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

Royce Special Equity Multi-Cap Fund Manager Commentary

Portfolio Manager Charlie Dreifus and Assistant Portfolio Manager Steven McBoyle think 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 they think should benefit their style of investing.


Fund Performance

Royce Special Equity Multi-Cap Fund advanced 13.7% in 2016, outperforming its large-cap benchmark, the Russell 1000 Index, which was up 12.1% for the same period. Unlike 2015, in which defensive sectors and growth strategies led the equity markets, 2016 saw leadership from cyclical companies and value approaches.

The Fund's classic value approach, which seeks conservatively managed mid- and large-cap companies with long histories of stable earnings, cash flows, and raising dividends consecutively over time—aka "Dividend Aristocrats"—was well-suited to this environment, particularly in the second half of the year. Its highly concentrated portfolio also provided an advantage.

The Fund trailed its benchmark in the first half of 2016, down 0.5% versus 3.7%, due to a difficult second quarter. Special Equity Multi-Cap then rebounded considerably in the second half, gaining 14.2% compared to 8.0% for the large-cap index. The Fund's average annual total return since inception (8/31/10) was 9.8%.

What Worked... And What Didn't

Five of the Fund's seven equity sectors made a positive contribution in 2016. Industrials led by a wide margin, making more than three times the impact of Consumer Discretionary, the portfolio's next-best contributor. Consumer Staples and Financials detracted, but their respective negative impacts were markedly modest.

At the industry level, machinery (Industrials) made by far the biggest positive impact. It was also the portfolio's largest industry weighting at year-end. Specialty retail (Consumer Discretionary) and electrical equipment (Industrials) followed. Detracting industries had a much smaller impact and were led by auto components (Consumer Discretionary), software (Information Technology), and textiles, apparel & luxury goods (Consumer Discretionary). The Consumer Discretionary sector was particularly interesting, housing some of the Fund’s very best and worst performers in 2016.

It seems to us 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.

The portfolio's top contributor for the calendar year was retailer Dicks Sporting Goods, which operates stores primarily in the eastern and central U.S. selling a broad selection of brand name sporting goods equipment, apparel, and footwear. It built on a strong first half to finish the year with a considerable positive impact.

Three machinery stocks followed closely behind, which gives a sense of the industry's strength in 2016. Parker Hannifin, a maker of motion control products, also enjoyed a strong first half before enjoying and even better second one, as did Illinois Tool Works, which produces industrial fluids and adhesives, tooling for specialty applications, welding products, and measurement equipment and systems.

Finally, long-time Royce favorite Lincoln Electric Holdings also thrived. The company has a global business manufacturing welding, cutting, and brazing products. Apple, the Fund's largest holding at year-end, rounded out the top five contributors.

The top detractors on a position level included Lear Corporation, which makes automobile parts, including seating systems, wiring harnesses, and body control electronics. Although its shares recovered somewhat in the second half of the year, we opted to exit our position. We chose to do the same with both domestic merchandise retailer Bed Bath & Beyond and software giant Microsoft.

During 2016, we initiated a position in home improvement retailer Lowe's Companies and rebuilt a stake in VF Corporation, an apparel company whose roster of brands includes Jansport, Kipling, Lee, Nautica, The North Face, Timberland, and Vans.

Relative to the Russell 1000, the Fund enjoyed its largest advantage with both savvy stock selection and its considerable overweight in Industrials. Our much lower exposure to Health Care, the benchmark's only sector with a negative return, and successful stock picking in Consumer Discretionary also helped.

Hurting relative performance were our lower exposure to banks and stock selection in capital markets, thanks to a disappointing result from T. Rowe Price Group, both of which created a lag in Financials. Our lack of exposure to surging energy stocks also impeded relative results as did the Fund's cash position.

Top Contributors to Performance
For 2016 (%)1

Dicks Sporting Goods 2.09
Parker Hannifin 2.07
Illinois Tool Works  2.03
Lincoln Electric Holdings 1.33
Apple 1.12
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Lear Corporation -0.64
Bed Bath & Beyond -0.40
Microsoft Corporation -0.33
Lowe's Companies -0.19
VF Corporation -0.17
2 Net of dividends

Current Positioning and Outlook

We would not be at all surprised if the market pauses to digest its recent advance while also trying to calibrate how well or incorrect expectations are versus actions it sees on the path to successful implementation by the current Administration. It is possible, after all, that perception has overtaken the likely reality. Considering the market's strength and resilience, we see too much complacency and perhaps too much recent emphasis on direction and strength, as opposed to valuation.

Bullishness is too pervasive to us, even if current levels of equity investment appear to indicate otherwise. Presuming lower tax rates, many investors are also deferring capital gains into 2017 so that selling could actually pick up in the new year. On a more positive note, it seems to us 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.

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

Special Equity Multi-Cap 5.51 13.69 2.37 10.29 N/A N/A 9.77 12/31/10
Russell 1000 3.83 12.05 8.59 14.69 7.08 7.86 12.38 N/A
Annual Operating Expenses: Gross 1.29 Net 1.24

*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 Gross operating expenses reflect gross total annual operating expenses for the Service Class and include management fees, 12b-1 distribution and service fees and other expenses. Net operating expenses reflect contractual fee waivers and/or reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive fees and/or reimburse operating expenses to the extent necessary to maintain the Service Classes’s net annual operating expenses, (excluding brokerage commissions, taxes, interest litigation expenses, acquired fund fees and expenses, and other expenses not borne in the ordinary course of business), at or below 1.24% through April 30, 2017.

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, Dicks Sporting Goods was 6.4% of the Fund's net assets, Parker Hannifan was 6.1%, Illinois Tool Works was 6.9%, Lincoln Electric Holdings was 2.4%, Apple was 8.6%, Lear Corporation was 0.0%, Bed Bath & Beyond was 0.0%, Microsoft was 0.0%, Lowe’s Companies was 2.2%, and VF Corporation was 2.6%.

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 1000 index is an unmanaged, capitalization-weighted 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 performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

There can be no assurance that companies that currently pay a dividend will continue to do so in the future.



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