Royce Total Return Fund Manager Commentary
article 12-31-2016

Royce Total Return Fund Manager Commentary

Lead Portfolio Manager Chuck Royce and Portfolio Manager Jay Kaplan believe that we have turned the page on the anomalous 2011-2015 period and are on the road back to a more historically normal market environment.

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Fund Performance

Royce Total Return Fund advanced 25.9% in 2016, outperforming its small-cap benchmark, the Russell 2000 Index, which gained 21.3% for the same period. In addition to this terrific absolute and relative result, the year gave us a lot to be happy about: small-cap dividends payers generally excelled, value took back leadership from growth, and cyclical stocks (long an area of primary focus) beat defensives.

Based on history and reversion to the mean, we believe each of these developments should have staying power, in particular because the previous five years (2011-2015) were so odd, with unprecedented levels of monetary policy intervention and little, if any, in the way of fiscal stimulus.

During the first half of 2016, Total Return increased 8.6% compared to 2.2% for the small-cap index. The third quarter saw a brief rebound for many growth stocks and the Fund gained 5.9% versus 9.0% for the benchmark. For the fourth quarter as a whole, the Fund was up 9.4% while the Russell 2000 increased 8.8%.

We were pleased that the Fund also held its relative edge over longer-term periods. Total Return outpaced the Russell 2000 for the one-, 15-, 20-year, and since inception (12/15/93) periods ended December 31, 2016. The Fund's average annual total return since inception was 10.9%, a notable long-term result that makes us quite proud.

What Worked... And What Didn't

Net contributions came from each of the Fund's 11 equity sectors in 2016. Industrials led by an appreciable margin, followed by noteworthy contributions from Financials and Materials. The leading industries by contribution were chemicals (Materials), machinery (Industrials), banks (Financials), and commercial services & supplies (Industrials). The first two groups were also the largest weightings in their respective sectors.

The portfolio's top contributor at the position level was Quaker Chemical, which provides process fluids, specialty chemicals, and technical expertise to a wide range of industries. Investors reacted favorably to earnings improvement, solid profits, and acquisitions in 2016, pushing its shares higher through most of the year.

Recreational vehicle (RV) maker Thor Industries has captured more than a third of the RV market with its roster of strong brands such as Airstream, Dutchman, and Keystone. Recent robust sales were driven in part by the favorable demographics of retiring Baby Boomers, with a new tailwind also coming in the form of first-time 30-to-50 year old buyers. The acquisition of its competitor Jayco in 2016 helped to further strengthen Thor's position in the entry level space, one of the faster-growing segments of the RV market.

Chase Corporation makes protective materials for various applications and operates through Industrial Materials and Construction Materials segments. Expanding margins, steady earnings growth, and an earnings-accretive acquisition in the fall kept investors interested.

We are grateful to have been able to deliver such strong absolute and relative results for our investors and firmly believe that we have turned the page on the anomalous 2011-2015 period, in which extraordinary monetary accommodations caused financial markets to behave in unprecedented ways. In our view, we are on the road back to a more historically normal market environment.

Disappointments were relatively few and decidedly modest in 2016. The biggest detractors among the portfolio's industry groups were technology hardware, storage & peripherals (Information Technology), life sciences tools & services (Health Care, the only sector in the Russell 2000 to finish the year with a net loss), and multiline retail (Consumer Discretionary).

The position that detracted most was SEI Investments, an asset manager that also provides technology solutions. The company disappointed investors as a key division reported results below expectations. We have long liked its core businesses, but saw what we thought was better value elsewhere at the time and exited our position in March.

Value Partners Group is a Hong Kong-based asset manager that emphasizes value approaches similar to some of our own. Subpar short-term performance, net outflows, and a CEO resignation all contributed to investors' concerns. Because we remain confident in its long-term prospects, particularly in China, as well as in its Chairman, who has assumed CEO responsibilities, we were comfortable holding our stake at the end of 2016.

In spite of its own stock price volatility, we also held a good-sized position in Diebold Nixdorf, which makes software-based self-service delivery and security systems. The company announced an expensive acquisition that, while making the combined company the world’s largest maker of automated teller machines, also sported a price tag which worried other investors.

Relative to the Russell 2000, the Fund benefited most from its underweight in Health Care and overweights in Materials and Industrials. The calendar year's largest detractor was Financials, where our underweight in banks and some poor stock selection in capital markets caused the Fund to lag.


Top Contributors to Performance
For 2016 (%)1

Quaker Chemical 0.87
Thor Industries 0.87
Chase Corporation 0.85
TMX Group 0.69
Ritchie Bros. Auctioneers 0.61
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

SEI Investments -0.21
Value Partners Group -0.19
Diebold Nixdorf -0.18
Flowers Food -0.13
Artisan Partners Asset Management Cl. A -0.13
2 Net of dividends

Current Positioning and Outlook

We are grateful to have been able to deliver such strong absolute and relative results for our investors and firmly believe that we have turned the page on the anomalous 2011-2015 period, in which extraordinary monetary accommodations caused financial markets to behave in unprecedented ways.

In our view, we are on the road back to a more historically normal market environment. We think this bodes well for small-cap stocks. In our view cyclicals look well-positioned for ongoing leadership. In addition to our usual cyclical tilt, we are looking in some defensive areas such as healthcare. It is very much on a stock-by-stock basis, with a focus on individual dividend-paying companies that combine attractive valuations with strong fundamentals.

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

 
  QTR* 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Total Return 9.45 25.86 5.78 12.45 6.86 9.83 10.93 12/15/93
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 9.09 N/A
Annual Operating Expenses: 1.22%

* 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 Investment Class as of the Fund's most current prospectus and include management 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 investments 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.

As of 12/31/16, Quaker Chemical was 1.8% of the Fund's net assets, Thor Industries was 1.5%, Chase Corporation was 0.8%, TMX Group was 0.7%, Ritchie Bros. Auctioneers was 0.9%, SEI Investments was 0.0%, Value Partners Group was 0.3%, Diebold Nixdorf was 0.7%, Flowers Food was 0.2%, and Artisan Partners Asset Management Cl. A was 0.2%. 

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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