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

Royce Small-Cap Value Fund Manager Commentary

Portfolio Manager Jay Kaplan expects interesting buying opportunities to materialize when some of the current widespread optimism dissipates, and he is prepared to wait. If there is a correction, he plans to act opportunistically, consistent with what he has always done when the market trends down.


Fund Performance

Royce Small-Cap Value Fund advanced 21.1% in 2016, very narrowly trailing its small-cap benchmark, the Russell 2000 Index, which was up 21.3% for the same period. While we were satisfied with the Fund's absolute showing, relative results were disappointing, even by such a razor-thin margin. We were, however, pleased to see the Fund's contrarian approach do better than the benchmark in both the bearish first quarter and the down month of October.

We were also happy to see value recapture leadership from growth in 2016 and cyclical stocks beat their defensive counterparts in 2016, both of which could bode well for the Fund and active small-cap management.

The Fund gained 3.3% in the first half of 2016, ahead of the 2.2% increase for the Russell 2000 during the same period. The Fund trailed its benchmark in the third quarter, up 4.2% versus 9.0%. This period wound up sealing the Fund's slight relative disadvantage for the year. During the fourth quarter, the Fund outpaced the small-cap index, up 12.4% compared to 8.8% for the Russell 2000. Looking at longer-term periods, the Fund outpaced its benchmark for the 15-year, and since inception (6/14/01) periods ended December 31, 2016. Small-Cap Value's average annual total return since inception was 9.9%.

What Worked... And What Didn't

Net gains came from six of the portfolio’s nine equity sectors in 2016. Three— Financials, Industrials, and Information Technology— made outsized contributions to 2016's results while Health Care and Materials each had a small net loss and Utilities was basically flat. The top-contributing industries were electronic equipment, instruments & components (Information Technology), and two from Financials, banks and thrifts & mortgage finance. The specialty retail group (Consumer Discretionary) detracted most by a wide margin, followed by multiline retail (also from Consumer Discretionary) and a modest net loss for chemicals (Materials).

Saia provides less-than-truckload (relatively small freight) services throughout the U.S.. Coming into 2016, the firm had many underpriced routes and was moving to eliminate those that did not make economic sense. Operating results improved more or less steadily throughout 2016 as its industry recovered, and we began to trim our stake as its shares climbed.

We expect interesting buying opportunities to materialize when some of the current widespread optimism dissipates, and we are prepared to wait. If we do get a correction, we plan to act opportunistically, consistent with what we have always done when the market trends down.

TrustCo Bank Corp. NY operates what we think is a terrific home mortgage business and also boasts an attractive yield. The steepening yield curve and rising interest rates spurred its shares in 2016. We reduced our stake in the second half of the year, though it was the Fund's eleventh-largest holding at the end of December. Top-10 position Reinsurance Group of America has a long history of successful execution. Now in the hands of newer executive management, the company handled the transition smoothly. The firm has substantial excess capital, and its stock seemed to benefit from the positive impact rising rates should have on its interest income as well as its solid business.

Apparel retailer Express detracted most at the position level and sat high atop of a list of struggling retailers in the portfolio. We sold the last of our shares in August based on what we thought was an extended period of poor execution. We chose to hold our shares of The Buckle, an apparel retailer that remains profitable and in our view well-managed even as its business has had to cope with declining mall traffic and pinched margins, the latter caused by a shift to lower price points for its merchandise.

Fitbit, makers of the wrist device that tracks health data, saw its shares fall thanks to slow growth, some analyst downgrades, and manufacturing problems for one of its two new products. Although we like its cash-rich balance sheet, we sold our shares early in 2017.

Relative performance was hurt in 2016 primarily by poor stock selection in Consumer Discretionary, though our overweight in the sector was also a factor. The specialty and multiline retail industries were the primary trouble spots. An underweight in Materials also detracted from relative results, as did ineffective stock picks in Energy and our cash position. Finally, the Fund's cash position also affected relative results.

Helping performance versus the benchmark was an underweight in Health Care, the only Russell 2000 sector to finish 2016 with a loss. In addition, stock selection gave the portfolio a sizable relative advantage in Information Technology and was also a factor in Consumer Staples and Financials, albeit to a lesser extent. In Industrials, the Fund was helped mostly by our overweight in the sector, though stock picks contributed to relative results as well.

Top Contributors to Performance
For 2016(%)1

Saia 1.63
TrustCo Bank Corp. NY 1.19
Reinsurance Group of America 1.15
Fabrinet 1.12
Spirit Airlines 1.10
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Express -1.12
Buckle (The) -0.61
Fitbit Cl. A -0.58
Dillard's Cl. A -0.41
2 Net of dividends

Current Positioning and Outlook

As 2016 drew to a close, we were working to high-grade the portfolio. While many holdings looked pretty richly priced, we have generally been hanging on to those that show high quality and strong fundamentals. We have also been selling or significantly trimming those that looked even more richly priced or have more business risk than we are willing to live with at their current valuation.

Given our contrarian approach, it has been hard to find exciting new ideas because most of the cheap stocks we have been investigating have turned out to be priced that way for very good reasons—they look like classic value traps. Patience is therefore key right now. We expect interesting buying opportunities to materialize when some of the current widespread optimism dissipates, and we are prepared to wait. If we do get a correction, we will act opportunistically, consistent with what we have always done when the market trends down.

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

Small-Cap Value 12.40 21.06 2.32 8.44 5.54 N/A 9.87 06/14/01
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 8.13 N/A
Annual Operating Expenses: 1.48

* 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 Operating expenses reflect the Fund’s total annual operating expenses for the Service Class as of the Fund’s most current prospectus and include management fees, 12b-1 distribution and service fees, and other expenses.

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 1.1% of the Fund's net assets, TrustCo Bank Corp. NY was 2.6%, Reinsurance Group of America was 2.7%, Fabrinet was 0.0%, Spirit Airlines was 3.0%, Express was 0.0%, The Buckle was 1.9%, Fitbit Cl. A was 0.6%, Dillard's Cl. A was 0.0%, and STRATTEC SECURITY was 0.8%.

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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