FUND PERFORMANCE
Royce Premier Fund was down 9.9% in 2015, lagging its smallcap benchmark, the Russell 2000 Index, which declined 4.4% for the same period. For the yearto-date period ended June 30, 2015, the Fund gained 1.7% versus a 4.8% increase for its small-cap benchmark. Markets reversed course somewhat violently in the third quarter when Premier fell 12.4% compared to a loss of 11.9% for the Russell 2000. Equities recovered a bit in the fourth quarter, and the Fund increased 1.2% versus 3.6% for the small-cap index.
The year ended, therefore, in much the same way it began—with narrow market leadership from mostly growth-oriented stocks, particularly in Health Care (though the fourth quarter also saw strength for more growth-oriented tech businesses). The lack of breadth was an issue, with one data point, we think, being especially telling: In 2015 the Russell 2000 lost 10.1% on an equal-weighted basis.
In 2015 the Russell 2000 lost 10.1% on an equal-weighted basis. During the year’s most noticeable exception to this pattern of narrow leadership—the third-quarter correction—small-cap value enjoyed an all-too-brief period of leadership. This short-lived phase was nonetheless encouraging to us—we suspect that contracting access to credit, lower equity returns, and reversion to the mean should all help to boost active approaches. We feel confident that our focus on companies with discernible competitive advantages, high returns on invested capital, and a sustainable, moat-like franchise can do well in such a climate. We were also pleased that Premier outperformed the Russell 2000 for the 15-, 20-year, and since inception (12/31/91) periods ended December 31, 2015. The Fund’s average annual total return since inception was 11.0%. We remain proud of the portfolio’s long-term record.
WHAT WORKED… AND WHAT DIDN’T
Six of the Fund’s eight equity sectors posted net losses in 2015, with the largest coming from Industrials followed by Energy and Consumer Discretionary. On an industry basis, two groups detracted meaningfully—energy equipment & services and machinery. Both were substantially overweight vis-à -vis the Russell 2000. The first was home to Unit Corporation (UNT, Financial), a long-time Royce favorite. The company is something of an anomaly in the energy industry because it runs multiple businesses, including oil and natural gas exploration and contract drilling of onshore oil and natural gas wells. Most energy companies focus on only one of these activities. We opted to sell our shares of Unit in Premier based on our own growing preference in the portfolio for companies involved in single lines of business. Slotted in Consumer Discretionary, Sotheby’s (BID, Financial) auctions fine art, antiques, and collectibles, along with brokering luxury residential real estate. A company we have owned a number of times dating back to 1992, we like its market share in a highly specialized niche.
Declining revenues and earnings kept investors from bidding up its shares in 2015, but we were content to hold a position at year-end. We also held a good-sized stake in footwear retailer Wolverine World Wide (WWW, Financial), which owns a suite of brands such as Merrell, Keds, and Hush Puppies. Sales and earnings have been disappointing, but we think the strength of its well-established names can help it regain its footing. We also held shares of mall-based casual clothing retailer The Buckle (BKL, Financial). Facing declining mall traffic and sluggish sales, the company has been executing well through a challenging period for retailers. Kennametal (KMT, Financial), from the machinery group, makes tools and tooling systems, focusing on the metalworking, mining, oil, and energy industries, all of which faced inhospitable industry conditions in 2015. Seeing the potential for steadier long-term growth elsewhere, we sold our shares.
As it was in the first half of the year, the Fund’s top contributor in 2015 was Cal-Maine Foods (CALM), the largest producer of eggs in the U.S. Egg prices more than doubled in anticipation of supply constraints caused by a serious outbreak of avian flu in the Midwest. This happened as quick-service restaurants were also broadening their breakfast offerings. We took gains as its price soared.
On a sector basis, poor stock selection in Information Technology, an overweight in Industrials, and an underweight in Health Care combined to detract most from calendar-year relative performance. For Information Technology, stock selection within the electronic equipment, instruments & components and semiconductors & semiconductor equipment industries proved troublesome. In Industrials, the primary problem was an overweight in machinery stocks, many of which experienced sizable declines due to concerns about slowing global growth. Stock picking was a notable relative advantage, on the other hand, in the Materials and Consumer Staples sectors.
Top Contributors to Performance For 2015 (%)
- Cal-Maine Foods 0.60%
- Fair Isaac 0.48%
- Pool Corporation 0.41%
- Stella-Jones 0.38%
- Jack Henry & Associates 0.36%
Top Detractors from Performance For 2015 (%)
- Unit Corporation -0.94%
- Sotheby’s -0.73%
- Kennametal -0.73%
- Wolverine World Wide -0.72%
- Buckle (The) -0.65%
CURRENT POSITIONING AND OUTLOOK
We expect reversals in a number of trends that should help benefit a number of 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 believe 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.
