Royce Small-Cap Leaders Fund Manager Commentary
article 02-12-2018

Royce Small-Cap Leaders Fund Manager Commentary

While investors showed a greater preference for growth stocks in 2017, there was good news for cyclicals in the fourth quarter.


Fund Performance

Outperformance by for small-cap growth stocks created some challenges in 2017 for the valuation-sensitive, quality-centric strategy we use in Royce Small-Cap Leaders Fund. The Fund gained 10.1% in 2017, trailing its small-cap benchmark, the Russell 2000 Index, which was up 14.6% for the same period.

Investors showed a greater preference for growth stocks and companies without earnings in 2017. There was, however, one potentially important reversal that occurred in the fourth quarter: small-cap cyclicals enjoyed higher returns than defensive stocks. This helped the Fund to outperform the Russell 2000 for the quarter, up 4.4% versus 3.3%.

What Worked… and What Didn’t

Led by an impressive positive contribution from Financials, six of the portfolio’s nine equity sectors finished 2017 in the black, with Industrials also making a notable impact. Energy—the only Russell 2000 sector with a negative return in 2017—and Consumer Discretionary detracted modestly while Materials was basically flat.

At the industry level, capital markets, from the Financials sector, led by a wide margin, followed by machinery (Industrials) and semiconductors & semiconductor equipment (Information Technology). The impact of industries that detracted was comparably minor, with the largest net losses coming from specialty retail (Consumer Discretionary) and energy equipment & services (Energy).

Relative to the Russell 2000, the Fund was hurt most by its significant underweight in Health Care, the top-performing small-cap sector in 2017. The disadvantage came mostly from very low exposure to biotechnology, which rebounded strongly after correcting in 2017. Ineffective stock selection hampered results in Consumer Discretionary, particularly in the aforementioned specialty retail group, as well as in Industrials and Information Technology.

Conversely, savvy stock picking gave the portfolio a sizable relative edge in Financials, much of it coming from holdings in the previously mentioned capital markets group as well as thrifts & mortgage finance companies. Our underweight in struggling bank stocks was another source of outperformance in the sector. Stock selection was also additive in Consumer Staples, while in Real Estate we benefited from a combination of a strong year for top-10 holding Marcus & Millichap, which provides sales, financing, research, and advisory services in the commercial real estate industry, as well as our low weighting in the sector.

Another top-10 position, residential mortgage insurance specialist Genworth MI Canada, was the portfolio’s top contributor. The firm saw below-average insured mortgage loss ratios thanks to stronger oil prices, which led to improved employment and economic growth in energy-driven provinces such as Alberta. Its business also benefited from premium rate increases that offset slower overall market growth due to the higher capital requirements that Canada implemented early in 2017.

Artisan Partners Asset Management is another top-10 holding. It led the capital markets group, boosted by strong equity markets, improved performance for key funds, and promising early inflows for the firm’s newer, more differentiated portfolios. All of this seemed to inspire confidence that the company would return to net inflows if these trends can be sustained.

Celestica, the Fund’s top detractor at the position level, is another Canadian business. The company manufactures electronic components and has been making strides toward its higher-margin advanced technology solutions segment, which accounts for about one third of its sales, but not at a fast enough clip to offset sluggish near-term trends in its core communications and enterprise business.

Additionally, spending in advance of revenue from new programs wins pressured profit margins. We began to rebuild our position in September. Steelcase suffered from choppy demand in its North American business, which exacerbated the headwind of an ongoing shift to open plan office furniture solutions at the expense of layouts geared toward Steelcase’s office and cubicle offerings. While the company has aggressively ramped up new products to meet the trend, they are just now reaching scale where their growth offsets legacy sale declines.

Ongoing unprofitability in Europe, caused by temporarily elevated spending and uneven revenues, has further pushed out the unlocking of this earnings power. We reduced our stake in 2017.

Top Contributors to Performance 20171 (%)

Genworth MI Canada1.33
Artisan Partners Asset Management Cl. A1.14
Houlihan Lokey Cl. A0.92
Lazard Cl. A0.72

1 Includes dividends

Top Detractors from Performance 20172 (%)

Steelcase Cl. A-0.59
CIRCOR International-0.51

2 Net of dividends

Current Positioning and Outlook

It remains an open question, of course, if the Fund’s strength toward the end of 2017 marked a temporary shift or if it established a more discerning environment for quality. We think the latter is more likely. In fact, we still believe that growth’s dominance in 2017 was a pause in the long overdue reversion to the mean of small-cap value and quality outperformance that began in 2016. Not only will fiscal (rather than monetary) policy increasingly be the likely top-down focus of investors, but the growing global economy should also reward small-cap cyclicals, as previous accelerations have done.

Finally, while second-half—and especially fourth-quarter—performance for many holdings was highly encouraging, several of our more cyclical companies remain more attractively valued after having lagged through the first three quarters of 2017 despite continuing to post in-line financial results and guidance.

Average Annual Total Returns Through 12/31/17 (%)

Small-Cap Leaders 4.3610.1510.156.558.906.899.73 06/30/03

Annual Operating Expenses: Gross 1.59 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 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. 

All performance and risk information presented in this material prior to the commencement date of Investment Class shares on 3/15/07 reflects Service Class results. Service Class shares bear an annual distribution expense that is not borne by Investment Class shares.

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, 2017, 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, 2017 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 12/31/17, the percentage of Fund assets was as follows: Marcus & Millichap was 3.1%, Genworth MI Canada was 2.9%, Artisan Partners Asset Management Cl. A was 2.9%, Celestica was 2.0%, CIRCOR International was 2.0%, Lazard Cl. A was 2.0%, Houlihan Lokey Cl. A was 1.9%, Kadant was 1.3%, Steelcase Cl. A was 0.7%, Xperi was 0.0%, Genesco was 0.0%.

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 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 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 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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