Royce Pennsylvania Mutual Fund Manager Commentary
article 06-30-2018

Royce Pennsylvania Mutual Fund Manager Commentary

Though it maintained its longer-term relative advantages, our flagship portfolio fell behind its benchmark during a quarter.

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Fund Performance

Following two consecutive years of strong absolute and relative performance, our flagship portfolio fell behind the Russell 2000 Index, its small-cap benchmark, in the first half of 2018. Royce Pennsylvania Mutual Fund advanced 5.7% for the year-to-date period ended June 30, 2018, trailing the Russell 2000, which rose 7.7% for the same period. The Fund maintained its longer-term relative advantages, outperforming the benchmark for the three-, 20-, 25-, 30-, and 35-year periods ended June 30, 2018. (Additionally, Penn lagged the small-cap index by only a narrow margin for the one-year period ended June 30, 2018.)

What Worked… And What Didn’t

During the first half the market favored higher growth, lower quality, and more yield-sensitive equities. Health Care, a key growth-stock sector, continued the run that kicked off in 2017 as the best-performing sector in the Russell 2000. Information Technology followed in second and saw the lion’s share of its strength coming from two growth-oriented industries—Internet software & services and software. These same two sectors also made the largest positive contributions to the Fund’s first-half results, while Industrials and Utilities detracted very modestly.

At the industry level, the top contributor was energy equipment & services (Energy) as the rebound for oil prices fed through to improved prospects for these businesses. Norway’s TGS-NOPEC Geophysical, which provides geoscience data to oil and gas companies worldwide, was the largest contributor in this industry and in the portfolio overall. Its revenue and earnings were boosted by improving exploration and production spending, higher oil prices, and the longer-term need for energy companies to replenish reserves, which is driving increased spending on seismic data. SEACOR Marine Holdings, which provides global marine and support transportation services to the energy industry, was another top performer from the same industry. Stronger operating results coming from nearly all of its geographic markets helped its shares to rise. Outside of energy, the shares of commercial and industrial real estate developer FRP Holdings rose on news of robust sales growth, and U.S. Physical Therapy, which owns and operates outpatient physical therapy clinics, saw growth in its core business as well as in its industrial injury prevention initiatives.

The largest negative effect on relative returns came from Industrials and Information Technology. In fact, a large share of Penn’s underperformance versus the Russell 2000 at the industry level came from the machinery group, which was also home to three of the Fund’s five largest detractors at the position level. Several holdings in this group reported disappointing earnings and lackluster guidance, due partially to margin compression caused by higher input costs. Our analysis suggests some of these margin issues should prove transitory as manufacturers must first absorb these increased costs before realizing higher product prices. In a robust economy, we are comfortable that our companies can successfully put through price increases and see margins rebound.


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We built our respective stakes in machinery companies Sun Hydraulics and CIRCOR International, which makes valves and flow control products, while making only a modest trim to our position in John Bean Technologies, which produces specialized products and services for food storage and transport. A closer examination of Sun Hydraulics, which makes hydraulic and electronic valves, controls, and instruments for industrial machinery and off-highway vehicles, offers a good example of our thinking about select holdings in this industry. Despite robust sales growth, the company’s margins and earnings have been weaker than expected due to operating inefficiencies incurred by a ramp up to meet strong demand, as well as higher materials and commodity costs. We expect a reversal as the impact of management’s corrective actions—which include price increases, new supply agreements to ease constraints, and reduced temporary and overtime labor—to take effect. We also have a favorable view of the strategies the company has been implementing that could help lead to revenue and operating profit growth over the long term. After finishing as Penn’s top-contributing holding in both 2016 and 2017, laser diode and equipment maker Coherent’s shares underwent a correction in the first half, which led us to reduce our position.

 


Top Contributors to Performance Year-to-Date Through 6/30/181 (%)

TGS-NOPEC Geophysical0.42
FRP Holdings0.39
U.S. Physical Therapy0.32
SEACOR Marine Holdings0.29
FLIR Systems0.24

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/182 (%)

Sun Hydraulics-0.53
Coherent-0.25
John Bean Technologies-0.22
CIRCOR International-0.21
LCI Industries-0.18

2 Net of dividends

Current Positioning And Outlook

The market’s recent behavior looks curious to us. We hear optimism and solid progress from the management teams we meet with, see solid earnings reports, and observe consistently strong macroeconomic data. On the other hand, small-cap market leadership has stubbornly remained with defensive and yield-oriented stocks, while cyclicals have lagged. Despite new highs for the Russell 2000, we are therefore far from ebullient, as we anticipate that increased volatility will accompany a shift in market leadership to value/cyclical leadership. We are also mindful that these shifts rarely occur without some turbulence. On balance, we are raising cash levels modestly and actively adjusting portfolio weightings by culling some smaller holdings and putting increased weight behind what we think are the most timely opportunities.

Average Annual Total Returns Through 06/30/18 (%)

QTR1 YTD1 1YR 3YR 5YR 10YR 15YR 20YR 30YR 45YR
Pennsylvania Mutual 5.005.7017.23 11.21 10.63 8.92 10.40 9.77 10.68 13.50
Russell 2000 7.757.6617.57 10.96 12.46 10.60 10.50 8.03 9.85 N/A

Annual Operating Expenses: 0.92

1 Not annualized.

Important Performance, Expense, 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 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 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 June 30, 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 June 30, 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 6/30/18, the percentage of Fund assets was as follows: TGS-NOPEC Geophysical was 1.0%, FRP Holdings was 1.2%, U.S. Physical Therapy was 0.9%, SEACOR Marine Holdings was 0.6%, FLIR Systems was 1.9%, Sun Hydraulics was 1.5%, Coherent was 0.1%, John Bean Technologies was 0.9%, CIRCOR International was 0.7%, LCI Industries was 0.4%


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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