FUND PERFORMANCE
Royce Pennsylvania Mutual Fund fell 11.4% in 2015, compared to a decline of 4.4% for its smallcap benchmark, the Russell 2000 Index, for the same period. For the year-to-date period ended June 30, 2015, the Fund gained 0.1% versus 4.8% for the Russell 2000. The equity markets then experienced a sweeping correction in the third quarter—the steepest decline for U.S. stocks in four years. The Fund fell 13.0% versus a decline of 11.9% for the benchmark. The fourth quarter saw a recovery that benefited small-cap growth companies more than their value siblings. For the fourth quarter, the Fund was up 1.7% while the small-cap index rose 3.6%.
For a sense of how challenging the year was for small-cap stocks (and the active managers who pick them), consider that the Russell 2000 lost 10.1% on an equal-weighted basis in 2015. This shows just how hard it was to find stocks that grew appreciably by year-end, especially in the more economically sensitive, cyclical areas of the market that have been our primary focus over the last few years. In this climate, we continued to focus on companies that in our analyses showed a combination of attractive valuation, balance sheet strength, and/or promising growth prospects. We were also pleased that Pennsylvania Mutual outperformed the Russell 2000 for the 15-, 20-, 25-, 30-, and 35-year periods ended December 31, 2015. The Fund’s average annual total return for the 40-year period ended December 31, 2015 was 13.7%, all under the management of Chuck Royce (Trades, Portfolio).
WHAT WORKED… AND WHAT DIDN’T
Industrials, where we were substantially overweight at the end of 2015, detracted most on an absolute basis in 2015. It also hurt relative performance, but our disadvantage resulted from greater exposure to the sector—stock selection was a net positive versus the benchmark. On an industry level, the largest net losses in Industrials came from machinery stocks, which was also a significant overweight. Long-time holding Kennametal makes tools and tooling systems, focusing on the metalworking, mining, oil, and energy industries, all of which faced sluggish industry conditions in 2015. However, the Fund’s top contributor John Bean Technologies, also came from the machinery group. The company provides technology solutions primarily to the food processing and air transportation industries and benefited from healthy earnings growth in 2015.
Consumer Discretionary was also a sore spot, hurt most by net losses in the specialty retail category, where another long-time holding, casual clothing retailer The Buckle, was a loss leader, as was America’s Car-Mart, which sells and finances used cars and trucks. The Buckle was hurt by declining mall traffic and a long (and mostly successful) history of not discounting its merchandise. We like how the company coped with the increasingly challenging situation for retailers in 2015. America’s Car-Mart faced lighter volumes that were mostly the result of increased competition. We held shares of each at the end of 2015.
The ongoing decline of oil and natural gas prices also kept energy services businesses in the red for the year. A holding for more than a decade, Unit Corporation detracted most in the Energy sector. The company, which operates as a contract driller and exploration & production company, among other energy-related businesses, continues to execute effectively in one of the most difficult environments for energy companies in the last 30 years. Its attractively capitalized balance sheet is also likely to be an advantage as its industry is already feeling the effects of credit constraints. Shares of residential mortgage insurer Genworth MI Canada often track the price of oil due to the company’s large share of business in commodity-dependent western Canada. Believing that the potential losses have been more than priced in (making its shares attractively inexpensive), we increased our position in 2015, confident in the firm’s long-term potential to recover.
The biggest detractor to relative performance on a sector basis in 2015 was Information Technology, where poor stock selection in the electronic equipment, instruments & components and semiconductors & semiconductor equipment industries hurt most. The combination of an underweight in banks, an overweight in capital markets, and poor stock selections in insurance and diversified financial services all hampered relative results in Financials. Health Care’s modest net gain in the portfolio was mitigated by our significant underweight in the sector—it detracted from results relative to the Russell 2000. We were pleased, however, with our stock-picking strength in Energy and Materials—two highly challenged sectors in which we sought to high-grade positions in 2015.
Top Contributors to Performance For 2015 (%)
- John Bean Technologies (JBT, Financial) 0.29%
- Core-Mark Holding Company (CORE, Financial) 0.21%
- Blackbaud (BLKB, Financial) 0.21%
- Stella-Jones (STLJF, Financial) 0.19%
- SEI Investments (SEIC, Financial) 0.18%
Top Detractors from Performance For 2015 (%)
- Unit Corporation (UNT, Financial) -0.38%
- Kennametal (KMT, Financial) -0.32%
- Buckle (The) (BKE, Financial) -0.31%
- Genworth MI Canada (TSE:MIC, Financial) -0.27%
- America’s Car-Mart -0.26%
CURRENT POSITIONING AND OUTLOOK
We expect reversals in a number of trends that should help benefit many portfolio holdings over the next few years. Our own research and regular meetings with confident management teams have made us comfortable with a contrarian, pro-cyclical bias for the portfolio. Moreover, we suspect that the protracted leadership of growth over value stocks is likely to reverse in 2016 and that companies with better balance sheets will do well in an environment of elevated corporate bond spreads. We also expect the combined effects of these reversals to put the market’s focus squarely on the attributes we emphasize, which we think are overdue for recovery.
