Royce Smaller-Companies Growth Fund Manager Commentary
article 06-30-2017

Royce Smaller-Companies Growth Fund Manager Commentary

First-half results for the Fund's 'GARP' approach were impressive on both an absolute and relative basis.


Fund Performance

Royce Smaller-Companies Growth Fund came back strong and turned in an impressive absolute and relative performance in the first half. The Fund advanced 11.3% for the year-to-date period ended June 30, 2017, well ahead of its small-cap benchmark, the Russell 2000 Index, which was up 5.0% for the same period. We were also pleased that the Fund, which uses a valuation-aware, ‘growth-at-a-reasonable-price’ (GARP) strategy, outpaced the Russell 2000 Growth Index (+10.0%) in the first half.

The first half of 2017 reversed most of the equity market leadership from 2016, including a rotation from value back to growth. This reversal, along with the related resurgence of biotechnology, was a factor in first-half performance. The Fund enjoyed a strong first quarter, gaining 5.1% versus 2.5% for the Russell 2000. It then slightly improved on that result with a 5.9% advance in the second quarter when the small-cap index once again climbed 2.5%. Smaller-Companies Growth also outpaced the Russell 2000 for the one-year, 15-year, and since inception (6/14/01) periods ended June 30, 2017. The Fund’s average annual total return since inception was 11.4%.

What Worked… And What Didn’t

Eight of the Fund’s 10 equity sectors finished the semiannual period in the black. Perhaps unsurprisingly for a GARP strategy in a growth-driven market, Information Technology and Health Care made the biggest contributions to first-half results. The degree to which they dominated performance, however, was notable—at least to us. Three groups in tech, for example, were the portfolio’s leaders at the industry level—electronic equipment, instruments & components, software, and internet software & services. These were followed by pharmaceuticals, biotechnology, health care equipment & supplies, and health care providers & services—all from the Health Care sector.

Top contributor and top-10 holding Clovis Oncology develops and acquires treatments that target specific subsets of cancer. It bypassed a competitor on the road to FDA approval for one product and went on to experience better-than-expected trial results. At the end of June, we thought both its existing product line and those in its pipeline made its business look highly attractive. Shopify is a Canadian company that provides a cloud-based, omni-channel commerce platform, mostly for smaller businesses. Fiscal first-quarter revenues soared by more than 75%, easily beating Wall Street’s consensus. We saw our investment as a toehold in a business with a long runway for growth, especially with growing demand for the company’s newer services. It was the Fund’s twelfth-largest holding at the end of June.

Energy was the only portfolio sector to make a significant detraction in the first half as net losses for Consumer Staples were minor. After increasing our exposure to Energy in 2016, we cut back in 2017 in the

face of tumbling oil prices and our contention that drilling innovations are disrupting the industry’s business cycle. Unit Corporation went from finishing 2016 as the portfolio’s top contributor to its second-biggest detractor in the first half. The company operates as a contract driller and exploration & production company while also offering energy-related services. Oil and gas production declined while its rig business suffered margin contraction due to long-term contract repricing and additional expenses from rig relocations and startups. We chose to sell our shares in June. We acted similarly with the Fund’s top detracting position, western and work gear retailer Boot Barn Holdings, whose business was hit with something of a double whammy, hurt by both the travails affecting many retailers and declining energy prices that slowed its previously strong business in oil-rich states.

Relative to the Russell 2000, the Fund benefited most in the first half from savvy stock selection in Information Technology, Health Care, and Industrials. Conversely, our previously higher exposure to Energy, ineffective stock picks in Consumer Discretionary, and the Fund’s cash position all produced a relative detraction, although to a much lower degree.

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

Clovis Oncology0.97
Shopify Cl. A0.93
Universal Display0.92
Paylocity Holding Corporation0.82

1 Includes dividends

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

Boot Barn Holdings-0.62
Unit Corporation-0.43
CyberOptics Corporation-0.30
RSP Permian-0.26
Progenics Pharmaceuticals-0.24

2 Net of dividends

Current Positioning and Outlook

After a strong first half, we have seen fewer businesses that fully satisfy the key criteria of our GARP approach. In addition, we have been trimming holdings that exceeded our sell targets and/or sported valuations that looked unsustainable and therefore too risky. The result was a higher-than-usual cash position of 7.0% at the end of June that we are eager to reduce as opportunities are hopefully uncovered in the year’s second half. We also remain cautiously optimistic that policies affecting corporate tax rates, regulation, and healthcare can be implemented over the next six to 12 months that could boost GDP growth.

Moreover, we are still bullish on the themes that have guided much of our stock picking over the last 12-18 months: companies involved in cloud software and solutions, automation, robotics, and industrial technology, healthcare innovators (with a focus on device and drug discovery companies), and likely beneficiaries of increased spending on infrastructure and defense. At the end of the first half, we were overweight our two largest sectors, Information Technology and Health Care. Our exposure to both increased in the first half, mostly due to share price appreciation, as was the case with Financials and Industrials. We also actively reduced our weightings in Consumer Discretionary, Consumer Staples, and Energy due to our uncertainty about the near-term prospects for these underperforming areas.

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

Smaller-Companies Growth 5.8811.2626.086.0512.354.5310.9811.42 06/14/01

Annual Operating Expenses: 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. 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: Clovis Oncology was 1.6%, Shopify Cl. A was 1.2%, Universal Display was 1.4%, Paylocity Holding Corporation was 1.5%, Coherent was 0.9%, Boot Barn Holdings was 0.0%, Unit Corporation was 0.0%, CyberOptics Corporation was 1.4%, RSP Permian was 0.5%, Progenics Pharmaceuticals was 0.8%.

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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