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

Royce Small-Cap Value Fund Manager Commentary

It was a difficult first half for value stocks and a disappointing one for our contrarian value approach.


Fund Performance

For the year-to-date period ended June 30, 2017, Royce Small-Cap Value Fund was down 4.2%, significantly lagging its small-cap benchmark, the Russell 2000 Index, which gained 5.0% for the same period. It was a difficult first half for value stocks and a disappointing one for our contrarian value approach.

The Fund slipped 1.5% in the first quarter versus a 2.5% advance for the small-cap index. Value stocks began to fall behind their growth counterparts early in the year, spurred in large part by strong results for biotechnology companies and less stellar performance for many of the cyclical areas that did so well in 2016. This pattern held sway in the second quarter, when Small-Cap Value was down 2.7% compared to another 2.5% increase for the Russell 2000. The leadership that began early in the year thus remained in place for most of the first half, as large-caps, growth, healthcare, and non-U.S. equities all stayed in the lead after lagging in 2016. Longer-term results were better as the Fund outperformed its benchmark for the 15-year and since inception (6/14/01) periods ended June 30, 2017. Small-Cap Value’s average annual total return since inception was 9.3%.

What Worked…And What Didn’t

Consumer Discretionary made by far the largest negative impact at the sector level, detracting more than twice as much as Energy, the Fund’s second-biggest detractor for the semiannual period. The specialty retail industry disproportionately drove negative results, with seven of the Fund’s eight biggest first-half detractors coming from the group. Brick and mortar retailers continue to struggle with shifts in consumer spending and shopping habits, along with the ensuing margin contraction, developments keyed to a large degree by the omnipresence of Amazon. We sold our shares of footwear, headwear, and sports apparel retailer Genesco in June and reduced our stake in each of the Fund’s other positions in specialty retail during the first half, including sporting goods company Hibbett Sports, women’s fashion and accessories retailer The Cato Corporation, and footwear specialist Shoe Carnival.

The energy equipment & services group also had a substantial negative impact, led by Matrix Service, the Fund’s top detractor at the position level in the first half. The company is a contractor to the energy, power, and industrial markets. Ongoing delays in new project awards and starts, depressed maintenance spending, and increased cost estimates on an electrical infrastructure project all discouraged investors, including us. We sold the last of our shares in the portfolio in May.

Industrials, Information Technology, and Financials made the biggest sector-based contributions to 2017’s first-half results, while at the industry level, building products (Industrials), IT services (Information Technology), and capital markets (Financials) made notable positive impacts. Kitchen cabinet and vanity manufacturer American Woodmark led the building products group, and the Fund overall, thanks to impressive sales growth in both its new construction and remodeling products. We trimmed our stake as its share price climbed.

We chose to add shares of truck trailer manufacturer (and top-10 holding) Wabash National in the first half. Investors seemed to respond positively to its raised earnings guidance for the rest of 2017 as well the company’s efforts to emphasize its diverse line of transportation products. NCI offers network engineering, information assurance, systems development, and integration for government agencies. Fiscal first-quarter revenues exceeded the midpoint of management’s guidance range given earlier in the year, driven in part by margin improvements resulting from higher contributions from fixed-price contracts.

Relative to the Russell 2000, the Fund’s first-half results were affected most by both our overweight and ineffective stock picking in Consumer Discretionary, where the previously mentioned specialty retail group detracted most. Both our lower exposure to Health Care and ineffective stock picks in Information Technology also notably hurt relative results. Bright spots included better stock selection in Financials—most notably in capital markets stocks such as Moelis & Company—and Industrials, where American Woodmark helped the building products group to shine.

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

American Woodmark0.54
Wabash National0.54
NCI Cl. A0.50
Genworth MI Canada0.38
Moelis & Company Cl. A0.38

1 Includes dividends

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

Matrix Service-1.10
Hibbett Sports-0.72
Shoe Carnival-0.49

2 Net of dividends

Current Positioning and Outlook

Our outlook has not changed appreciably since the end of 2016. Our valuation-sensitive contrarian approach has made finding new ideas difficult because most of the cheap stocks we have been investigating look priced that way for very good reasons that look likely to persist—classic value traps. Patience, therefore, remains key. We still expect that more interesting opportunities will materialize when some of the current widespread optimism dissipates, and we are prepared to wait. In the event of a correction, we will act opportunistically as we always have when the market trends down.

During the first half, in addition to reducing the specialty retail group, we made discrete purchases in both residential and non-residential construction companies, as well as in distribution and networking technology businesses—consistent with our ‘low-tech tech’ ethos and including top-10 holdings Fabrinet and PC Connection. We also purchased shares in a small number of boutique investment banks that look well positioned to benefit from ongoing global uncertainty as well as what we think will be a more robust M&A market in the months to come.

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

Small-Cap Value -2.75-4.2112.22-0.267.873.7510.009.26 06/14/01

Annual Operating Expenses: Gross 1.51 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 date of commencement of Investment Class shares on 3/15/07 reflects Service Class results. Shares of the Fund's Service Class bear an annual distribution expense that is not borne by the Investment Class.

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: American Woodmark was 1.5%, Wabash National was 2.1%, NCI Cl. A was 1.5%, Genworth MI Canada was 2.3%, Moelis & Company Cl. A was 1.5%, Matrix Service was 0.0%, Hibbett Sports was 0.5%, Genesco was 0.0%, Shoe Carnival was 1.7%, Kirkland's was 0.6%, The Cato Corporation was 0.2%, PC Connection was 2.1%, Fabrinet was 2.3%.

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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