Royce Special Equity Fund Manager Commentary
article 12-31-2020

Royce Special Equity Fund Manager Commentary

We were pleased the Fund outperformed its primary benchmark, the Russell 2000 Value Index, in 2020.


Fund Performance

Royce Special Equity Fund gained 7.4% in 2020, outperforming its primary benchmark, the Russell 2000 Value Index, which was up 4.6%, while lagging the Russell 2000 Index, which advanced 20.0% for the same period.

What Worked… And What Didn’t

Six of the nine equity sectors in which the Fund held investments in 2020 contributed positively to performance, with Consumer Discretionary and Information Technology—two of its three largest sectors—leading by a wide margin while Communication Services detracted the most by far, followed by Real Estate and Materials. Household durables (Consumer Discretionary) and IT services (Information Technology) contributed most at the industry level while the top detractors were media (Communication Services), which led by a substantial margin, and specialty retail (Consumer Discretionary).

The top-contributing positions in 2020 were recreational product manufacturer Johnson Outdoors and Computer Services. The latter provides banking, payment processing, and related services and was a strong performer through much of the year. Also contributing notably to 2020’s performance was Cooper Tire & Rubber, which manufactures replacement tires for automobiles and trucks, with subsidiaries that specialize in medium truck, motorcycle, and racing tires. Furniture makers Flexsteel Industries and Hooker Furniture rounded out the portfolio’s top five contributors.

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Conversely, the two biggest detractors at the position level were media conglomerate Meredith Corporation and children’s publishing, education, and media company Scholastic Corporation. They were followed by apparel retailer Children’s Place; Standard Motor Products, which manufactures and distributes automotive parts in the automotive aftermarket industry; and Mercer International, which owns and operates three pulp mills that produce bleached softwood kraft pulp for use in tissues, hygiene products, and high-end printing and writing paper.

For the calendar year, the Fund’s outperformance came from sector allocation decisions—stock selection was a negative. At the sector level, lower exposure to Financials (along with a modest contribution from stock selection), no exposure to Energy, and a combination of our underweight and savvy stock picks in Real Estate all helped versus the benchmark. By contrast, ineffective stock picks and our overweight in Communication Services hampered relative performance. The positive effect of our higher weight in Materials was undone by poor stock selection while our lower exposure to Health Care overwhelmed the success of our stock picks in the sector.

Top Contributors to Performance 20201 (%)

Johnson Outdoors Cl. A2.34
Computer Services2.14
Cooper Tire & Rubber1.97
Flexsteel Industries1.52
Hooker Furniture1.27

1 Includes dividends

Top Detractors from Performance 20202 (%)

Meredith Corporation-4.50
Scholastic Corporation-2.38
Children's Place-1.65
Standard Motor Products-1.24
Mercer International-0.86

2 Net of dividends

Current Positioning and Outlook

We are very mindful that we could be in for tougher times over the next several months due to the spike in coronavirus cases. However, once we are past this, with more of the population vaccinated and barring a new black swan event, economic improvement should arrive, coinciding with easy earnings comparisons in the second quarter versus 2020’s. In our view, however, this has already been amply discounted into most earnings estimates and thus into valuations. In markets that are fully or highly priced, pro risk-taking behavior resulting from low risk-free returns leaves every market vulnerable to any form of shock. Assets with high valuations that resulted from being discounted at near zero interest rates will therefore not be immune to the laws of gravity.

The rolling 10-year Russell 2000 return spread between value and growth is still historically elevated at over two standard deviations. While there have been several false starts in favor of value over recent years, the steepening yield curve, rising commodity prices, and anti-‘big-tech’ rhetoric all suggest that the fourth-quarter rotation toward small-cap value may prove to be the real thing. In fact, we feel confident that the rotation towards value and cyclicals that materialized later in 2020 has further to run. It seems reasonable to expect that a growing economy, especially if accompanied by the possible fiscal stimulus such as infrastructure improvements, broadband buildout, etc. all have large multiplier effects and allow investors to buy earnings growth via value and/or cyclical names at more reasonable valuations than the growth names they initially sought out. The removal, or even reduction, of policy uncertainty should help.

At the same time, the primary force supporting high equity valuations at the end of 2020 was low interest rates, including negative real 10-year Treasury yields and $18 billion in negative-yielding sovereign debt around the globe, which has made equities and other assets appear inexpensive. Ultimately, the durability of high valuations will be determined in large part by the speed and direction of interest rates. And for as long as the pandemic remains a threat—and probably for a good while after—rate increases seem unlikely. Using the same consistent methodology for picking stocks in the portfolio, our tried-and-true indicators are predicting lower market returns, as they have accurately done in the past (though admittedly not always in a timely manner). This simple yet logical comparison of cap rate to cost of capital has proven hard to beat. Simplicity has its virtues. We are therefore advising caution and raising cash.

Average Annual Total Returns Through 12/31/20 (%)

Special Equity 16.437.437.432.939.247.497.689.888.57 05/01/98

Annual Operating Expenses: 1.23

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, 2020, 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, 2020 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 12/31/20, the percentage of Fund assets was as follows: Johnson Outdoors Cl. A was 5.0%, Computer Services was 6.3%, Cooper Tire & Rubber was 3.7%, Flexsteel Industries was 2.8%, Hooker Furniture was 3.8%, Meredith Corporation was 0.2%, Scholastic Corporation was 0.0%, Children's Place was 0.0%, Standard Motor Products was 3.5%, Mercer International was 0.0%

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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