Royce Small-Cap Fund Manager Commentary
article 02-15-2024

Royce Small-Cap Fund Manager Commentary

The Fund had a stellar 2023, up 26.7% and outperforming its small-cap benchmark, the Russell 2000 Index, which climbed 16.9% for the same period. The Fund even narrowly outpaced the large-cap Russell 1000 Index, which was up 26.5% in 2023.


Fund Performance

Our flagship, Royce Pennsylvania Mutual Fund, had a stellar 2023, up 26.7% and outperforming its small-cap benchmark, the Russell 2000 Index, which climbed 16.9% for the same period. The Fund even narrowly outpaced the large-cap Russell 1000 Index, which was up 26.5% in 2023. The Fund also beat the Russell 2000 for the 3-, 5-, 10-, 15-, 20-, 25-, 30-, 35-, 40- and 45-year periods ended 12/31/23. In addition, the Fund’s average annual total return for the 50-year period ended 12/31/23 was 13.2%.

What Worked… and What Didn’t

All 10 equity sectors in which the Fund held investments finished 2023 in the black, with the largest contributions coming from Industrials, Information Technology, and Financials. Communication Services, Energy, and Health Care made the smallest positive contributions. At the industry level, two of the portfolio’s largest industry weights—semiconductors & semiconductor equipment in Information Technology and machinery in Industrials—were the top contributors, followed by another good-sized weighting—building products in Industrials. The top detractors were communications equipment from Information Technology, air freight & logistics in Industrials, and interactive media & services in Communication Services.

The top-contributing position in 2023 was First Citizens BancShares, which the Fund has owned for many years due mostly to its strong liquidity position and stellar deposit franchise. Its valuation looked attractive to us in late 2022, when we began adding shares that were trading at roughly 5x earnings per share. In late March of 2023, First Citizens made its FDIC-assisted acquisition of Silicon Valley Bank. The market eventually re-rated its shares, first as it became clear that this acquisition was accretive and again when there was not a systemic banking crisis. Builders FirstSource manufactures building products for professional homebuilders. It continues to benefit from its merger with BMC Stock Holdings, which expanded its value-added product footprint in fast growing markets, furthered share gains in key product categories (chiefly in manufactured components), and created cost synergies. The company has also enjoyed strong financial results, generated ample free cash flow, and seen widening margins.

The Fund’s biggest detractor was James River Group Holdings, which is a specialty insurer and reinsurer. We had thought that the company had put underwriting issues behind it, but they resurfaced in 2023, as did problems in the company’s casualty reinsurance business. A negative restatement of 2Q23 financials worsened an already difficult situation. Valmont Industries manufactures products focused on the infrastructure and agricultural markets, including those used in utility grid resilience, solar energy, upgrades to lighting and transportation infrastructure, and the 5G rollout. The company endured significant impairments in its Agriculture Technology unit, due to slower growth and lower-than-expected adoption rates, while facing inflationary pressures and lower sales in its telecom business. To address these issues, Valmont initiated an organizational realignment that entailed executive leadership changes aimed at improving efficiency and streamlining decision-making, which led to short-term disruptions and uncertainty (as major organizational changes often do) that drove other investors away from its shares.

The Fund’s advantage over the Russell 2000 came mostly from stock selection in 2023, though sector allocation was also highly additive. Altogether, 10 of 11 equity sectors contributed to the Fund’s outperformance. Stock selection and our higher weighting in Industrials and Information Technology, as well as stock selection in Financials helped relative performance. Conversely, stock selection detracted in Communication Services while the smallest contributions to outperformance came from our lower weightings in Consumer Staples and Energy.

