Fund Performance
Although the first half was challenging for quality-oriented cyclical small-caps, our high-quality small-cap core offering held its advantage over its small-cap benchmark for the three-, 15-, 20-, 25-year, and since inception (12/31/91) periods ended June 30, 2018. After two calendar years with 20%-plus returns, a moderation in the pace of returns seemed reasonable. Royce Premier Fundadvanced 2.6% for the year-to-date period ended June 30, 2018, underperforming its benchmark, the Russell 2000 Index, which rose 7.7% for the same period.
What Worked… and What Didn't
Of the Fund’s nine equity sectors, seven made positive contributions to first-half performance. Health Care and Information Technology were the top contributors, while Consumer Discretionary and Consumer Staples had modest negative results. Two holdings from two different groups in Industrials made the biggest positive impact of all the Fund’s holdings. Copart is the largest online salvage auction provider in the U.S. The company saw higher volumes and revenue per car as market conditions remained robust in the first half. Copart’s continuous improvement of its virtual bidding platform is expanding the pool of potential buyers, auction participants, and bids per car. A shift within its non-insurance auto auction business toward dealers and financial institutions has been lifting both average selling prices and gross margins higher. Finally, the company has been supplementing its expanding European footprint with the acquisition of a salvage operation in Finland, augmenting its buyer base in Russia and the Baltic States.
Kirby Corporation (KEX, Financial) has the largest inland and coastal tank barge fleet in the U.S. and also draws revenue from servicing and distributing industrial engines, transmissions, parts, and oil field services equipment. The tank barge markets seem to be recovering well, thanks to retirements of older barges, limited new builds, and solid utilization rates. Kirby has also benefited from two recent acquisitions over the last 18 months that are allowing it to drive industry consolidation. In addition, higher land drilling activity resulting from rising oil prices has been stoking demand for new and remanufactured hydraulic fracturing units. It was the portfolio’s largest position at the end of June.
Among positions that detracted, Sun Hydraulics makes hydraulic and electronic valves, controls, and instruments for industrial machinery and off-highway vehicles. Despite robust sales growth, the company’s margins and earnings have been weaker than expected due to operating inefficiencies incurred by a ramp up to meet strong demand, as well as higher materials and commodity costs. We expect a reversal as the impact of management’s corrective actions—which include price increases, new supply agreements to ease constraints, and reduced temporary and overtime labor—to take effect. CIRCOR International (CIR, Financial) makes an array of valves and related flow control products and services. Solid fiscal first-quarter results, strong orders, and margin improvement potential across its core and newly acquired businesses led to an April recovery that was undone in June due to the secondary offering by Colfax (a recent acquisition) of CIRCOR shares, combined with tariff- and trade war-driven underperformance by global industrials. A multi-year contributor to performance, Cognex Corporation has a dominant position as the global leader in machine vision technology. It was hurt by slackening demand in its consumer electronics market, in particular by iPhone sales that were well below expectations.
On a relative basis, the biggest sector detractor was Information Technology, as multiple factors contributed, including overweights in lagging industries, such as electronic equipment instruments & components, and having no holdings in Internet software & services. The previously mentioned weakness for Cognex also hurt. Industrials was another source of underperformance, largely the result of being the Fund’s largest sector, as well as increasing investor concerns about the prospects for economic cyclicals. The largest relative positive contribution came from Energy, where superior stock selection among energy equipment & services stocks provided a relative edge, while Real Estate saw a benefit from having no exposure to REITs, which lagged.
Current Positioning and Outlook
The small-cap market looks curious to us, an observation that extends beyond our disappointing performance in the first half. While the market’s preference for lower-quality stocks was frustrating, we are confident in the long-term efficacy of the Fund’s high-quality approach. More troubling is the disconnect between the solid fundamentals we see—optimism from management teams, solid earnings reports, and consistently strong macroeconomic data— contrasted with market behavior we observe that looks odd in this context—leadership from defensive and yield-oriented stocks, lagging cyclicals, and a modestly rising 10-year yield. We do anticipate a shift in the market environment to one with greater volatility and more value/cyclical leadership, though we are also mindful that these shifts rarely occur without some turbulence. In this environment, we are on balance raising cash levels modestly. We are also actively re-populating the portfolio, having added seven new names over the past three quarters.
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 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 June 30, 2018, 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 June 30, 2018 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.
