Royce Small-Cap Leaders Fund Manager Commentary
article 02-14-2019

Royce Small-Cap Leaders Fund Manager Commentary

Although the Fund underperformed its index, we were pleased that it held its value better than the Russell 2000 Index in the highly volatile fourth quarter.

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Fund Performance

Royce Small-Cap Leaders Fund was down 12.7% in 2018 compared to a decline of 11.0% for its small-cap benchmark, the Russell 2000 Index, for the same period. Underperformance resulted from the Fund trailing its benchmark through the first three quarters of the year, a bullish period of low volatility in which small-cap growth stocks beat small-cap value, and defensives outpaced cyclicals. We were pleased, then, to see the Fund hold its value better than its index in the fourth-quarter downturn, -18.3% versus -20.2%.

What Worked… And What Didn’t

Many companies in the industrial and technology areas were especially hard hit in the downturn, which resulted in certain highly profitable cyclical holdings performing better as companies in 2018 than they did as stocks. The potential of these companies to execute effectively in a slower but still growing U.S. economy, as well as the attractive valuations of these companies (even on a normalized earnings basis) failed to draw attention. Investors’ shorter-term focus seemed to give little credit to what we think are the true drivers of these companies’ long-run market worth—their ability to grow and compound value at above-average returns into the future. But in 2018 investors were more concerned with falling energy prices, inflation-driven margin compression, and recession anxieties. 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.


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Six of the Fund’s 10 equity sectors detracted from performance in 2018. With a negative impact more than three times as large as the second-worst performer at the sector level (Financials), Industrials had by far the biggest adverse effect on 2018’s results, accounting for more than 70% of the Fund’s loss. The four sectors that made positive contributions registered a collectively modest impact, led by Consumer Staples and Health Care.

Housed in Industrials, the machinery group detracted most. Nine of the portfolio’s 10 holdings in this industry detracted from 2018’s results, including three of its biggest at the position level. CIRCOR International makes valves for fluid control systems. Its shares fell 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. Sun Hydraulics (which does business as Helios Technologies) 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. Wabash National makes truck trailers and has seen robust orders since the second half of 2017. However, component shortages, raw materials cost increases, and self-inflicted operational issues all pressured margins, causing the company to post earnings well below expectations in such a vibrant demand environment.


Top Contributors to Performance 20181 (%)

Fabrinet1.17
Inter Parfums0.80
RLI Corp.0.38
Marcus & Millichap0.31
Heidrick & Struggles International0.31

1 Includes dividends

Top Detractors from Performance 20182 (%)

CIRCOR International-1.49
Artisan Partners Asset Management Cl. A-1.21
Sun Hydraulics-0.88
Wabash National-0.86
Advanced Energy Industries-0.69

2 Net of dividends

Contract manufacturer Fabrinet was the Fund’s top contributor in 2018, as optical equipment spending by telecommunications and datacenter customers reaccelerated, and its business development efforts continued to ride a tailwind. Additional strong demand from industrial laser customers in its non-optical business provided welcome diversification and the company remains focused on increasing that business from its current 35% of sales toward 50% over the long term. Fabrinet has also benefited from U.S.-China trade disputes as American optical component companies began to reconfigure their supply chains by shifting outsourced production from China to Fabrinet’s facilities in Thailand. Inter Parfums, which produces a wide array of fragrances and related products, saw strong new product introductions and brand extensions, as well as an uptick in European and Asian demand for its roster of prestige fragrances. These developments drove better-than-expected sales growth in 2018. With an active new product launch calendar in 2019, as well as the addition of brands first licensed in 2018, the company seems poised for sales growth to accelerate toward the mid-to-high single digit range and earnings-per-share growth in the low teens—should consumers respond well to its new offerings.

Relative to the Russell 2000 in 2018, our overweight and ineffective stock selection in Industrials hurt most by far, followed by stock picking mishaps in Information Technology. Conversely, savvy stock selection gave the Fund a relative edge in Energy and Consumer Staples while our cash holdings also helped relative performance.

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

QTR1 YTD1 1YR 3YR 5YR 10YR 15YR SINCE INCEPT. DATE
Small-Cap Leaders -18.30-12.72-12.726.460.429.157.688.12 06/30/03

Annual Operating Expenses: Gross 1.62 Net 1.49

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 www.roycefunds.com. Gross operating expenses for the Service Class reflect the Fund’s gross total 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, without right of termination, to waive fees and/or reimburse expenses to the extent necessary to maintain the Service Class'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 1.49% through April 30, 2019.

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: Fabrinet was 0.5%, Inter Parfums was 2.6%, RLI Corp. was 2.0%, Marcus & Millichap was 3.1%, Heidrick & Struggles International was 0.9%, CIRCOR International was 1.1%, Artisan Partners Asset Management Cl. A was 2.3%, Sun Hydraulics was 0.6%, Wabash National was 1.4%, Advanced Energy Industries was 1.6%


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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