Royce Heritage Fund Manager Commentary
article 06-30-2017

Royce Small/Mid-Cap Premier Manager Commentary

The Fund's impressive first half was especially notable in a growth-led period.


Fund Performance

Royce Small/Mid-Cap Premier Fund (formerly Royce Heritage Fund) climbed 5.7% for the year-to-date period ended June 30, 2017, slightly trailing the 6.0% gain for its new small- and mid-cap benchmark, the Russell 2500 Index, while outpacing the 5.0% increase for the small-cap Russell 2000 Index for the same period. We changed the Fund’s name and shifted its benchmark from the Russell 2000 to the Russell 2500 to better reflect the portfolio’s small- and mid-cap selection universe, which Royce defines as those with market capitalizations up to $15 billion. The Fund’s investment approach, however, remained unchanged—we continue to seek companies that we consider “premier”—those that we believe have sustainable, moat-like franchises, discernible competitive advantages, a history of prudent capital allocation, and opportunities to profitably reinvest excess cash flow.

The Fund outpaced both indexes in the first quarter, up 4.4% versus respective gains of 3.8% and 2.5% for the Russell 2500 and Russell 2000 Indexes. This was especially notable during a period in which growth stocks led and approaches similar to the Fund’s valuation-sensitive, high-quality approach were out of favor. Second-quarter results were more pedestrian, with the Fund gaining 1.2% versus 2.1% for the Russell 2500 and 2.5% for the Russell 2000. We were pleased that the Fund outpaced both benchmarks for the 20-year and since inception (12/27/95) periods ended June 30, 2017. Small/Mid-Cap Premier’s average annual total return since inception was 12.3%.

What Worked… And What Didn’t

Eight of the Fund’s nine equity sectors finished the semiannual period in the black with Information Technology and Industrials leading by impressive margins. Two industries—one from each of the two leading sectors—made by far the biggest positive impacts on first-half performance: electronic equipment, instruments & components and professional services. Results for the first group were primarily driven by two positions. Top-10 position IPG Photonics, which produces high-power fiber lasers and amplifiers, saw earnings growth push its shares higher as the company continued to benefit from the accelerated pace at which its fiber lasers are replacing conventional lasers and non-laser technology on a global scale. The stock price of laser diode and equipment maker Coherent was galvanized by ongoing sales and earnings growth.

The top contributing position in professional services, and second in the Fund as a whole, was global staffing and services company—and top-10 holding—ManpowerGroup. The company saw its stock benefit from improved topline growth and a strong bottom line in 2016, solid fiscal first-quarter 2017 earnings, and a brightening global employment picture. From the Consumer Discretionary sector, NVR builds homes and engages in mortgage banking activities. Its shares benefited from ongoing strength in the U.S. housing market, which helped the company post respective first-quarter increases in net income and diluted earnings per share of 58% and 59%.

Consumer Discretionary was the only sector to detract from performance in the first half, though its impact was decidedly modest. While the sector offered an interesting mix of contributing and detracting industries and positions, its specialty retail group had a significant negative effect. Some of this is attributable to the “Amazon Effect,” a broadly used term that describes the significant shifts that are adversely affecting brick and mortar retailers. The growing popularity of e-commerce is introducing price transparency and algorithmic-based pricing strategies that are threatening profits across many industries, making it arguably the greatest deflationary force in the economy today. This has resulted in a regular reexamination of our holdings in the retail space.

Speaking of which, two retailers topped the portfolio’s list of detractors. We substantially reduced our stake in Dicks Sporting Goods in the first half as the company, which has been cutting costs and streamlining operations, nonetheless reported disappointing fiscal first-quarter earnings due to poor sales. We opted to exit our position in Signet Jewelers, the company that operates Zales, Jared, and Kay Jewelers, due to our discomfort with the company’s reliance on in-house financing to spur sales and sluggish earnings.

Relative to the Russell 2500, the Fund was disadvantaged by stock selection in Consumer Discretionary, a much lower weighting in Health Care, and the portfolio’s cash position. By contrast, our lack of exposure to Energy helped as did both our lower weightings and stock selection in Financials and Real Estate were also a plus. Effective stock selection in Information Technology and Industrials.

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

IPG Photonics0.73
Westlake Chemical0.50

1 Includes dividends

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

Dicks Sporting Goods-0.53
Signet Jewelers-0.53
Monro Muffler Brake-0.25
Carlisle Companies-0.19
Dollar Tree-0.16

2 Net of dividends

Current Positioning and Outlook

We continue to anticipate lower returns, higher volatility, and lower correlation levels. Evidence continues to mount that a normalization in the markets is taking place, which should make them far more discriminating. For these reasons, we believe our bottom-up, quality-oriented process has the potential to do well. Other than reducing our retail exposure, portfolio positioning has remained largely unchanged. The largest sectors at the end of June were Industrials, Consumer Discretionary, and Information Technology. Along with Materials, the first two were also our largest overweights versus the Russell 2500 at the end of the semiannual period.

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

Small/Mid-Cap Premier 1.255.6818.273.8010.115.739.0411.3912.33 12/27/95

Annual Operating Expenses: 1.32

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. 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: IPG Photonics was 2.3%, ManpowerGroup was 2.6%, NVR was 1.4%, Coherent was 0.7%, Westlake Chemical was 2.6%, Dicks Sporting Goods was 0.9%, Signet Jewelers was 0.0%, Monro Muffler Brake was 0.9%, Carlisle Companies was 1.3%, Dollar Tree was 1.5%.

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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