Fund Performance
Known more for historical downside outperformance, the classic value strategy we have been using for nearly 20 years in Royce Special Equity Fund performed largely in line with our expectations in a steadily rising small-cap market that also favored growth stocks and companies without earnings in the calendar year.
Special Equity held its advantage over the small-cap index for the 10-year and since inception (5/1/98) periods ended December 31, 2017. The Fund gained 7.9% in 2017, trailing its small-cap benchmark, the Russell 2000 Index, which was up 14.6% for the same period.Within the Russell 2000, the highest returns went to companies with the lowest returns on equity, highest foreign sales, no earnings, no dividends, and fastest sales growth as well as the highest betas.
What Worked… and What Didn't
Five of the Fund’s six equity sectors made positive contributions to performance in 2017. Information Technology, Consumer Discretionary, and Industrials led while Consumer Staples was the sole detractor.
The largest positive contributions at the industry level came from specialty retail—helped by a terrific performance from Children’s Place—and semiconductors & semiconductor equipment, where automatic test equipment maker Teradyne led by a wide margin. The leading detractors in 2017 were food & staples retailing (Consumer Staples), where our sole holding—supermarket chain operator Weis Markets—endured a very tough year.
Highlighting the strategy’s patient, low-turnover approach was the fact that nine of the Fund’s top-10 positions at the end of 2016 remained on the same list at the end of 2017—and three of these companies were top contributors to performance—Children’s Place, Teradyne, and AVX Corporation.
(We also continued to hold stakes in recreational vehicle maker Winnebago Industries and Kaiser Aluminum as well as shares of wooden and upholstered furniture maker Flexsteel Industries and wire products manufacturer Insteel Industries at year-end.)
Lower calendar-year results relative to the Russell 2000 came from less-than-perfect stock selection in Consumer Staples, where our overweight was also a factor. In addition, the portfolio’s lack of exposure to Health Care, the top-performing sector in the small-cap index for the year, hurt relative returns, as did stock picking woes in Consumer Discretionary—most impactfully in household durables and auto components.
Conversely, stock selection in Information Technology was a relative strength in 2017, thanks again to Teradyne. Lack of exposure to two lagging sectors—Financials and Energy—also helped performance vis-?-vis the small-cap index.
More than 200 companies in the Russell 2000 are “zombie companies,” defined by Cornerstone Macro as those that have been unable to make their interest payments out of cash flow for three straight years. They have to borrow just to make interest payments. Low interest rates and the search for yield have allowed these companies not to die.
This is not a sustainable situation—and there are some signs that investors are becoming more concerned about the sustainability of profit growth: companies that reported better-than-expected third-quarter earnings did not receive the usual bounce while those who missed were punished more severely than usual.
Moreover, a striking—and potentially very significant—reversal took place in the fourth quarter: small-cap companies with earnings enjoyed higher returns than those without.
The Russell 2000 as a whole looks increasingly expensive—and thus more risky—to us, while we believe our portfolio holdings as a group look attractive. Our reasoning is based on the portfolio’s high cap rate, high returns on invested capital, and low leverage.
Furthermore, relative performance improved in the fourth quarter when the Fund beat the Russell 2000 (up 4.6% versus 3.3%). With cost pressures mounting and most companies having already squeezed out costs wherever possible, the need for more volume and/or lower costs to maintain or expand margins is increasingly hard to come by.We therefore expect to see more strategic acquisitions in the months ahead. This could create opportunities for select portfolio holdings to become targets for takeovers/business combinations.
Current Positioning and Outlook
It remains an open question if the Fund’s strength in 2017’s final quarter marked a more lasting change. It is clearly possible that a more discerning environment with an emphasis on quality may be upon us. While small-cap stocks did well in 2017, they generally lagged expectations based upon their status as the likely prime beneficiaries of the tax overhaul.
The catch, we suspect, is that about one-third of the companies in the Russell 2000 have no income while many others have so much debt that the limits on interest deductibility may actually harm them.
The portfolio, on the other hand, appears better-positioned to potentially benefit as it holds profitable companies that generate most of their earnings—and pay the bulk of their taxes—here in the U.S. They also have little debt and thus are not harmed by deductibility limits. We have carefully sifted through the deck and like what we own as we embark on 2018.
Important Performance 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 www.roycefunds.com. 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 December 31, 2017, 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 December 31, 2017 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.
