Royce International Small-Cap Fund Manager Commentary
article 12-31-2016

Royce International Small-Cap Fund Manager Commentary

Portfolio Managers Dilip Badlani and Jim Harvey continue to find attractive opportunities in international small-cap companies as valuations in many parts of the world remain compelling to them.


Fund Performance

Royce International Small-Cap Fund was down 1.7% in 2016, trailing its benchmark, the Russell Global ex-U.S. Small Cap Index, which rose 5.0% for the same period. We were disappointed in this result, especially following underwhelming results for the Fund over the last two years. We were also struck by the contrasting pattern of sector results for international small-caps, which were choppier than those of domestic small-caps. The benchmark's two cyclical, commodity-based sectors, Energy and Materials, did best in 2016, followed by strong results for the defensive Utilities sector. This stood in sharp contrast to the U.S. small-cap market, in which cyclical leadership was more pronounced.

During the first half of the calendar year, the Fund fell 1.6% compared to a gain of 1.0% for the Russell Global ex-U.S. Small Cap. Returns were not much better on an absolute or relative basis in the second half of 2016, in which the Fund fell 0.1% versus a 4.0% gain for its benchmark.

What Worked... And What Didn't

Eight of the Fund's 11 equity sectors finished 2016 in the black while the top detractors were Health Care, Utilities, and Materials. The last of these sectors was the second-best performer of the benchmark's sectors in 2016. Real Estate, Industrials, and Information Technology led the list of contributors by a meaningful margin. At the industry level, the leading detractors were textiles, apparel & luxury goods, specialty retail (both from Consumer Discretionary), and metals & mining (Materials) while contributions again came disproportionately from three areas— real estate management & development (Real Estate), auto components (Consumer Discretionary), and consumer finance (Financials).

The Fund's leading detractor at the position level was Banca Sistema, an Italian bank specializing in financing and managing trade receivables owed by the Italian Public Administrations. Despite its unique business model and attractive growth profile, it has been caught up in the widespread downdraft for Italian banks, considered one of the more vulnerable areas of European finance in the aftermath of Brexit. However, the company continued to execute effectively and delivered strong earnings growth. We think that it is well positioned to take advantage of the large opportunity set in front of it and added shares in October and November.

With three times as many small- and micro-cap companies headquartered outside the U.S., we continue to see ample opportunity to uncover well-run, underfollowed small-cap companies trading at attractive valuations.

We felt less confident in the long-term prospects for Wasion Group Holdings, a Hong Kong-based company that provides smart power, water, heat, and gas meters. Earnings announced early in 2016 were unsteady primarily due to its reliance on the Chinese government’s budgeting. This influenced our decision to move on.

Technicolor is a French media and entertainment company engaged in the sale of digital set-top boxes and high-speed gateways for home digital, the replication and distribution of DVD and Blu-ray discs, and special effects services and post-production for studios. It also has a patent portfolio. Technicolor's shares suffered when it missed consensus revenue growth expectations and gave back some of its gains from 2015. We reduced our position in 2016.

The top contributor at the position level was Minth Group, a Chinese auto supplier that has seen a steady increase in operating earnings as investments geared toward greater manufacturing efficiencies have paid off. Although we trimmed our position in 2016, we liked its long-term prospects based on its solid backlog and ability to grow its global business.

Manappuram Finance, one of India’s leading Non-Bank Financial companies (NBFC), has been enjoying robust market conditions for its specialized lending focus which offers loans against gold collateral. A stable gold market coupled with healthy demand helped Manappuram to continue its mid-doubledigit growth rate. After a strong run, we sold the last of our shares in October. Brazil's T4F Entretenimento operates at multiple levels of the entertainment industry, including venue operation, ticketing, food & beverage, merchandise sales, and corporate sponsorships. T4F participated in a strong rally that saw Brazilian small-caps rise approximately 60% in 2016. After a few difficult years in which profitability suffered from heightened competition, T4F increased its profits for the second consecutive year. We reduced our stake as its shares climbed.

Companies headquartered in Canada, China, and Brazil had the largest positive impact on performance while those based in Australia, Italy, and Hong Kong detracted most. Relative to its benchmark, the Fund suffered somewhat from both its underweight and poor stock selection in the Materials and, to a lesser degree, Energy sectors. Conversely, stock selection was a strength in Real Estate, as was our portfolio underweight. Lower exposure also provided a relative advantage in Health Care.

Top Contributors to Performance
For 2016 (%)1

Minth Group  1.07
Manappuram Finance 0.86
T4F Entretenimento 0.64
Morneau Shepell 0.60
Haitian International Holdings 0.47
1 Includes dividends

Top Detractors from Performance
For 2016 (%)2

Banca Sistema -0.63
Wasion Group Holdings -0.51
Technicolor -0.43
Value Partners Group -0.41
Saracen Mineral Holdings -0.41
2 Net of dividends

Current Positioning and Outlook

We continue to find attractive opportunities in international small-cap companies as valuations in many parts of the world remain compelling to us. With three times as many small- and micro-cap companies headquartered outside the U.S., we continue to see ample opportunity to uncover well-run, underfollowed small-cap companies trading at attractive valuations. Two of our three largest sectors at year-end—Industrials and Information Technology—were also overweighted versus the benchmark.

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

International Small-Cap -5.43 -1.72 -3.62 3.80 N/A N/A 3.14 06/30/08
Russell Glo x US SC -3.61 5.04 0.57 7.22 2.65 5.95 3.08 N/A
Annual Operating Expenses: Gross 1.92 Net 1.45

*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 2% 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 total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, and other expenses, and acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive its fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’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 1.44% 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, Minth Group was 0.8% of the Fund's net assets, Manappuram Finance was 0.0%, T4F Entretenimento was 0.7%, Morneau Shepell was 0.0%, Haitian International Holdings was 0.5%, Banca Sistema was 1.1%, Wasion Group Holdings was 0.0%, Technicolor was 0.7%, Value Partners Group was 1.1%, and Saracen Mineral Holdings was 0.7%.

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 Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States.  The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.



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