Royce Pennsylvania Mutual Fund Manager Commentary
article 02-14-2019

Royce Pennsylvania Mutual Fund Manager Commentary

Our flagship portfolio not only beat its small-cap benchmark for the third consecutive year, but it also held its long-term advantages against the Russell 2000 Index.


Fund Performance

In a difficult market, our flagship Royce Pennsylvania Mutual Fund managed to stay ahead of its small-cap benchmark for the third consecutive year, which helped it to outperform the Russell 2000 Index for the one-, three-, 15-, 20-, 25-, 30-, 35-, and 40-year periods ended December 31, 2018. The Fund lost 9.7% in 2018, losing less than the Russell 2000, which declined 11.0% for the same period. We believe that the portfolio’s multi-discipline approach, which integrates quality and value, helped it to preserve capital, especially in 2018’s calamitous fourth quarter, as the Fund has done during most declines over its long history.

What Worked… And What Didn’t

Nine of the Fund’s 11 equity sectors declined in 2018. Industrials detracted most by a sizable margin, followed by Financials and Information Technology. Health Care made a notable positive contribution, followed by a far more modest impact from Consumer Staples.

The six industry groups with the most significant net losses for the Fund came from five different sectors, which gives a sense of how broad declines were for small-caps in 2018. By sizable margins, the machinery group was both the biggest detractor and our heaviest weighting in Industrials at year-end. Fourth-quarter difficulties for two machinery stocks— Sun Hydraulics (which does business as Helios Technologies) and CIRCOR International—had sizable negative impacts on performance. Sun Hydraulics manufactures hydraulic and electronic controls systems for a variety of industrial and recreational equipment makers. The company continued to book solid incoming orders, but labor and materials cost pressures, as well as a series of operational miscues stemming from a rush to meet growing demand, brought margins and earnings below expectations. CIRCOR makes valves for fluid control systems. Its shares fell precipitously in the fourth quarter amid concerns that slowing global growth, U.S.-China trade tensions, and the significant drop in oil prices—energy companies being among its larger end markets—would put a damper on CIRCOR’s positive order trends, pushing out a long-awaited improvement in profit margins and free cash flow earmarked for debt reduction. We held shares in each company at year-end, confident in their respective abilities to recover.

Capital markets (Financials) followed at the industry level as the bulk of the Fund’s holdings in traditional asset managers suffered the steep declines that often afflict these businesses in down markets. Next came Information Technology’s semiconductors & semiconductor equipment group, where most stocks fell on warnings of a more prolonged industry slowdown than had been initially anticipated, and energy equipment & services, where slumping oil prices resulted in Energy suffering by far the steepest losses of any sector in the Russell 2000 for the calendar year. Generally confident in the long-term prospects for our holdings in all three areas, we were overweight in each at the end of 2018.

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Health care equipment & supplies and health care providers & services (Health Care) contributed most at the industry level. The portfolio’s two top-contributing positions, however, hailed from Information Technology’s electronic equipment, instruments & components group—Electro Scientific Industries, which was acquired by MKS Instruments at a 100% premium, and Fabrinet, a contract manufacturer that offers specialized products and services to original equipment manufacturers in the technology space. The merger of two large customers appeared to drive investors away in 2017 over concerns that the consolidation would contract Fabrinet’s business. The company then went ahead and executed successfully, and profitably, in 2018, which led its stock to recover.

The Fund’s outperformance in 2018 was the result of superior stock selection as sector allocation made a minor negative impact. Health Care was strongest, helped both by our underweight in the lagging biotechnology and pharmaceuticals industries as well as strong stock selection in health care providers & services. Also contributing to relative results was savvy stock picking in Energy, particularly in energy equipment & services. Conversely, our overweight in Industrials was the largest source of underperformance (though stock selection was additive in the sector). Our very low exposure to Utilities also hurt as did stock selection in Communication Services (where our underweight also hurt slightly).

