Royce Small-Cap Leaders Fund Manager Commentary
article 06-30-2017

Royce Small-Cap Leaders Fund Manager Commentary

After a terrific 2016, the Fund took a relative step back in 2017's first half.


Fund Performance

After benefiting in 2016 from a combination of strong stock-picking and the resumption of leadership for value and cyclical stocks, Royce Small-Cap Leaders Fund took a relative step back in 2017’s first half. The Fund was up 1.1% for the year-to-date period ended June 30, 2017, trailing its small-cap benchmark, the Russell 2000 Index, which gained 5.0% for the same period. The first half of 2017 featured a few reversals that affected relative performance for the kind of high-quality stocks that we seek, most notably a pronounced advantage for growth stocks, particularly in biotechnology.

This pattern began early in the year. For the first quarter, Small-Cap Leaders rose 0.9% versus 2.5% for the Russell 2000 while the second quarter saw more of the same, with the Fund gaining 0.3% while the small-cap index was up 2.5%. Small-Cap Leaders’ average annual total return since inception (6/30/03) was 9.4%.

What Worked… And What Didn’t

Of the Fund’s nine equity sectors, three detracted from first-half results, and a fourth was flat, while six made positive contributions, led by Financials and Information Technology. The largest negative impacts came from Consumer Discretionary, where specialty retail was the Fund’s worst-performing industry group, and Energy, where energy equipment & services finished second among the portfolio’s detractors at the industry level. Retailers have been under siege over the last few years as they attempt to cope with secular changes in consumer spending habits and the related margin-contracting specter of Amazon. As a result of these challenges—and the resulting downward pressure on stock prices—we reduced the Fund’s exposure to the industry in the first half. We sold our shares of footwear, headwear, and sports apparel retailer Genesco as first-quarter results and revised full-year guidance fell well below expectations due to intensified competition and management’s overconfidence that it could rebalance inventory to compensate for a key fashion shift it missed last year in its Journeys footwear chain.

We also significantly reduced our exposure to The Buckle in the second quarter as business for this clothing retailer continued to deteriorate in part due to heightened online competition. We felt more confident about the long-term prospects for footwear wholesaler and retailer Caleres. Recent sales and earnings growth has been solid, but early 2017 results fell short of investors’ optimistic expectations—and even minor disappointments in the industry are severely punished in the current highly challenging environment. We netted out a modest increase in our position during the first half.

Despite high employment and solid business confidence, revenue growth for office furniture manufacturer Steelcase remained constrained as North American customers were still cautious about spending. Additionally, while the company is introducing new product to address the “resi-mercial” office style trend, this growth has yet to offset sales declines from legacy office products. We were content to stay patient and held a good-sized stake at the end of June. Xperi was formed when Tessera Holding acquired DTS. The company, which licenses audio and semiconductor technologies, offered disappointing earnings guidance on the formation of the new company. The outlook is clouded by the pending resolution of a patent dispute with one large company and the signing of a licensing renewal by a second, which led us to reduce our position in the first half.

Top-10 holding Genworth MI Canada, that country’s leading residential mortgage insurance provider, was the Fund’s top-contributing position in the first half. Its stock extended its strong run from 2016 based on expectations that loss ratios have bottomed in oil-rich provinces where it has residential mortgage insurance in force, combined with a premium increase that offset new, higher capital requirements. Lazard, another top-10 position, continued to gain market share in its global mergers & acquisitions advisory business, particularly in Europe where activity is rebounding. It also saw healthy inflows in its asset management segment that were driven by its global and quantitative offerings.

Relative to the Russell 2000, the portfolio’s substantial underweight in Health Care, including a lack of exposure to biotechnology, hurt most. Also having a large negative impact was ineffective stock selection in Consumer Discretionary, mostly in specialty retail. Conversely, savvy stock picks provided a relative advantage in Financials and, to a lesser extent, Consumer Staples.

Top Contributors to Performance Year-to-Date Through 6/30/171 (%)

Genworth MI Canada0.44
Lazard Cl. A0.40
Bio-Rad Laboratories Cl. A0.33
Industrias Bachoco ADR0.32

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/172 (%)

Steelcase Cl. A-0.48
Oil States International-0.39

2 Net of dividends

Current Positioning and Outlook

Thus far in 2017, small-cap performance has reverted back to that of years such as 2015 – narrow leadership by growth-oriented sectors populated by unprofitable companies. During 2017’s first half, for example, Health Care and Information Technology accounted for approximately 90% of the Russell 2000’s return. However, we believe this is only a temporary pause in the long overdue reversion to the mean of small-cap value and quality outperformance that began in 2016. Fiscal rather than monetary policy will increasingly be the top-down focus of investors as the catalyst to a sustained breakout of U.S. GDP growth beyond the 1-2% range. Many of our more cyclical companies have become even more attractively valued after lagging in first-half stock price performance despite posting in-line financial results and guidance.

Average Annual Total Returns Through 06/30/17 (%)

Small-Cap Leaders 0.281.1419.801.499.045.729.43 06/30/03

Annual Operating Expenses: Gross 1.59 Net 1.49

1 Not annualized.

Important Performance, Expense and Disclosure 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 prior to the commencement date of Investment Class shares on 3/15/07 reflects Service Class results. Service Class shares bear an annual distribution expense that is not borne by Investment Class shares.

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, 2017, 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, 2017 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 6/30/17, the percentage of Fund assets was as follows: Genworth MI Canada was 2.9%, Lazard Cl. A was 2.6%, Fabrinet was 1.7%, Bio-Rad Laboratories Cl. A was 1.0%, Industrias Bachoco ADR was 1.6%, Steelcase Cl. A was 2.0%, Xperi was 0.6%, Genesco was 0.0%, Oil States International was 1.0%, Caleres was 2.4%, The Buckle 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 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 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 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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