Royce Smaller-Companies Growth Fund Manager Commentary
article 12-31-2016

Royce Smaller-Companies Growth Fund Manager Commentary

Portfolio Manager Chip Skinner continues to seek companies that look poised for multi-year periods of robust growth driven by sustainable competitive advantages and/or benefiting from secular growth themes that create favorable conditions for the business. After a summer of cautious investing, he was encouraged by the wave of optimism ushered in by the election.

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Royce Smaller-Companies Growth Fund gained 9.4% in 2016, trailing its small-cap benchmark, the Russell 2000 Index, which was up 21.3% for the same period. Underperformance in 2016 was not entirely surprising in the context of the Fund having outpaced the small-cap index in a very difficult 2015, the marked shift in leadership from growth to small-cap value in 2016, and the Fund's growth-at-a-reasonable price approach, which emphasizes companies with superior revenue and/or earnings growth selling at prices that Royce believes do not fully reflect their prospects.

During the year's first half, the Fund was down 3.5% compared to a gain of 2.2% for the small-cap index as the sharp corrections for biotechnology and other growth industries where the Fund typically invests affected small-caps earlier in the year. The second half of the year saw improvement on an absolute basis, though not enough to push it past its benchmark.

During the second half of 2016, the Fund increased 13.3% versus 18.7% for the small-cap index. Longer-term relative results were a bit better as Smaller-Companies Growth outperformed the Russell 2000 for the 15-year and since inception (6/14/01) periods ended December 31, 2016. The Fund's average annual total return since inception was 11.0%.

What Worked... And What Didn't

Eight of the Fund's 10 equity sectors made contributions to 2016 results, with Energy and Industrials making the largest positive impact. Consumer Staples detracted most while Health Care—the only Russell 2000 sector to finish the year in the red after leading in 2015—had a modest negative impact.

Three industries had a significant positive effect—electronic equipment, instruments & components (Information Technology), health care providers & services (Health Care), and energy equipment & services (Energy) while the leading detractors were biotechnology (Health Care), software (Information Technology), and pharmaceuticals (Health Care).

We continue to seek companies that look poised for multi-year periods of robust growth driven by sustainable competitive advantages and/or benefiting from secular growth themes that create favorable conditions for the business. After a summer of cautious investing, we were encouraged by the wave of optimism ushered in by the election.

Long-time Royce favorite Unit Corporation topped the list of contributors by position. The company operates as a contract driller and exploration & production company while also offering energy-related services. Its stock suffered mightily through much of the recent bear market for oil prices, though it continued to execute effectively in one of the worst periods for energy companies in the last 30 years. Better-than-expected results in a now-resurgent industry helped to bring investors back to its stock in 2016.

BioTelemetry is a wireless medical technology company that provides cardiac monitoring services and equipment for cardiac monitoring devices. Its organic growth hit some bumps late in 2015 that our analysis suggested would be temporary. We were proved correct when margin expansion and improvements to its top-line growth aided its stock’s recovery in 2016.

The Container Store Group posted the largest net loss at the position level in 2016. We were once confident that the company, a retailer of storage and organizational products, could benefit from its store expansion efforts in an economy with improving employment numbers, confident consumers, low energy prices, and higher levels of new household formation. We sold our position, however, when it became clear to us that management was struggling to make good on this potential in the face of weakening store traffic and the need for a more effective online presence.

Top-10 holding Zealand Pharma is a Danish biopharma firm whose share price decline was mostly driven by the sell-off in its industry. We remain optimistic about its long-term growth potential, based in part on the company's partnership with Sanofi in developing a diabetes drug (which went on the market in January 2017). After trimming our position earlier in the year, we began buying shares in the fourth quarter as its slipping stock made its valuation look attractively low. We had a different take on Lipocine, which we sold off in the first half. An early stage pharmaceuticals company, its shares declined precipitously after it failed to receive FDA approval for its lead product candidate, an oral testosterone replacement therapy.

Relative to the Russell 2000, the Fund was hurt most by stock selection in Information Technology, most notably in the software and electronic equipment, instruments & components industries. Stock selection was also an issue in Consumer Staples, Financials, and Industrials. However, successful stock picking created a relative advantage in Health Care, especially in health care providers & services. The Fund's overweight and stock selection were also relative strengths in Energy.


Top Contributors to Performance
For 2016 (%)1

Unit Corporation 1.24
Bio Corporation 1.22
Mercury Systems 1.02
iRobot Corporation 0.91
Inogen 0.89
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Container Store Group (The) -1.07
Zealand Pharma -0.89
Lipocine -0.85
Rubicon Project -0.78
SPS Commerce -0.77
2 Net of dividends

Current Positioning and Outlook

We continue to seek companies that look poised for multi-year periods of robust growth driven by sustainable competitive advantages and/or benefiting from secular growth themes that create favorable conditions for the business. After a summer of cautious investing, we were encouraged by the wave of optimism ushered in by the election.

Policies regarding corporate tax rates, regulation, and healthcare could shift in ways that could meaningfully boost GDP growth. So while the last year saw tough times for our "GARP" approach, we see ample opportunity. There are four themes about which we were especially confident at year-end: companies involved in infrastructure and defense spending, cloud storage solution businesses, healthcare innovators (with a particular focus on device and drug discovery companies), and automation, robotics, and industrial technology stocks.

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

  QTR 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Smaller-Companies Growth 7.36 9.37 3.71 11.25 4.68 N/A 11.04 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 www.roycefunds.com. 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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investment in mutual funds, hedge funds, private equity funds, and other investment companies.

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, Unit Corporation was 1.3% of the Fund's net assets, BioTelemtry was 1.5%, Mercury Systems was 1.2%, iRobot Corporation was 1.2%, Inogen was 1.1%, The Container Store Group was 0.0%, Zealand Pharma was 1.7%, Lipocine was 0.0%, Rubicon Project was 0.0%, and SPS Commerce was 0.0%.

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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