Royce Small-Cap Leaders Fund Manager Commentary
article 12-31-2016

Royce Small-Cap Leaders Fund Manager Commentary

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


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.

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.

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.

Top Contributors to Performance
For 2016 (%)1

Saia 1.87
Mentor Graphics 1.60
Minerals Technologies 1.54
Genworth MI Canada 1.25
Thor Industries 1.24
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Buckle (The) -0.67
TrueBlue -0.61
Artisan Partners Asset Management Cl. A -0.55
Zealand Pharma -0.39
Federal Signal  -0.39
2 Net of dividends

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 (%)

Small-Cap Leaders 11.67 25.51 2.04 9.17 6.62 N/A 9.70 06/30/03
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 10.00 N/A
Annual Operating Expenses: Gross 1.54 Net 1.49

*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 Gross operating expenses reflect the Fund’s gross total annual operating expenses for the Service Class 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 to waive fees and/or reimburse operating 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, 2017.

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, Saia was 0.7% of the Fund's net assets, Mentor Graphics was 0.4%, Minerals Technologies was 2.3%, Genworth MI Canada was 3.0%, Thor Industries was 1.3%, The Buckle was 1.6%, TrueBlue was 0.6%, Artisan Partners Asset Management was 2.2%, Zealand Pharma was 0.5%, and Federal Signal was 0.6%.

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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