Royce Heritage Fund Semiannual Letter
FUND PERFORMANCE:
Royce Heritage Fund was up 1.1% for the year-to-date period ended June 30, trailing its small-cap benchmark, the Russell 2000 Index, which gained 4.8% for the same period.
The year began on a difficult note for most equities, with the major indexes all trending downward during January. It was tougher on small-caps than on mid- and large-cap issues, though losses were mitigated in large part by a stronger rebound for the Russell 2000 during the recovery for share prices during February and March. The Fund performed in line with this pattern, struggling in January before coming back in the next two months, though its results were not as strong. For the first quarter, Heritage gained 1.2% versus a gain of 4.3% for the small-cap index. The second quarter had a pattern that was similar to that of the first— a bearish April was followed by mostly rising stock prices in May and June — but results were generally more muted. There was also the uncertainty, and resulting volatility, surrounding Greek debt that rocked the global equity markets at the very end of June and substantially tamped down second-quarter gains. Heritage defied the bearish trend in April but was unable to keep pace in the more growth-driven May and more tumultuous June. The Fund fell 0.1% for the second quarter compared to a 0.4% gain for the Russell 2000. Longer-term results were better on both an absolute and relative basis. Heritage beat the Russell 2000 for the 10-, 15-year, and since inception (Dec. 27, 1995) periods ended June 30. The Fund’s average annual total return since inception was 12.9%. We remain proud of the Fund’s nearly 20-year record.
What worked … and what didn't
On a relative basis, two sectors had a significant negative impact for the semiannual period. Health Care was the clear leader within the small-cap market as a whole, driven by highly impressive results for biotech stocks. The Fund was significantly underweight this sector and had very limited exposure to biotech companies, which hurt relative performance. While Heritage was substantially overweight in Information Technology during the first half, it was also significantly underweight in software companies, which dominated overall technology returns in a fashion similar to what biotech did in Health Care.
Seven of the Fund’s nine equity sectors posted net gains for the semiannual period, with Financials leading by a sizable margin. The portfolio was underweight in Financials compared to its benchmark, but easily compensated with effective stock selection — its sector holdings posted an overall better return than did those in the Russell 2000. The sector’s results in the portfolio were propelled primarily by excellent results from holdings in the capital markets industry, which was home to five of Heritage’s top-10 contributors in the first half.
Value Partners (Trades, Portfolio) Group is a Hong Kong-based asset manager with a value orientation that naturally appeals to us. Its stock often closely parallels movements in Hong Kong’s and China’s markets, which climbed precipitously into May before cooling off in June with the decline in Chinese stocks. We were pleased to see growth in its assets under management and improved performance and management fees, all of which helped its earnings.
Shares of ManpowerGroup (MAN, Financial), which is in the Industrials sector, rose as demand for temporary staffing recovered in Europe, the company’s largest revenue geography. It also experienced sturdy growth from its permanent placement segment, a high-margin end of its business. Finally, the firm announced two staffing acquisitions that expanded or solidified its status in Europe and the Australasia region and gave a hefty 63% boost to its dividend.
The Fund’s largest detractor by a wide margin, Anixter International (AXE, Financial) provides security systems and solutions, enterprise cabling and also distributes electrical and electronic wire. The company’s stock was hurt when Anixter reduced its organic growth outlook for the year in two of its core distribution businesses — the enterprise cabling and security solutions line and its electronic wire and cable segment. Other disadvantages included competitive pressures in cabling and security, slower U.S. industrial production due to the stronger dollar and lower energy-related capital spending. Lower copper prices also remained a sales drag.
Genesee & Wyoming (GWR, Financial) owns and operates short line and regional freight railroads and provides related rail services through its subsidiaries. A newer position, its business was slowed primarily by a number of factors related to lower shipping traffic for steam coal, agricultural products, oil and frac sand and metals.
Top contributors to performance
- Value Partners (Trades, Portfolio) Group
- ManpowerGroup
- Cal-Maine Foods (CALM, Financial)
- SEI Investments (SEIC, Financial)
- Clarkson (CKN, Financial)
Top detractors from performance
Anixter International
Genesee & Wyoming
Standard Motor Products (SMP, Financial)
Medley Management Cl. (MDLY, Financial)
Coronation Fund Managers (CML, Financial)
Current positioning and outlook
After stalling briefly in the first quarter, the economy appears to have resumed a steady pace of growth that should benefit small-caps as a whole, particularly those in more economically sensitive areas of the market such as Industrials and Materials — two sectors in which the Fund was significantly overweight at the end of June. As such, our focus remains on companies that are poised for profit margin expansion as their revenue growth normalizes in concert with a faster moving U.S. economy.