Top Contributors to Performance 20181 (%)

Electro Scientific Industries0.40
U.S. Physical Therapy0.33
America's Car-Mart0.26
Inter Parfums0.25

1 Includes dividends

Top Detractors from Performance 20182 (%)

Sun Hydraulics-0.96
CIRCOR International-0.52
Valmont Industries-0.33
Air Lease Cl. A-0.32

2 Net of dividends

Current Positioning And Outlook

While we acknowledge the many potential sources of risk on the horizon—economic, geopolitical, and financial—we also think that these concerns have already been reflected, perhaps even excessively so, in current valuations. In relatively short order, we transitioned from a period this summer when small-cap’s extended valuations seemed out of sync given the index’s high levels of debt and low profitability, to one at the end of the year where valuations seemed more pessimistic than we think is warranted—at least in select instances. As a result, we reduced the Fund’s cash holdings to a minimal amount by year-end. Down years for small-caps have often been followed by strong ones. We believe that the portfolio’s cyclical tilt will be rewarded as recessionary concerns dissipate during the year.

Average Annual Total Returns Through 12/31/18 (%)

QTR1 YTD1 1YR 3YR 5YR 10YR 15YR 20YR 30YR 45YR
Pennsylvania Mutual -18.35-9.66-9.66 9.92 3.15 11.34 7.71 9.15 10.02 13.20
Russell 2000 -20.20-11.01-11.01 7.36 4.41 11.97 7.50 7.40 9.21 N/A

Annual Operating Expenses: 0.92

1 Not annualized.

Important Performance and Disclosure Information

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 and other expenses.

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

Notes to Performance and Other Important Information

The thoughts expressed in this report concerning recent market movements and future prospects for small company stocks are solely the opinion of Royce at December 31, 2018, 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, 2018 and are subject to change at any time without notice. There can be no assurance that securities mentioned in this report will be included in any Royce-managed portfolio in the future.

As of 12/31/18, the percentage of Fund assets was as follows: Electro Scientific Industries was 0.3%, Fabrinet was 0.5%, U.S. Physical Therapy was 0.9%, America's Car-Mart was 0.5%, Inter Parfums was 0.8%, Sun Hydraulics was 1.3%, CIRCOR International was 0.5%, comScore was 0.5%, Valmont Industries was 0.9%, Air Lease Cl. A was 0.9%

Sector weightings are determined using the Global Industry Classification Standard (“GICS”). GICS was developed by, and is the exclusive property of, Standard & Poor’s Financial Services LLC (“S&P”) and MSCI Inc. (“MSCI”). GICS is the trademark of S&P and MSCI. “Global Industry Classification Standard (GICS)” and “GICS Direct” are service marks of S&P and MSCI. 

All indexes referred to are unmanaged and capitalization weighted. Each index’s returns include net reinvested dividends and/or interest income. Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 Index is an 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 Russell 2000 Value and Growth Indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 1000 Index is an index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index. The Russell Microcap Index includes 1,000 of the smallest securities in the Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It includes approximately 800 of the smallest securities in the Russell 1000 Index. The Russell Global ex-U.S. Small Cap Index is an index of global small-cap stocks, excluding the United States. The Russell Global ex-U.S. Large Cap Index is an index of global large-cap stocks, excluding the United States. The Russell 2500 is an unmanaged, capitalization-weighted index of the 2,500 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. Returns for the market indexes used in this report were based on information supplied to Royce by Russell Investments. Royce has not independently verified the above described information.

This material contains forward-looking statements within the meaning of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve risks and uncertainties, including, among others, statements as to: 

-the Funds’ future operating results,

-the prospects of the Funds’ portfolio companies,

-the impact of investments that the Funds have made or may make, the dependence of the Funds’ future success on the general economy and its impact on the companies and industries in which the Funds invest, and

-the ability of the Funds’ portfolio companies to achieve their objectives.

This discussion uses words such as “anticipates,” “believes,” “expects,” “future,” “intends,” and similar expressions to identify forward-looking statements. Actual results may differ materially from those projected in the forward-looking statements for any reason.

The Royce Funds have based the forward-looking statements included in this commentary on information available to us on the date of the commentary, and we assume no obligation to update any such forward-looking statements. Although The Royce Funds undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events, or otherwise, you are advised to consult any additional disclosures that we may make through future shareholder communications or reports.

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.)



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