Royce Co-CIO Believes U.S. Small-Cap Equities are "On a Road to Normalization"

Return to Quality is Coming

Aug 31, 2015, 09:30 ET from Legg Mason, Inc.

NEW YORK, Aug. 31, 2015 /PRNewswire/ -- While global equity markets were bringing sizable returns to many investors prior to the recent Asian-driven correction, Royce & Associates Co-Chief Investment Officer Francis D. Gannon believes the situation represents something akin to a suspension of laws of finance. The booming small-cap market in the U.S. is irrational and cannot be sustained – nor should it.

"Now this is starting to crack," Mr. Gannon recently told The New York Times. "I think we are on a road to normalization."

Though at times by fits and starts, markets continued to move forward in the first half of 2015.
"The Russell 2000 Index made a new all-time high, as did the Nasdaq Composite," Mr. Gannon observed. "Both were driven in large part by ongoing extraordinary results for biotech and, to a lesser extent, pharmaceuticals. There was a lot of volatility in biotech and plenty of commentary suggesting these stocks were in a bubble. These concerns proved to be no more than speed bumps as biotech companies remained market leaders through the end of the second quarter, while previous investor favorites such as utilities and REITs cooled off considerably."

"The concern going forward is the very narrow breadth of returns, evident to a large degree in the Russell 2000 Growth Index. It gained 8.7 percent year-to-date through June, versus an increase of 0.8 percent for the Russell 2000 Value Index. The Russell 2000 gained 4.8 percent."
A specialist in small-cap equities, Mr. Gannon and his team have argued for some time that the U.S. small-cap market is disjointed. This has led them to pass on some recently outperforming stocks.

"We are an active manager who embraces being an active manager," Mr. Gannon explained. "Our process has certain biases we have to embrace, so we're not going to be involved in certain aspects of the market. It's been challenging, waiting for many of our highest-confidence holdings to turn around. The shift we anticipated has taken longer than any of us initially thought."

"Change can take time. Often we're only aware that a dramatic move has occurred in retrospect. We're content to keep investing the same we always have – with a keen focus on managing risk, and by looking for the intersection of attractive valuation and organic growth potential."

The Royce Funds team believes U.S. Federal Reserve policies designed to keep the economy and capital markets above water, including multiple rounds of quantitative easing and keeping interest rates at or near zero, had unintended consequences – with outsized effects on small caps.

"It became easy and affordable to add debt, eroding risk differentials between lower- and higher-quality businesses," Mr. Gannon said. "Lower-quality and more highly levered companies began a historically atypical period of outperformance in which our funds mostly did not participate."

"The Fed's zero-interest-rate policy (ZIRP) stoked an intense hunger for yield, which drove up values for bond-proxy equities such as REITs and utilities, regardless of their underlying quality or profitability. This has only recently begun to correct."

These actions boosted stock correlations and reduced volatility. They also led to significant runs for high-growth, non-earning, and more speculative businesses, many with negative earnings before interest and tax (EBIT). All told, these historically aberrational moves have made it harder to find the kind of mispriced opportunities that have always been the stock in trade of active managers like Royce Funds.

"The recent contraction of small-cap leadership in the U.S. represents more of a bet on long-duration assets than current profitability," Mr. Gannon observed. "In each case, our more qualitative, risk-conscious approaches have in general kept us away from these areas. While we are confident this trend will fade and speculative bubbles will burst, we understand the frustrations of investors over the last few years as active managers such as ourselves continued to lag our benchmarks."

"Economic growth been a bit irregular, but we're seeing gathering strength in many previously depressed or sluggish economies. Revenue growth for many U.S. small-cap companies is in the 6-7 percent range, with earnings growth approaching 10 percent. Pretty strong and very encouraging."

Rising interest rates also should create more opportunities for active managers like Royce Funds.
"A higher-risk environment has historically benefitted quality companies: conservatively capitalized, profitable businesses with high returns on invested capital and effective, shareholder-friendly management," Mr. Gannon explained. "High rates are synonymous with higher risk, and nearly always correlated with a greater number of mispriced companies."

"We are not worried about rates rising or greater market volatility. In fact, we welcome both."
Mr. Gannon and his team have been engaged in spirited debates about what will be "normal" going forward. Yet all agree that the most recent declines should ultimately be good news for profitable companies with low leverage, which have historically held better during declines and periods of increased risk.

"You have an economic period now of pretty moderate growth, a low inflationary environment, solid earnings growth for small-cap companies and revenue growth anywhere between 6 and 7 percent," he said. "It's an interesting time to be looking at the small-cap space, particularly our part of the overall market, because there are some valuation discrepancies."

With small-cap returns being driven by lower-quality areas, Mr. Gannon "a wonderful period from a value proposition" is being set up. So why consider The Royce Funds?

"The increasingly global reach of the recovery is already benefiting several of our portfolios in the global and international space," Mr. Gannon explained. "Along with Royce Smaller-Companies Growth and Micro-Cap Opportunity Funds, our best performers in the first half of 2015 were Royce Global Value, International Premier, and European Small-Cap Funds. Certain portfolios increased exposure to consumer discretionary companies, beginning late last year."

"We saw a number of small-cap companies in the retail space – many of them old Royce favorites – that looked attractively undervalued or otherwise primed for growth. A flourishing economy with better employment numbers and lower energy prices has not spurred consumer spending to the degree many were anticipating. However, we usually have good-sized exposure to discretionary businesses in several of our funds, and we expect consumer activity to continue intensifying."

"The fact is we have solid portfolios of higher-quality businesses that we think are trading at a substantial discount to the overall market, in a world where people are forgetting about risk."

