Fund performanceÂ
Royce Heritage Fund was down 6.5% in 2015, trailing its small-cap benchmark, the Russell 2000 Index, which fell 4.4% for the same period. The Fund advanced 1.1% for the year-to-date period ended June 30, 2015 compared to a gain of 4.8% for the small-cap index. The equity markets then experienced a widespread correction in the third quarter, when Heritage lost 10.4% while the Russell 2000 declined 11.9%. Stocks rebounded somewhat in the fourth quarter, with the Fund increasing 3.2% while its benchmark was up 3.6%. Throughout the year, small-cap was characterized by narrow market leadership from mostly growth stocks, particularly in Health Care (though the fourth quarter also saw strength for similarly oriented tech businesses). This lack of breadth can best be seen by the equal-weighted calendar-year return for the Russell 2000, which was -10.1%. We were pleased that Heritage celebrated 20 years of history in December 2015 and outpaced its benchmark over longerterm periods. The Fund outperformed the Russell 2000 for the 15-, 20-year, and since inception (12/27/95) periods ended December 31, 2015. Heritage’s average annual total return since inception was 12.1%. We are quite proud of the Fund’s long-term record.
What worked… and what didn't
Six of the Fund’s nine equity sectors finished the year with net losses, which compared favorably to the benchmark, where eight of 10 were in the red for 2015. The largest detractors in Heritage were Financials, Industrials, and Materials, though net losses at the sector level were mostly modest. At the industry level, four groups posted notable net losses— machinery, capital markets, chemicals, and electronic equipment, instruments & components. The Fund’s biggest detractor was Minerals Technologies (MTX), a value-added, minerals-based product company. Revenue growth disappointed throughout the year as the company’s end markets—paper production and metals refractories— came under considerable stress. Throughout this period, the company has executed well in protecting operating margins largely via continued operational improvements at the recently acquired Amcol Corporation. The company continues to generate substantial cash flow and in September authorized a share repurchase program and became active buyers of its stock. It was the Fund’s fifteenth-largest holding at year-end—our confidence premised on the company’s ability to continue generating substantial cash flow.
Genesee & Wyoming (GWR, Financial) owns and operates short line and regional freight railroads and provides related rail services through its subsidiaries. A newer position, its business was slowed primarily by a number of factors related to lower shipping traffic for steam coal, agricultural products, oil and frac sand, and metals. Liking its core business and potential to recover, we added shares in the fourth quarter. We chose to reduce our stake in KKR (KKR, Financial), which topped a longish list of detractors in the capital markets group, after the company saw a reversal in carried interest income, performance fees, and investment income. A similar trajectory led us to exit our position in investment business Medley Management. The same industry was also home to the Fund’s top contributor, Value Partners (Trades, Portfolio) Group, a Hong Kong-based asset manager. Its stock often closely parallels movements in Hong Kong’s and China’s markets, which climbed precipitously into May before cooling off in June with the decline in Chinese stocks. We sold the bulk of our shares before the end of July and exited complete by year-end.
On a relative basis, the Fund was hurt most by Financials, Information Technology, and Health Care. In the first of these sectors, an underweight in banks, an overweight in capital markets, and ineffective stock selection in diversified financial services all hurt relative results. Stock selection was an issue in Information Technology while it was a strength in Health Care, but our low exposure to the top-contributing biotech industry was a factor in underperformance. Conversely, stock selection drove better results for our holdings in three sectors— Industrials, Consumer Discretionary, and Materials. Finally, the Fund also benefited from its large cash position at year-end.
Top Contributors to Performance For 2015 (%)
- Value Partners (Trades, Portfolio) Group - 0.43%
- Innospec (IOSP, Financial) - 0.29%
- Cal-Maine Foods (CALM, Financial) - 0.29%
- SEI Investments (SEIC, Financial) - 0.27%
- Fiserv (FISV, Financial) - 0.25%
Top Detractors from Performance For 2015 (%)
- Minerals Technologies - 0.74%
- KKR & Co. L.P. - 0.48%
- Genesee & Wyoming Cl. A - 0.47%
- Medley Management Cl. A (MDLY, Financial) - 0.39%
- Anixter International - 0.38%
Current positioning and outlook
The Fund remains oriented toward quality, with a focus on finding companies with durable moats, high returns on invested capital, and the capacity to reinvest into the business. Valuation is critical to this process, though our preference is to identify potential value creation as much as it is to spot what we think is a compelling bargain. In 2015 we made progress both toward reducing the overall number of names and increasing the Fund’s domestic focus, and we expect to continue refining the portfolio towards a more concentrated, increasingly domestic strategy. We are concerned about the deflationary effects from weakened commodities and the Internet, in tandem with the industrial recession, on the U.S. consumer. For this reason and others, we continue to believe the market will discount these incremental risks, market volatility will increase, and investors will become more discriminating. In such an environment, it follows that returns will be lower, and for that reason, among others, we believe our bottom-up, quality-oriented process should defend better. At the end of the year, the Fund was overweight in Industrials, Consumer Discretionary, and Materials, underweight Health Care and Financials, and had almost no exposure to Energy.
