environment. They think this bodes well for small-cap stocks and active small-cap managers. 

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Fund Performance

Royce Pennsylvania Mutual Fund advanced 26.5% in 2016, outperforming its small-cap benchmark, the Russell 2000 Index, which was up 21.3% for the same period. In such a strong year for small-cap stocks, we were pleased with the Fund's terrific absolute and relative showing—it was the Fund's fourth-best return in the last 25 years.

Penn's diversified, multi-theme core approach served investors well during a year in which factors such as dividends, low valuation, liquidity, low volatility, and quality all outperformed within the Russell 2000. Calendar-year performance was even more gratifying in light of the questions both active management and value-oriented approaches were facing between 2011 and 2015, which made the year feel very much like a validation for our approach.

Keyed by a vigorous rally that began off the 2016 low on February 11th, the Fund outperformed the small-cap index during the first half of 2016, gaining 7.6% versus 2.2%. In the third quarter, small-cap stocks pulled ahead of large-caps, building an advantage that would last through the end of the year. During this period the Fund slipped behind the Russell 2000, up 6.5% versus 9.0% for the benchmark.

After a rocky start, the fourth quarter then experienced its own robust rally to close out the year, driven by the aftermath of the election. In the final quarter of 2016, the Fund gained 10.4%, outperforming the small-cap index, which was up 8.8% for the same period.

Looking at longer-term periods, we were pleased that Penn outpaced the Russell 2000 for the one-, 15-, 20-, 25-, 30-, and 35-year periods ended December 31, 2016. The Fund's average annual total return for the 40-year period ended December 31, 2016 was 13.2%, all under the management of Chuck Royce.

What Worked... And What Didn't

Ten of the portfolio's 11 equity sectors finished 2016 in the black; the eleventh, Utilities, was essentially flat. Industrials led by a considerable margin, followed by a strong contribution from Information Technology that more than doubled the positive impact of Materials, the Fund's third-highest contributor. Notable net gains also came from the Consumer Discretionary and Financials sectors. This widespread cyclical strength was consistent with trends in the overall small-cap market.

Within Industrials, the best-performing industries were machinery (our largest industry weighting in the sector), commercial services & supplies, and road & rail. The portfolio's top-performing industry, however, came from the Information Technology sector— electronic equipment, instruments & components, which was home to three of the Fund's top five contributing positions in 2016.

Coherent, which manufactures laser diodes and equipment, owned the top spot. Its shares skyrocketed in 2016, lifted by a combination of strong profits, a record backlog, and a robust order pipeline. Quaker Chemical provides process fluids, specialty chemicals, and technical expertise to a wide range of industries. Investors reacted favorably to earnings improvement, solid profits, and acquisitions in 2016, pushing its shares higher. LCI Industries (formerly Drew Industries) saw its stock accelerate in 2016 largely on the strength of the recreational vehicle market. The company supplies components for that industry, as well as for manufactured homes and related aftermarkets.

"In many cases, it appears that the market has just begun to reward steady earnings and high profitability and is only gradually recognizing how low valuations had become for many cyclicals. Going forward, we remain confident that earnings, profitability, and low leverage will matter more and more to investors through what we expect should be a long-running cycle."

Even in a good year there are a few disappointments. The stock of long-time holding The Advisory Board fell in the fall as this specialist in performance improvement software and solutions to the health care and higher education industries reported disappointing fiscal third-quarter revenues. We opted to sell our position in Liberty Tax, a tax preparation services company, back in May on the heels of another earnings disappointment. We also significantly reduced our position in MTS Systems into June. The company supplies test systems and industrial position sensors. Fiscal second quarter earnings disappointed, leading its shares down as the company faced challenges in converting its project backlog.

Relative results in 2016 were driven by our underweight in the lagging Health Care sector, an area that has looked highly valued to us for some time, as well as positive stock selection in the sector. Also aiding relative performance was savvy stock selection in Information Technology. The two largest relative detractors had a similar theme—our underweight in banks caused the Fund to lag in Financials and our underweighting in REITs led to underperformance in the Real Estate sector. The Fund is typically underweight in these interest rate sensitive areas.


Top Contributors to Performance
For 2016 (%)1

Coherent 0.88
Quaker Chemical 0.85
LCI Industries 0.82
DTS 0.76
Cognex Corporation 0.67
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

The Advisory Board -0.37
Liberty Tax Cl. A -0.31
MTS Systems -0.19
STRATTEC SECURITY -0.19
Stella-Jones -0.17
2 Net of dividends

Current Positioning and Outlook

We are grateful to have been able to deliver such strong absolute and relative results for our investors and firmly believe that we have turned the page on the anomalous 2011-2015 period, in which extraordinary monetary accommodations caused financial markets to behave in odd and unprecedented ways.

In our view, we are on the road back to a more historically normal market environment. We think this bodes well for small-cap stocks. In our view cyclicals look well-positioned for ongoing leadership.

In addition to our usual cyclical tilt, we are looking in some defensive areas such as healthcare. It is very much on a stock-by-stock basis, with a focus on individual companies that combine attractive valuations with strong fundamentals.

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

  QTR 1YR 3YR 5YR 10YR 20YR 40YR
Pennsylvania Mutual 10.38 26.47 3.61 11.50 6.45 10.33 13.19
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 N/A
Annual Operating Expenses: 0.93%

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 www.roycefunds.com. 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 it's investment 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.

As of 12/31/16, Coherent was 0.9% of the Fund's net assets, Quaker Chemical was 1.9%, LCI Industries was 1.1%, DTS was 0.0%, Cognex Corporation was 0.9%, The Advisory Board was 0.5%, Liberty Tax was 0.0%, MTS Systems was 0.2%, STRATTEC SECURITY was 0.4%, and Stella-Jones was 0.9%.

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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