About Francis D. Gannon
Francis Gannon is Co-Chief Investment Officer of Royce & Associates, LLC, investment adviser to The Royce Funds, of which he is a Managing Director. He has 22 years of investment experience. Prior to joining the firm in 2006, Mr. Gannon was Chief Investment Strategist and Portfolio Manager with AIG SunAmerica Asset Management. For several years he was a regular panelist with the late Louis Rukeyser's "Wall Street" newsletter. Mr. Gannon holds a bachelor's degree and a master's degree from Boston College.

About Royce & Associates, LLC
For more than 40 years Royce & Associates, LLC, investment adviser to The Royce Funds, has used a disciplined, value-oriented approach to select micro-cap, small-cap and mid-cap companies. The firm has a seasoned staff of investment professionals, most with more than 15 years of experience. Chuck Royce, the firm's founder and a pioneer of small-cap investing, enjoys one of the longest tenures of any mutual fund manager. Royce & Associates, LLC is a wholly owned affiliate of Legg Mason Inc.

About Legg Mason
Legg Mason is a global asset management firm with $696 billion in assets under management as of July 31, 2015. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

Definitions:
Nasdaq Composite Index NASDAQ Composite Index is a market-capitalization-weighted index that is designed to represent the performance of NASDAQ securities and includes over 3,000 stocks. Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

Russell 2000 Index Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies. Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

Russell 2000 Value Index Russell 2000 Value Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their value orientation. Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

Russell 2000 Growth Index Russell 2000 Growth Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their growth orientation.  Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges

Royce Smaller-Companies Growth Fund The Fund invests primarily in stocks with market caps up to $7.5 billion, which may involve considerably more risk than investing in larger-cap stocks. In addition, as of 3/31/15 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund's overall value to decline to a greater degree. The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments.

Royce Global Value Fund As with any mutual fund that invests in common stocks, Royce Global Value Fund is subject to market risk — the possibility that common stock prices will decline over short or extended periods of time. As a result, the value of an investment in the Fund will fluctuate with the market, and you could lose money over short or long periods of time.  The Fund primarily invests in international companies, which may be subject to risks different from those of investments in securities of U.S. companies, including adverse political, social, economic or other developments that are unique to a particular country or region. The Fund primarily invests in micro-, small- and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also generally invests in a limited number of stocks, which may involve considerably more risk than a less-concentrated portfolio because a decline in the value of these stocks would cause the Fund's overall value to decline to a greater degree.

Royce International Premier Fund As with any mutual fund that invests in common stocks, Royce International Premier Fund is subject to market risk — the possibility that common stock prices will decline over short or extended periods of time. As a result, the value of your investment in the Fund will fluctuate with the market, and you could lose money over short or long periods of time.  Royce's estimate of a company's current worth may prove to be inaccurate, or this estimate may not be recognized by other investors, which could lead to portfolio losses.  The prices of small-cap securities are generally more volatile and their markets are less liquid relative to larger-cap securities. Therefore, the Fund may involve more risk of loss and its returns may differ significantly from funds investing in larger-cap companies or other asset classes. The Fund's limited portfolio may also involve more risk to investors than a more broadly diversified portfolio of small-cap securities because it may be more susceptible to any single corporate, economic, political, regulatory or market event.  In addition to general market risk, securities of international companies may be subject to different risks than investments in U.S. securities, including adverse political, social, economic or other developments that are unique to a particular country or region. Prices of international securities in particular countries or regions may, at times, move in a different direction and/or be more volatile than those of U.S. securities. The Fund's investments are usually denominated in or tied to the currencies of the countries in which they are primarily traded. Because the Fund does not intend to hedge its foreign currency exposure, the U.S. dollar value of the Fund's investments may be harmed by declines in the value of foreign currencies in relation to the U.S. dollar. This may occur even if the value of the investment in the currency's home country has not declined. These risk factors may affect the prices of international securities issued by companies domiciled in developing countries more than those domiciled in developed countries. For example, many developing countries have in the past experienced high rates of inflation or sharply devalued their currencies against the U.S. dollar, thereby causing the value of investments in companies located in those countries to decline. Transaction costs are often higher in developing countries, and there may be delays in settlement procedures.  To the extent that the Fund's investments in the securities of international companies consists of non-U.S. domiciled companies that trade on a U.S. exchange, some or all of the above-stated risks of investing in international companies may not apply.

Royce European Smaller-Companies Fund As with any mutual fund that invests in common stocks, Royce European Smaller-Companies Fund is subject to market risk — the possibility that common stock prices will decline over short or extended periods of time. As a result, the value of an investment in the Fund will fluctuate with the market, and you could lose money over short or long periods of time.   The Fund invests primarily in securities of micro-cap, small-cap and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also generally invests in a limited number of stocks, which may involve considerably more risk than a less-concentrated portfolio because a decline in the value of these stocks would cause the Fund's overall value to decline to a greater degree. Investing in foreign securities may involve political, economic, currency and other risks not encountered in U.S. investments. These risks are magnified in emerging markets.

Royce Micro-Cap Opportunity Fund The Fund invests primarily in microcap companies, which may involve considerably more risk than investing in larger-cap stocks. The Fund generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 25% of its net assets in foreign securities (measured at the time of investment), which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)

The views expressed are as of the date indicated and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Securities and sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision.

An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

All investments involve risk, including loss of principal. Past performance is no guarantee of future results.

Before investing, carefully consider a fund's investment objectives, risks, charges and expenses. You can find this and other information in each prospectus, or summary prospectus, if available, which is available at www.leggmason.com/individualinvestors. Please read it carefully.

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