Top Contributors to Performance 20231 (%)

First Citizens BancShares Cl. A1.90
Builders FirstSource1.32
Onto Innovation1.00

1 Includes dividends

Top Detractors from Performance 20232 (%)

James River Group Holdings-0.38
Valmont Industries-0.33
Forward Air-0.30
Forrester Research-0.25
Mesa Laboratories-0.22

2 Net of dividends

Current Positioning and Outlook

Our outlook is constructive. First, we suspect that returns are likely to be spread more widely over the next few years and that the reign of the Magnificent 7—the mega-cap cohort of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla—may be coming to an end, especially if 2023’s fourth quarter and early January 2024 are any indication. The backdrop of moderating inflation, normalized interest rates, and a still growing U.S. economy also bolsters our belief that small-cap’s lengthy stretch in the relative performance wilderness has run its course. We believe moderate growth and the more normalized rate environment should support a broadening of equity market returns where small-caps could be clear beneficiaries, especially those businesses that have largely sat out the mega-cap performance regime. Even more important is what we’ve been hearing from management teams—most of whom remain cautiously optimistic about 2024. We see an increasing likelihood for example, that the U.S. economy will achieve the much-desired soft landing—which is encouraging for many reasons. The next few years are expected to see even more tangible benefits of reshoring, the CHIPS Act, and numerous infrastructure projects, and we see many of our holdings as poised to benefit from these developments. We’re looking forward to what we think should be a favorable cycle for small-cap stocks.

Average Annual Total Returns Through 12/31/23 (%)

QTR1 YTD1 1YR 3YR 5YR 10YR 15YR 20YR 25YR 35YR 45YR
Small-Cap 12.8626.6626.668.6413.118.0211.939.039.9310.4512.39
Russell 2000 14.0316.9316.932.229.977.1611.308.117.919.3210.97

Annual Operating Expenses: 0.94

1 Not annualized.

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 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 and other investment companies.

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, 2023, 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, 2023 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.

As of 12/31/23, the percentage of Fund assets was as follows: First Citizens BancShares Cl. A was 1.4%, Builders FirstSource was 1.3%, Onto Innovation was 1.3%, Arcosa was 1.9%, Kadant was 1.2%, James River Group Holdings was 0.2%, Valmont Industries was 0.6%, Forward Air was 0.2%, Forrester Research was 0.5%, Mesa Laboratories was 0.5%.

Sector weightings are determined using the Global Industry Classification Standard (“GICS”). GICS was developed by, and is the exclusive property of, Standard & Poor’s Financial Services LLC (“S&P”) and MSCI Inc. (“MSCI”). GICS is the trademark of S&P and MSCI. “Global Industry Classification Standard (GICS)” and “GICS Direct” are service marks of S&P and MSCI.

All indexes referred to are unmanaged and capitalization weighted. Each index’s returns include net reinvested dividends and/or interest income. Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 Index is an index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth Indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell Microcap Index includes 1,000 of the smallest securities in the Russell 2000 Index, along with the next smallest eligible securities as determined by Russell. The Russell 2500 is an unmanaged, capitalization-weighted index of the 2,500 smallest publicly traded U.S. companies in the Russell 3000 index. The returns for the Russell 2500-Financial Sector represent those of the financial services companies within the Russell 2500 index. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The MSCI ACWI Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks.The MSCI ACWI ex USA Small Cap Index is an index of global small-cap stocks, excluding the United States.The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. Returns for the market indexes used in this report were based on information supplied to Royce by Russell Investments. Royce has not independently verified the above described information.

This material contains forward-looking statements within the meaning of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve risks and uncertainties, including, among others, statements as to:

-the Funds’ future operating results,

-the prospects of the Funds’ portfolio companies,

-the impact of investments that the Funds have made or may make, the dependence of the Funds’ future success on the general economy and its impact on the companies and industries in which the Funds invest, and

-the ability of the Funds’ portfolio companies to achieve their objectives.

This discussion uses words such as “anticipates,” “believes,” “expects,” “future,” “intends,” and similar expressions to identify forward-looking statements. Actual results may differ materially from those projected in the forward-looking statements for any reason.

The Royce Funds have based the forward-looking statements included in this commentary on information available to us on the date of the commentary, and we assume no obligation to update any such forward-looking statements. Although The Royce Funds undertake no obligation to revise or update any forward-looking statements, whether as a result of new information, future events, or otherwise, you are advised to consult any additional disclosures that we may make through future shareholder communications or reports.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see ""Primary Risks for Fund Investors"" in the prospectus.)



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