Fund Performance
Like 2017, the first half of 2018 was a period of lower-than-average volatility in which small-cap growth stocks beat small-cap value, and small-cap companies that pay no dividends outpaced those that do. Non-dividend payers were up 11.8% for the year-to-date period ended June 30, 2018, finishing well ahead of small-cap dividend payers in the Russell 2000, which rose only 3.8% over the same period. Additionally, the Fund’s preference for more economically cyclical dividend-paying stocks, as opposed to those more sensitive to interest rates, worked doubly against it in the more bullish second quarter, when the former group lagged while the latter rallied. Finally, Health Care and Information Technology—the two best-performing sectors in the Russell 2000 during the first half—have been persistent portfolio underweights owing to their relative lack of dividend payers. Needless to say, this made for a less than ideal environment for our risk-conscious dividend value approach. Royce Total Return Fund advanced 0.6% for the year-to-date period ended June 30, 2018, significantly trailing its small-cap benchmark, the Russell 2000 Index, which gained 7.7% for the same period.
What Worked… And What Didn't
Six of the Fund’s 11 equity sectors finished the first half in the black. Energy, where our exposure was low and slightly underweighted, led by a considerable margin, followed by Health Care, another very low weighting. The collective impact of the five detracting sectors was modest, but unfortunately included the Fund’s two largest—Financials and Industrials.
At the industry level, the energy equipment & services (Energy) and specialty retail (Consumer Discretionary) groups led. The first was lifted by the rebound for oil prices. The largest positive contributor in this industry–and in the portfolio overall—was Norway’s TGS-NOPEC Geophysical, which provides geoscience data to oil and gas companies worldwide. Its revenue and earnings were boosted by improving exploration and production spending, higher oil prices, and the longer-term need for energy companies to replenish reserves, which is driving increased spending on seismic data. Specialty retail has been a fairly consistent trouble spot in the market over the previous three-plus years as retailers have struggled with near constantly contracting margins in the face of online competition and related changes in shopping patterns. This began to shift for a select number of businesses in the second quarter when sales began to recover. We took some gains in footwear retailers Shoe Carnival and DSW as well as in casual clothing business American Eagle Outfitters.
Manpower Group is a Milwaukee-based temporary staffing business. Earnings remained positive in 2018’s first half, its prospects in a still-tightening global labor market appear strong, and recent acquisitions expanded its global footprint. Its shares fell mostly on a change in tax subsidy rate in France for companies that provide temporary labor and loftier expectations for growth than even strong earnings earlier in the year could meet. We remained confident enough in its core global business to keep it among the portfolio’s top-10 holdings at the end of June. Thor Industries is a leading manufacturer of RVs (recreational vehicles) and has emerged as an innovative industry leader over the last several years. The firm announced record fiscal second-quarter sales in March, but also reported higher raw material and commodity costs. Along with concerns that its industry may have hit a sales peak, this was enough to drive investors away. We trimmed our stake but were holding shares at the end of June.
Relative to the Russell 2000, the Financials sector detracted most in the first half of 2018. Ineffective stock selection in that sector’s insurance and capital markets groups was the major source of underperformance, though our overweight also hurt. Our lower exposure made Health Care the portfolio’s second-largest relative detractor, as it was small-cap’s top-performer, while our underweight and poor stock selection created a relative disadvantage in Information Technology. Conversely, Energy’s positive effect was driven by superior stock selection in energy equipment & services holdings, while Real Estate benefited from the portfolio’s underweight as the sector underperformed in the first half.
Current Positioning and Outlook
The market’s behavior is curious to us. On the one hand, we hear optimism and solid progress from the management teams we meet with, see solid earnings reports, and observe consistently strong macroeconomic data. On the other hand, small-cap market leadership has stubbornly remained with defensive and yield-oriented stocks, while cyclicals have lagged. Despite new highs for the Russell 2000, we are therefore far from ebullient. We are continuing to reduce the portfolio’s exposure to companies with higher valuations and expectations while modestly raising cash levels. We do anticipate a change in market leadership to more cyclical stocks, but admit that changes in leadership seldom occur without turbulence. If higher volatility reemerges, we aim to be able to take advantage of what may be temporarily lower prices.
Important Performance, Expense 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, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies.
