Royce Special Equity Fund Manager Commentary
article 06-30-2018

Royce Special Equity Fund Manager Commentary

Despite an environment not conducive to the Fund’s classic value approach, we liked the way the portfolio was positioned at the end of June.


Fund Performance

For the year-to-date period ended June 30, 2018, Royce Special Equity Fund was down 0.3%, lagging its small-cap benchmark, the Russell 2000 Index, which was up 7.7% for the same period. This was a disappointing period, in which small-cap growth again outperformed small-cap value, while defensive sectors outpaced their cyclical counterparts. And in spite of higher volatility in the first quarter and a wild finish to the second, overall volatility (as measured by the percentage of trading days in which the Russell 2000 moved 1% or more) was substantially lower during the first half of 2018 than its historical average. Altogether, it was not an environment conducive to Special Equity’s classic value approach. We were, however, encouraged by the portfolio’s improved performance in May and June, which hopefully portended a more lasting shift to value stocks.

What Worked… and What Didn't

Consumer Staples was the Fund’s top-contributing sector by a significant margin in the first half of the year while Consumer Discretionary made an even larger negative impact. The latter sector was home to six of the portfolio’s 10 largest detractors and four of its top five. The biggest negative impact came from retailer The Children’s Place, which was the Fund’s second-largest holding at the end of June. Elsewhere in the sector, we added shares of diversified media company Meredith Corporation and replacement tire manufacturer Cooper Tire & Rubber, while trimming our stake in recreational vehicle maker Winnebago Industries. Outside of Consumer Discretionary, we also held a sizable stake in Hubbell, which makes electrical and electronic products.

The Consumer Staples sector was buoyed by an impressive rebound for supermarket operator Weis Markets and nut specialist John B. Sanfilippo & Son, while in the Industrials sector a strong showing in June lifted the shares of National Presto Industries, which manufactures everything from defense products to housewares and small appliances. Two holdings in Consumer Discretionary rounded out the top five positive contributors—for-profit education business Capella Education and children’s book publisher Scholastic Corporation. Each was a top-10 position at June 30th.

Relative to the Russell 2000 in the first half, the Fund was substantially disadvantaged by poor stock picks in Consumer Discretionary, where The Children’s Place hurt most, and Information Technology, where 2017’s top contributor, automatic test equipment maker Teradyne, pulled back. Our lack of exposure to Health Care, the top-performing sector in the Russell 2000, also detracted meaningfully. Superior stock selection helped year-to-date relative results in Consumer Staples and Real Estate, while a lack of exposure to Financials was also a positive factor.

Top Contributors to Performance Year-to-Date Through 6/30/181 (%)

Weis Markets1.18
National Presto Industries1.05
Capella Education0.91
John B. Sanfilippo & Son0.68
Scholastic Corporation0.62

1 Includes dividends

Top Detractors from Performance Year-to-Date Through 6/30/182 (%)

Children's Place-1.14
Hubbell Cl. B-1.07
Meredith Corporation-0.99
Cooper Tire & Rubber-0.98
Winnebago Industries-0.83

2 Net of dividends

Current Positioning and Outlook

We liked the way the portfolio was positioned at the end of June. It remains highly concentrated with 37 holdings and more than half of its assets invested in two cyclical sectors, Consumer Discretionary and Industrials. The stronger dollar and growing concerns about economies outside the U.S. should continue to favor small-caps. This, we believe, will be a particularly favorable environment for our low-debt, cash-rich holdings as weaker companies that benefited from quantitative easing begin to struggle with quantitative tightening (QT). Indeed, QT has broader unknown consequences. After nearly 10 years of propping up assets, the Fed is changing direction—and no one knows for sure what the ramifications will be. However, it is reasonable to assume that those companies that were helped in the past 10 years will at least see smaller benefits, while those neglected or harmed look likely to recover. Among those most likely to be adversely affected are growth stocks in general. Small-cap growth has outperformed small-cap value for most of the last decade, 2016 being among the most recent, quite welcome, exceptions. Moreover, despite the improved performance of value names in the second quarter, the valuation spread between growth and value remained historically wide at the end of the first half. Until recently, most of the post-2008 era of anemic economic growth favored growth stocks. But growth is no longer scarce in the U.S., so investors need not pay up for it.

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Absent a major policy error by the White House or the Fed, we expect U.S. economic growth to continue, though perhaps at a slower pace, with a developing advantage for less expensive value stocks over more expensive growth issues. Much of what is coming out of Washington—in both words and actions—has caused us all to feel badly despite things being good. Too much strong rhetoric has raised anxiety and stoked volatility, creating a tug-of-war between solid fundamentals and policy uncertainty. Our old standby is that rate of return is a function of entry level—which in general are not too appealing for equities these days. Along with the uncertainty surrounding us, this makes a risk vs. reward approach seem sensible, which leads us to favor investments that have a good historical record during drawdowns. We remain proud of the Fund’s long-term history of low volatility and better risk-adjusted returns than the Russell 2000.

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

Special Equity 4.93-0.327.927.797.719.679.139.339.20 05/01/98

Annual Operating Expenses: 1.18

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.

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: Weis Markets was 3.4%, National Presto Industries was 3.7%, Capella Education was 3.8%, John B. Sanfilippo & Son was 4.0%, Scholastic Corporation was 5.1%, Children's Place was 5.4%, Hubbell Cl. B was 3.7%, Meredith Corporation was 4.2%, Cooper Tire & Rubber was 2.8%, Winnebago Industries was 1.5%, Teradyne was 3.2%

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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