Royce Special Equity Fund Manager Commentary
article 02-14-2019

Royce Special Equity Fund Manager Commentary

Much of the Fund’s relative advantage in 2018 came during the fourth-quarter downturn, when it held its value significantly better than its benchmarks, down 9.8% versus respective losses of 20.2% and 18.7% for the small-cap and small-cap value indexes.


Fund Performance

Royce Special Equity Fund fell 9.9% in 2018, losing less than both of its small-cap benchmarks, Russell 2000 Index, which declined 11.0%, and the Russell 2000 Value, which fell 12.9%, for the same period. Much of the Fund’s calendar-year relative advantage was won during the fourth-quarter downturn, when it held its value significantly better than its benchmarks, down 9.8% versus respective losses of 20.2% and 18.7% for the small-cap and small-cap value indexes. This pattern of better downside protection helped for the three-year period ended December 31, 2018 as well—Special Equity’s average annual total return during that period was 8.7% versus 7.4% for the Russell 2000 and 7.4% for the Russell 2000 Value.

What Worked… And What Didn’t

For calendar 2018, six of the Fund’s eight equity sectors detracted from performance. Consumer Discretionary fared worst by a substantial margin, followed by Industrials. These were also the portfolio’s largest sectors at year-end as well as two of its biggest overweights. Consumer Staples and Real Estate managed small positive contributions for the year. Hurt by particularly poor showings for furniture manufacturers Hooker Furniture, Flexsteel Industries, and Bassett Furniture Industries, the household durables group (Consumer Discretionary) detracted most at the industry level. Specialty retail, also part of Consumer Discretionary, and electrical equipment (Industrials) followed. Apparel retailer The Children’s Place made most of the negative impact in specialty retail while electrical and electronic products maker Hubbell detracted most in electrical equipment. Motor home and recreational vehicle manufacturer Winnebago Industries also endured a difficult year. We held shares in all six companies at year-end.

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Food & staples retailing (Consumer Staples), diversified consumer services (Consumer Discretionary), and aerospace & defense (Industrials) made the largest positive contributions at the industry level in 2018. For-profit education company Capella Education led at the position level after news of a merger lifted its stock. Supermarket operator Weis Markets and diversified manufacturing company National Presto Industries followed as top contributors.

Relative to the Russell 2000 in 2018, outperformance resulted from sector allocation—stock selection actually (and unfortunately) detracted from calendar-year returns. The portfolio’s very limited exposure to Energy boosted relative results most, followed by a combination of savvy stock selection and (to a much smaller degree) our overweight in Consumer Staples. Both our underweight and successful stock picking were additive in Materials while stock selection lifted Industrials. The Fund’s cash position also benefited relative performance. Conversely, ineffective stock selection in Consumer Discretionary made by far the biggest negative impact, with the sector’s largest detractions coming from holdings in the aforementioned household durables and specialty retail industries. Our lack of exposure to software and poor stock picking in semiconductors & semiconductor equipment hindered relative performance in Information Technology while the same was true for our lack of exposure to Health Care and Utilities, where the first sector lost less than the Russell 2000 and the second came out of 2018 with a positive return.

Top Contributors to Performance 20181 (%)

Capella Education1.01
Weis Markets0.88
National Presto Industries0.69
Standard Motor Products0.45
Park Electrochemical0.27

1 Includes dividends

Top Detractors from Performance 20182 (%)

Children's Place-1.46
Hubbell Cl. B-1.30
Winnebago Industries-1.20
Hooker Furniture-1.14
Flexsteel Industries-0.96

2 Net of dividends

Current Positioning and Outlook

With multiple challenges facing the developed world’s economies, it’s still reasonable to believe that quality will be in greater demand in 2019, particularly after a transition from quantitative easing to quantitative tightening. According to Deutsche Bank Asset Management, 84% of the companies in the Russell 2000 with a credit rating are rated junk. In addition, unprofitable companies represented about 36% of the Russell 2000 but only 13% of the Russell 1000 at year-end, which likely means that small-cap companies will receive greater scrutiny regarding their sustainability and quality. We think this can inure to the benefit of the portfolio. Our careful selection practice and the requirement that a company have good financials and accountability should stand out in a more selective environment.

A number of negative issues have been weighing on the market, some of which could be viewed as magnifying the odds of a recession. However, as of this writing it is not yet evident that a recession will occur in the near term. Still, that does not mean that investors will no longer fret about one or that one won’t occur. We certainly do not dismiss the market’s forward-looking discounting mechanism with regard to macro issues. We are also mindful of how quickly the trade and monetary concerns could turn. Certain economic signposts have turned weaker as have both consumer and corporate confidence. It’s important to emphasize again that these are not necessarily signs of a recession, though they certainly look like yellow flashing lights. The substitution of uncertainty for optimism will likely create greater volatility, as it has historically–and this has helped relative performance in the past. Most important for us, falling prices have bred opportunities to add new names to the portfolio. We have been trying to take advantage of other investors’ selling, which in many cases seems more motivated by fear than fundamentals. We have found new investment opportunities, but we are buying at a very deliberate pace. Stocks may not yet have hit bottom, so prices can still move lower.

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

Special Equity -9.78-9.86-9.868.732.6410. 05/01/98

Annual Operating Expenses: 1.18

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.

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: Capella Education was 0.0%, Weis Markets was 4.0%, National Presto Industries was 4.1%, Standard Motor Products was 5.5%, Park Electrochemical was 0.7%, Children's Place was 2.4%, Hubbell Cl. B was 4.4%, Winnebago Industries was 1.3%, Hooker Furniture was 2.5%, Flexsteel Industries was 1.4%, Bassett Furniture was 0.8%

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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