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

Royce Small-Cap Special Equity Fund Manager Commentary

The Fund outperformed its primary benchmark, the Russell 2000 Value Index, for the 3-, 20-, 25-year, and since inception (5/1/98) periods ended 12/31/23—and beat the Russell 2000 in each of those periods except the 20-year span.


Fund Performance

Royce Small-Cap Special Equity Fund increased 12.8% in 2023 versus a 14.6% gain for its primary benchmark, the Russell 2000 Value Index, and 16.9% for its secondary index, the Russell 2000 Index. The portfolio outperformed the small-cap value index for the 3-, 20-, 25-year, and since inception (5/1/98) periods ended 12/31/23—and beat the Russell 2000 in each of those periods except the 20-year span.

What Worked… and What Didn’t

Six of the portfolio’s nine equity sectors made a positive impact on calendar year performance. The sectors making the largest positive contributions were Industrials, Consumer Discretionary, and Materials, while the negative impacts came from Communication Services, Energy, and Financials. At the industry level, electrical equipment (Industrials), machinery (Industrials), and construction materials (Materials) contributed most for the calendar year period, while media (Communication Services), consumer staples distribution & retail (Consumer Staples), and broadline retail (Consumer Discretionary) were the largest detractors.

Encore Wire, which manufactures building electrical wire, was the largest contributor for the year. Its shares surged in mid-February of 2023 after the company reported better-than-expected quarterly earnings, in part due to margins proving more resilient than had been anticipated. After trading rangebound through much of the year, Encore shares broke out again late in 2023 on stronger-than-expected volume sales and optimism due to lower interest rates. United States Lime & Minerals produces lime and limestone products used in various industrial applications. The company posted strong results throughout 2023, including impressive revenue growth and margin expansion driven in large part by continued pricing power. Mueller Industries primarily makes copper tubes, fittings, and climate-related components. Mueller’s market position has allowed for continued pricing power despite declining demand. Similar to Encore Wire, its shares rallied in December due to the impact of lower interest rates on its residential end markets. John B. Sanfilippo & Son processes and distributes nuts and snack products. The company posted excellent results through 2023’s first half as customers continued to gain appreciation for category expertise and service. It also introduced new products that have been purchased by large customers.

TEGNA, a TV broadcasting company, was the largest detractor for the year. Its acquisition by Standard General was blocked by the FCC at the end of February, removing the acquisition premium from the stock. Regional grocer Ingles Markets endured stagnating revenue growth and margins that deteriorated from Covid peaks due to cost inflation and raw material shortages that weighed on the stock through much of 2023. Hurco Companies manufactures computer numerical control machines. Its shares declined largely in 2023’s first half as revenue and earnings declined relative to 2022 and because the global machine tool market experienced declining demand. Shares of omnichannel retailer Macy’s were pressured throughout the year by concerns over consumer spending, co-branded credit card performance, and potential credit card regulation, though its shares rose in December following reports that an investor group had offered to acquire the company at a 21% premium to the prior close.

The portfolio’s disadvantage versus its benchmark was primarily attributable to sector allocation in the calendar year period, with the Consumer Discretionary, Communication Services and cash holdings making the most significant negative impact versus the benchmark. Conversely, Industrials, Health Care, and Utilities contributed most to relative calendar year period results.

Top Contributors to Performance 20231 (%)

Encore Wire2.71
United States Lime & Minerals1.66
Mueller Industries1.55
John B. Sanfilippo & Son1.53
NVE Corporation1.08

1 Includes dividends

Top Detractors from Performance 20232 (%)

Ingles Markets Cl. A-0.79
Hurco Companies-0.36
Diamond Hill Investment Group-0.26

2 Net of dividends

Current Positioning and Outlook

Slower economic growth during a period when price increases accounted for most revenue gains suggests the possibility of a margin squeeze as revenues may weaken faster than costs. We see earnings levels as reflecting the over-earning based upon inventory building and price increases. This appears to be reversing. However, the degree to which is to be determined. If prices do not hold, we expect trouble. Recent revenue growth has been largely price based. Yet investors insist on fighting the Fed. Chair Powell has made it clear he wishes to be compared to Paul Volcker, not Arthur Burns. Absent additional evidence of some significant slowdown in the economy, or slowdown in Super Core Personal Consumption Expenditures Price Index (services), it is hard for us to envision the magnitude or frequency of rate cuts the market is expecting. The financing needs of the U.S. government will also bias rates higher. So, while much commentary has centered on rates over the next year or two, we have a longer-term outlook. One could argue that rates will remain high compared to the last decade plus. Globalization has decreased as supply chains move back to the U.S., with resulting higher prices. Climate change, green transition initiatives, an aging population, and a tense geopolitical stage, with resulting increases in military spending, are just some of the reasons we expect interest rates to be higher for longer. With so much going on, we think that risk management should be the order of the day, especially since the market has already priced in the expected lower rates.

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

Small-Cap Special Equity 8.9312.8312.838.999.395.969.857.729.178.62

Annual Operating Expenses: 1.22

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 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, 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: Encore Wire was 6.3%, United States Lime & Minerals was 3.6%, Mueller Industries was 3.4%, John B. Sanfilippo & Son was 4.1%, NVE Corporation was 3.3%, TEGNA was 3.8%, Ingles Markets Cl. A was 6.2%, Hurco Companies was 0.8%, Macy's was 2.6%, Diamond Hill Investment Group was 2.9%.

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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