Royce Special Equity Fund Manager Commentary
article 12-31-2016

Royce Special Equity Fund Manager Commentary

Lead Portfolio Manager Charlie Dreifus and Portfolio Manager Steven McBoyle believe that stock picking is 'in' again, as market correlations have dropped, valuations are extended, interest rates have risen, and earnings results are more dispersed. Granular portfolio construction once again matters, which we think should benefit us.


Fund Performance

Royce Special Equity Fund was up 32.2% in 2016, posting the highest calendar-year return in its history and handily outperforming its small-cap benchmark, the Russell 2000 Index, which advanced 21.3% for the same period.

At the end of last year, we bid 2015 good riddance we stated our belief that the period was an outlier and remarked that we expected much better times ahead for Special Equity. We were very pleased that 2016 offered exactly that.

The Fund's calendar-year advantage over the small-cap index was mainly the result of better performance during the declines in the first and fourth quarters. The latter period got off to a rocky start with a bearish October. These difficult periods proved again our emphasis on the importance of outperforming on the downside, which the Fund has a long history of accomplishing.

During the first half of 2016, Special Equity increased 8.3%, compared to a 2.2% gain for the small-cap index. In the volatile third quarter, the Fund lagged its small-cap benchmark (+5.7% versus +9.0%). The Fund then gained 15.5% in the fourth quarter, well ahead of the 8.8% increase for the Russell 2000.

We were also pleased with the Fund’s longer-term advantages as it outpaced the small-cap index for the one-, 10-, 15-year, and since inception (5/1/98) periods ended December 31, 2016. Special Equity's average annual total return since inception was 9.5%.

What Worked... And What Didn't

Six of the portfolio's seven equity sectors finished 2016 in the black, with the biggest contribution coming from Consumer Discretionary, which more than doubled the impact of Industrials, the Fund's second-best contributing sector.

Information Technology also made a strong contribution in 2016. At the industry level, four of the portfolio's top six contributors came from Consumer Discretionary, led by specialty retail and media followed by diversified consumer services and auto components. Commercial services & supplies (Industrials) and electronic equipment, instruments & components (Information Technology) rounded out the top-six industries.

As was the case in 2016's first half, the Fund’s top-performing contributor by a wide margin was Children's Place, which retails value-priced apparel and accessories for newborn to 12-year-old children.

We think stock picking is 'in' again, as market correlations have dropped, valuations are extended, interest rates have risen, and earnings results are more dispersed. Granular portfolio construction once again matters, which we think should benefit us.

UniFirst Corporation, which provides workplace uniforms and protective clothing, was another holdover from the first half's top performers. The rising share price of Capella Education, an online postsecondary education services company, was more of a fourth-quarter story, as its stock price began to accelerate in late October.

Detractors and disappointments were in short supply in 2016. The capital markets (Financials), building products (Industrials), metals & mining (Materials), and tobacco (Consumer Staples) industries showed modest net losses.

By the end of June, we had sold our shares in each of the portfolio's four top detractors for 2016—specialty chemicals provider Minerals Technologies, specialty retailer Bed Bath & Beyond, cable, wire, and security instrument distributor Anixter International, and asset manager Waddell & Reed Financial. The sale of the second of these companies was part of a revamp of the Consumer Discretionary sector, which included reducing and refining our exposure to the multiline and specialty retail industries.

Looking at relative results for the full year, Consumer Discretionary again made by far the largest positive impact. Relative strength also came from Consumer Staples and Industrials. In addition, having no exposure to correcting Health Care stocks had a nicely positive effect in 2016. The portfolio's very low weighting in Financials, along with its cash position, hurt relative performance most. More modest detractions from relative performance came from Real Estate and from our lack of exposure to Energy and Utilities.

Top Contributors to Performance
For 2016 (%)1

Children's Place 3.65
UniFirst Corporation 2.55
Capella Education 2.47
AVX Corporation 2.17
Weis Markets 2.02
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Minerals Technologies -0.29
Bed Bath & Beyond -0.27
Anixter International -0.17
Waddell & Reed Financial Cl. A -0.11
Insteel Industries -0.09
2 Net of dividends

Current Positioning and Outlook

The increased confidence in the equity markets is good in that it removed the excessive hesitancy that we observed earlier this year. Overconfidence, however, is usually a sign of a market top. Have investors pulled forward 2017 returns more than sufficiently? We think so.

Clearly, they have already discounted better growth. Perhaps the market is priced to perfection already with no margin of safety for delays, errors, or world events. As a result of unstable economic conditions in many areas outside the U.S., a rising dollar, and the fact that U.S. small-cap companies stand to gain the most from a lower tax rate, U.S. small caps are being recognized as the sweet spot for current asset allocation. While not a concern with our portfolio, because our companies generally have little to no debt, there is at the same time a potential headwind for other small-cap companies in the form of rising interest rates.

For companies in the Russell 2000, 51% of debt is floating rate while for those in the S&P 500, it is only 9%. It seems that the backdrop is therefore close to perfect for high active share portfolios in our view.

We think stock picking is 'in' again, as market correlations have dropped, valuations are extended, interest rates have risen, and earnings results are more dispersed. Granular portfolio construction once again matters, which we think should benefit us.

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

Special Equity 15.48 32.21 5.42 11.82 8.50 N/A 9.54 05/01/98
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 7.08 N/A
Annual Operating Expenses: 1.15%

* 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 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 reflects Investment Class results. Shares of RSE's Service and Consultant Classes bear an annual distribution expense that is not borne by the Investment Class.

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.

As of 12/31/16, Children's Place was 5.1% of the Fund's net assets, UniFirst Corporation was 5.1%, Capella Education was 3.2%, AVX Corporation was 5.5%, Weis Markets was 4.5%, Minerals Technologies was 0.0%, Bed Bath & Beyond was 0.0%, Anixter International was 0.0%, Waddell & Reed Financial was 0.0%, and Insteel Industries was 1.2%.

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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