Royce Special Equity Fund Manager Commentary
article 06-30-2017

Royce Special Equity Fund Manager Commentary

The first half saw a rotation away from what worked in 2016—small-cap, value, many cyclical sectors—into what lagged, such as growth stocks and more defensive areas, which did not suit our classic value approach.


Fund Performance

Royce Special Equity Fund fell 0.4% for the year-to-date period ended June 30, 2017, trailing its small-cap benchmark, the Russell 2000 Index, which rose 5.0% for the same period. After posting the best calendar-year return in its history in 2016, an increase of 32.2%, the Fund was susceptible to some adjustment in results. Further, there was a rotation in the first half of 2017 away from what worked last year—small-cap, value, many cyclical sectors—into what lagged, such as growth stocks and more defensive areas, neither of which suits our classic value approach. So while disappointing, first-half performance was not surprising in this inhospitable context.

The return pattern was established in the first quarter, when small-cap results were dominated by the lowest return on equity, non-earners, non-dividend payers, fastest sales growth, and highest beta companies. Special Equity was down 0.3% for the quarter while the Russell 2000 was up 2.5%. The Fund fared only marginally better in the second quarter, which again saw leadership from more speculative businesses. Special Equity fell 0.05% versus a 2.5% increase for the small-cap benchmark. Longer-term results were better on both an absolute and relative basis, and we were pleased that the Fund outperformed the Russell 2000 for the 10-year and since inception (5/1/98) periods ended June 30, 2017. Special Equity’s average annual total return since inception was 9.3%.

What Worked… And What Didn’t

Two of the Fund’s six equity sectors detracted from first-half performance, though only Consumer Staples made a significant negative impact—net losses for Real Estate were de minimis. Most of the net losses in Consumer Staples came from a disappointing performance for supermarket chain operator Weis Markets. The portfolio’s sole holding in the food & staples retailing group and its biggest overall detractor for the semiannual period, Weis was also a top-10 position at the end of June. While we finished the semiannual period with fewer shares than we owned at the end of 2016, we made small share purchases in April and June of this year as its stock price fell.

Also detracting in the first half was multinational business consulting firm Resources Connection. We acted in a similar fashion with its stock by adding shares in the second quarter after trimming in the first. Children’s publishing, education, and media company Scholastic Corporation is another top-10 holding that fared poorly. We built our stake modestly in March. We also added to positions in two top-20 holdings. Flexsteel Industries manufactures residential and contract upholstered and wooden furniture while John B. Sanfilippo & Son, a second holding in Consumer Staples, distributes a diverse product line of mostly nut-based snack items.

Of the four sectors that made positive contributions to first-half results, Information Technology made by far the most substantial impact, boosted by strong results for three industry groups—semiconductors & semiconductor equipment, electronic equipment, instruments & components, and IT services. The Fund’s top-performing industry, however, was machinery, which is in the Industrials sector. Automatic test equipment maker—and top-10 holding—Teradyne was the Fund’s best performer at the position level and in the semiconductors & semiconductor equipment group.

Machinery company Wabash National, which manufactures truck trailers, made a notable contribution to first-half results, while manufacturer Bassett Furniture Industries turned around a difficult first quarter to make the list of top first-half contributors. Computer Services, which provides financial technology solutions and regulatory compliance software to banks, financial institutions, and other businesses, also contributed to results.

Results relative to the Russell 2000 were affected most by both our overweight and ineffective stock picking in the Consumer Staples and Consumer Discretionary sectors, especially in the latter’s household durables group, where first-quarter losses outweighed the second-quarter rebound. Our lack of exposure to Health Care also detracted. Conversely, the Fund’s lack of exposure to both Financials and Energy was a strength relative to the benchmark in the first half.

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

Wabash National0.43
Bassett Furniture Industries0.41
Computer Services0.38
Kaiser Aluminum0.36

1 Includes dividends

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

Weis Markets-1.18
Resources Connection-0.48
Scholastic Corporation-0.39
Flexsteel Industries-0.25
John B. Sanfilippo & Son-0.24

2 Net of dividends

Current Positioning and Outlook

The market looks too complacent to us. Stocks advancing on the prospect of economic growth are inconsistent with declining bond yields that suggest a weaker outlook. Only one of these views can be right. Investors thus far seem willing to pay up for the shares of companies that they believe can continue to do well even if the overall outlook may be saying otherwise. The favored issues this year have had perceived growth at rates much more vibrant than the tepid outlook for the economy. A more refined approach— and dare we say a potentially more rewarding one?—might be companies that have the capacity and willingness to grow their dividends.

We continue to believe that the world is both yield conscious and yield undernourished and think that an aging population with expectations of a longer retirement period will exert downward pressure on yields. We also suspect that this hunger, coupled with likely low absolute rates for the foreseeable future, portends a likely revolution of companies that will be raising their dividends. This remains a key component of our search. We think growing income scarcity is just as important as scarcity in revenue and earnings growth, perhaps even more so.

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

Special Equity -0.05-0.3621.635.2310.457.318.859.26 05/01/98

Annual Operating Expenses: 1.17

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.

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: Teradyne was 3.4%, Wabash National was 1.5%, Bassett Furniture Industries was 2.0%, Computer Services was 2.3%, Kaiser Aluminum was 2.7%, Weis Markets was 3.4%, Resources Connection was 1.3%, Scholastic Corporation was 4.6%, Flexsteel Industries was 2.0%, John B. Sanfilippo & Son was 2.8%.

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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