Royce Small-Cap Leaders Fund Manager Commentary
article 06-30-2018

Royce Small-Cap Leaders Fund Manager Commentary

Despite increased volatility and worrisome macro headlines, buying opportunities in new and existing names were created for the Fund.


Fund Performance

Royce Small-Cap Leaders Fund gained 3.6% for the year-to-date period ended June 30, 2018, underperforming its small-cap benchmark, the Russell 2000 Index, which was up 7.7% for the same period. It was disappointing that the portfolio’s bottom-up, cyclical bias, which focuses on finding what we think are attractively valued, high-quality small-cap companies, was out of favor in the year’s first half. In this somewhat inhospitable climate, we worked to take advantage of company-specific issues that appeared temporary to us in order to build existing holdings that became even more attractively valued in the first six months of 2018. Increased volatility in the first quarter and worrisome macro headlines throughout the first half hit small-cap companies with above-average international exposure hard—but also created buying opportunities in new and existing names.

What Worked… And What Didn’t

Seven of the Fund’s nine equity sectors finished the first half in the black, led by Information Technology and Energy, which rebounded significantly in the second quarter. The leading detractor at the sector level was Industrials, the portfolio’s largest and one of its most significant overweights versus the Russell 2000. Financials also had a negative impact on first-half results.

At the position level, the largest contributor by a comfortable margin was Norway’s TGS-NOPEC Geophysical, which provides geoscience data to oil and gas companies worldwide. 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. We held a good-sized stake at the end of June. Fabrinet offers outsourced manufacturing services for complex, differentiated products, primarily for optical communications equipment. The company posted better-than-expected results despite choppy near-term trends for optical equipment spending. We like its niche in optical products as well as the potential drivers of future growth, including possible share gains with its largest customer and further diversification into non-optical areas, such as lasers, sensors, and medical equipment.

Artisan Partners Asset Management detracted most as its shares fell in the first quarter in the face of heightened market volatility, despite posting solid results. With much of its assets under management invested in equities, investors seemed to fear that the long-awaited return to positive net flows might be mitigated by ongoing fee pressures on active equity managers. Liking its potential to rebound, we added shares in the first half. We acted in similar fashion with CIRCOR International, which makes an array of valves and related flow control products and services. Solid fiscal first-quarter results, strong orders, and margin improvement potential across its core and newly acquired businesses led to an April recovery for its stock that was undone—and then some—in June due to the secondary offering of CIRCOR shares by Colfax—a recent acquisition—that were received as part of the acquisition price. Its stock also felt the effects of the tariff and trade war talk that led to widespread underperformance for global industrials.

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Relative to the Russell 2000, first-half results were impaired most by ineffective stock selection, as well as our overweight, in Industrials, most meaningfully in the machinery group, which includes CIRCOR and Sun Hydraulics. The struggles of Artisan and Federated Investors drove underperformance in Financials, while in Health Care—the top-performing sector for the Russell 2000 in the first half—our substantial underweight hurt most. Helping relative results most was savvy stock selection in Energy, fueled by TGS-NOPEC’s strength. Stock picking was also a strength in Real Estate, where our sole position, Marcus & Millichap, which provides sales, financing, research, and advisory services in the commercial real estate industry, enjoyed a strong first half.

Top Contributors to Performance

1 Includes dividends

Top Detractors from Performance

2 Net of dividends

Current Positioning and Outlook

We were pleased with our positioning at the end of June. Valuations for many holdings appear to have priced in the negative macro headlines and look to be trading on the questionable assumption that short-term profit pressures will not abate. We see things much differently, as financial reports and our meetings with managements both reveal consistently positive evidence in sales and order trends, along with specific actions being taken to improve margins, e.g., price increases and investments in automation. These businesses performed far better than their stocks did in the first half. If they deliver earnings growth, then we believe a strong case can be made for rotation into these names, especially since they offer both attractive growth prospects and the potential for multiple expansion. Several holdings looked not only well-positioned to us for a sustained improvement on existing growth trends, but many also appeared poised to benefit from a rebound for cyclical sectors, such as Industrials, large swaths of Information Technology, and Financials. Many holdings in these sectors continued to trade at steeper-than-normal discounts to defensives at the end of the first half, despite strong fundamentals and earnings growth outlooks. This gave us encouragement about the portfolio’s prospects going forward.

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

4.433.6412.877.877.507.999.669.66 01/01/01

Annual Operating Expenses: Gross 1.62 Net 1.49

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 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, 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 1.8%, Fabrinet was 2.6%, Movado Group was 0.8%, Marcus & Millichap was 2.2%, Inter Parfums was 1.8%, Artisan Partners Asset Management Cl. A was 2.8%, CIRCOR International was 2.3%, Sun Hydraulics was 2.3%, Federated Investors Cl. B was 0.8%, LCI Industries was 1.1%, Colfax was 0.0%

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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