FUND PERFORMANCE
Royce Special Equity Fund was down 12.4% in 2015, underperforming its small-cap benchmark, the Russell 2000 Index, which declined 4.4% for the same period. For the year-todate period ended June 30, 2015, the Fund was down 0.5% versus an advance of 4.8% for the small-cap index, which was disproportionately led by non-earning, lowest ROE quintile, and non-yielding companies—none of which meet the standards we’ve established for our classic value approach. During the widespread downturn that shook the markets in the third quarter, the Fund lost only slightly less than the Russell 2000, down 11.3% versus the benchmark’s 11.9% slide. Share prices recovered somewhat in the fourth quarter but the portfolio was down 0.6% while the Russell 2000 increased 3.6%. 2015 was the first calendar year since we joined Royce in 1998 during which the Fund underperformed the small-cap index when the latter had a negative return. It was also a more difficult year for small-caps than the benchmark’s return might show—on an equal-weighted basis, the Russell 2000 was down 10.1% in 2015. We were pleased, though, that the Fund beat the Russell 2000 for the 10-, 15-year, and since inception (5/01/98) periods ended December 31, 2015. Special Equity’s average annual total return since inception was 8.4%.
WHAT WORKED… AND WHAT DIDN’T
Six of the Fund’s eight equity sectors posted net losses in 2015, which was better than the index, where eight of 10 sectors were under water. Net losses for Consumer Discretionary more than doubled those of the portfolio’s next-worst, Industrials. The bulk of the losses came from the specialty retail industry including three of the portfolio’s four largest holdings: Bed, Bath & Beyond (BBBY, Financial), which sells primarily domestics merchandise and home furnishings, casual clothing retailer The Buckle (BKE, Financial), and The Finish Line (FINL, Financial), which sells brand name athletic and leisure footwear. We held large stakes in each at the end of 2015. Consumption is doing all right. A new phrase—secular rejuvenation— is being used to describe the improving consumer situation in the U.S. Real incomes, as well as expectations, have risen, and perhaps more important is the fact that household formations picked up in 2015 and many expect them to rise again in 2016. Prospects for the 2016 economy also got a boost late in December when Congress increased spending and cut business taxes, a common occurrence ahead of elections. These actions could add 0.7% to U.S. GDP in 2016.
Industrials also posted a substantial net loss, keyed in part by net losses forc L.B. Foster Company (FSTR, Financial), which manufactures, fabricates, and distributes rail and trackwork piling, highway products, earth wall systems, and tubular products for the rail, mining, and construction industries. We sold the last of our shares in October.
The Fund’s largest holding at year end, UniFirst Corporation (UNF, Financial) also detracted from results. The company provides workplace uniforms and protective clothing in the U.S. and Canada. A large and diverse sector, Industrials was also home to the portfolio’s top contributor in 2015, long-time holding National Presto Industries (NPK, Financial). The company runs a diverse number of manufacturing businesses, including defense products, housewares and small appliances, and absorbent products. Net losses in Information Technology came from the electronic equipment, instruments & components and were spread among several holdings, including AVX Corporation (AVX, Financial) (our second-largest holding at year-end), Park Electrochemical (PKE, Financial), and Anixter International (AXE, Financial).
Relative results were hampered primarily by both our overweight and stock selection in Consumer Discretionary, with ineffective choices and a substantially larger weighting in specialty retail hurting most. Stock selection was the chief culprit in Information Technology while the portfolio’s significant underweight in both Financials and Health Care also detracted meaningfully from relative performance in 2015. By contrast, stock selection in Consumer Staples and Materials were bright spots while low exposure to Energy also helped in the calendar year period. The first of these sectors included one of the portfolio’s top net gainers for 2015, independent leaf tobacco merchant Universal Corporation (UVV, Financial). Both absolute and relative success for Materials came from Neenah Paper, a global manufacturer of premium, performancebased papers and specialty products with manufacturing operations in the U.S. and Germany. Semiconductor test product maker and services business Teradyne also helped on both an absolute and relative basis.
Top Contributors to Performance For 2015 (%)
- National Presto Industries (NPK, Financial) 0.64%
- Universal Corporation (UVV, Financial) 0.50%
- Teradyne (TER, Financial) 0.25%
- Neenah Paper (NP, Financial) 0.23%
- Scholastic Corporation (SCHL) 0.14%
Top Detractors from Performance For 2015 (%)
- Bed Bath & Beyond (BBBY, Financial) -2.42%
- Foster (L.B.) Company (FSTR, Financial) -1.24%
- Buckle (The) (BKE, Financial) -1.18%
- Finish Line (The) Cl. A (FINL, Financial) -1.14%
- UniFirst Corporation (UNF, Financial) -1.09%
CURRENT POSITIONING AND OUTLOOK
2015 offered a potent reminder of how humbling this business can be. We have always ordered pencils with erasers to account for our mistakes knowing that our process does not work in all markets—it is not the Rosetta Stone. However, against the backdrop of tepid demand for equities, particularly from individual investors who have endured two major market declines in the past 15 years, wide-scale multiple expansion looks unlikely. In our view, this highlights the case for the kind of bottom up, granular security selection that has always distinguished our disciplined and contrarian approach. We remained overweight at the end of 2015 in Consumer Discretionary, Industrials, and Materials while maintaining significantly lower exposure to Financials and Health Care.
