FUND PERFORMANCE
Royce Small-Cap Value Fund lost 11.5% in 2015 versus a decline of 4.4% for its small-cap benchmark, the Russell 2000 Index for the same period. For the year-to-date period ended June 30, 2015, the Fund rose 1.0%, compared to an advanced of 4.8% for the small-cap index. In the third quarter’s sweeping correction, Small-Cap Value lost 10.9% while the Russell 2000 was down 11.9%. Small-caps stocks began to recover in October and November, though in general growth companies outpaced their value counterparts. The Fund was down 1.6% for the fourth quarter compared to a 3.6% gain for the Russell 2000. The year proved challenging for strategies focused on valuation, profitability, and out-of-favor companies. Our large weightings in Consumer and Energy stocks and slight exposure to the bio-pharma complex were major factors in underperformance. We are, however, guardedly optimistic looking ahead and were pleased that the Fund beat the Russell 2000 for the since inception (6/14/01) period ended December 31, 2015. Royce Small-Cap Value’s average annual total return since inception was 9.1%.
WHAT WORKED… AND WHAT DIDN’T
Five of the Fund’s eight equity sectors finished 2015 in the red. The most significant net losses came from holdings in Consumer Discretionary, which also detracted most from relative results by a sizable margin. Both absolute and relative results were hurt by significant exposure to this sector’s specialty retail group. A longstanding area of focus, the prospects for many retailers began to look even more attractive in 2014 when oil prices began to decline because consumers often spend more on discretionary purchases when energy prices are low. Following a very difficult holiday season for retailers, we are being patient, confident in the financial strength, management expertise, and previous operational success of our holdings.
Casual clothing retailer The Buckle (BKE, Financial), a long-term core holding, detracted most in the specialty retail group and third-most in the portfolio as a whole in 2015. Its shares suffered chiefly from the sorry state of mall traffic, which extended into the normally robust holiday shopping season. Our confidence in its capable management team, long history of success, and ability to execute effectively during a very trying period for its industry helped make it the Fund’s secondlargest position at year-end. Net losses for the Industrials and Energy sectors also tested our patience and conviction. The energy equipment & services group posted large net losses. While our overweight in this group also hampered relative results, our stock selection was a strength vis-à -vis the benchmark. Unit Corporation (UNT, Financial) is a long-time holding. A contract driller, Unit also explores for and produces oil and natural gas, and engages in midstream activities. It has been executing effectively through a painful period for its industry and with access to capital becoming an issue for leveraged energy businesses, the company is operating within its own internal cash flow generation. Shares of residential mortgage insurer Genworth MI Canada (MIC, Financial) often move with the direction of energy prices, and ongoing concerns about mortgage losses in energy-dominated western Canada continued to push its price down. Ever contrarian, we suspect the bulk of those losses have already been reflected in the stock price. It was our thirdlargest holding at year end. Within Industrials, the road & rail group was the third-largest detractor at the industry level, and its biggest net loss came from top-10 holding Saia (SAIA, Financial), a trucking company serving the retail, petrochemical, and manufacturing industries—all of which were slow in 2015.
In addition to those factors already mentioned, stock selection and a substantial underweight in Financials hurt relative performance, as did a significant underweight in Health Care, our overweight in Energy, and ineffective stock selection in Information Technology. Health Care was the top-performing small-cap sector in 2015, but with many health-related companies having no earnings, the sector was not a significant area of investment for the portfolio. Conversely, strong stock selection made Materials and Consumer Staples relative strengths, though the latter’s advantage was more modest.
Top Contributors to Performance For 2015 (%)
- Fabrinet (FN, Financial) 0.84%
- Innospec (IOSP, Financial) 0.44%
- Steven Madden (SHOO, Financial) 0.41%
- Convergys Corporation (CVG, Financial) 0.41%
- Westlake Chemical (WLKP, Financial) 0.40%
Top Detractors from Performance For 2015 (%)
- Unit Corporation (UNT, Financial) -1.49%
- Saia (SAIA, Financial) -1.43%
- Buckle (The) (BKE, Financial) -1.21%
- Genworth MI Canada (MIC, Financial) -1.14%
- Deckers Outdoor (DECK, Financial) -1.10%
CURRENT POSITIONING AND OUTLOOK
Early in 2016, both the economic and equity fronts looked even more uncertain than usual, especially when the increasingly troubled junk bond market and geopolitical risks were factored in. However, this pessimism about the near term makes us more confident in the long term. Until recently (as well as during the fall of 2015) the general state of small-cap valuations did not look very attractive. The recent contractions in share values, however, have created some potentially promising opportunities. It also appears that the “leverage is good” era has come to a close, which we believe should benefit the kind of conservatively capitalized, free-cash-flow-generating companies that we seek for the portfolio. As we wait for many underperforming holdings to turn around, we maintained a significant overweight in Consumer Discretionary at the end of 2015, as we did in Information Technology and Industrials—two sectors where the portfolio was diversified across a number of industries at the year-end.
