More about the manager

Chief Executive Officer, Portfolio Manager

Our flagship, Royce Pennsylvania Mutual Fund. was up 2.0% for the year-to-date period ended June 30, 2014, finishing the first half behind its small-cap benchmark, the Russell 2000 Index, which gained 3.2% for the same period. This was somewhat disappointing because the market has at times been more hospitable to disciplined and active investment approaches over the last 14 months, dating back to the May 2, 2013 low for the 10-Year Treasury. This occasional strength could be seen in the Funds results from the second half of 2013, when it outperformed its benchmark.

Unlike the previous four years, 2014 got off to a slow, though still positive, start. This was not terribly surprising in the context of a highly bullish 2013, a year that saw no major corrections and enjoyed a particularly dynamic second half. The result was a nondescript opening quarter in which the Fund was up 0.3% versus a gain of 1.1% for the Russell 2000. The second quarter seemed similarly uninspired, though it was more volatile. Equities failed to establish any clear direction as the economy continued to grow slowly and a stillunresolved debate went on about whether or not stocks are overvalued or still have some room to run. This argument has so far been a low-intensity dispute, at least insofar as it has affected share prices. The same could be said for volatility, which has been low. Smallcaps reached a first-half high on March 4, declining 9.1% through May 15. This was as close to a correction as stocks have come so far in 2014. Markets began to rally in May and continued doing so through the end of June. For the second quarter, Pennsylvania Mutual rose 1.7% while the Russell 2000 was up 2.0%.

We have been very pleased to see valueoriented styles such as our own gradually narrow the performance gap over the last several months with their respective benchmarks and the passively managed portfolios and ETFs that mirror the indexes. While the Funds first-half results did not show this growing strength to the degree that we would like, results over the one-year period ended June 30, 2014 were more encouraging. We therefore remain resolute about the Funds approach and optimistic about its long-term prospects. We were also happy that its longer-term performance advantages remained in place. The Fund outpaced the Russell 2000 for the one-, 10-, 15-, 20-, 25-, 30-, and 35-year periods ended June 30, 2014. The Funds average annual total return for the 40-year periodall under the management of Chuck Roycewas 15.2%. We take great pride in this four-decade result .

Although net losses were relatively light, the portfolio held a number of detractors clustered in the Industrials sector, a cyclical area that has seen some recovery in the small-cap market and where the Fund was overweight in the first half compared to the Russell 2000. Global supply chain logistics services and solutions company UTi Worldwide suffered from weaker freight-forwarding volumes and pricing. Combined with delays collecting receivables due to the implementation of a major new IT system in the U.S. this caused the company to violate its debt covenants, forcing an expensive and dilutive recapitalization. Liking its chances for a turnaround, we built our position in the first half. KBR, a Houstonbased engineering and construction firm with global operations, saw its fiscal 2014 outlook reduced by cancellations and losses on some engineering and construction bids, as well as on pushed out start dates for certain LNG (liquefied natural gas) projects. We also liked its prospects for reversing its fortunes and added shares as its price slipped.

As for those sectors that made a positive contribution in the first half, Energy stocks led by a wide margin, followed by solid net gains for Materials, Health Care, and Financials. Holdings in the Energy sector accounted for three of Pennsylvania Mutuals five, five of its 10, and eight of its 20 top contributors. Helmerich & Payne, Unit Corporation, and Pason Systems are all long-term holdings. Along with other strong performers in the sector, they benefited from a revival of interest in energy stocks. Helmerich & Payne saw growth in demand for new rigs, confirming that its technologically superior offerings are driving market share gains for companies eager to reduce drilling costs by upgrading to its more efficient rigs. Unit Corporation operates as a contract driller and exploration and production company, among other energy-related businesses. Double-digit production growth, the introduction of a new advanced drilling rig, and continued strong performance from its midstream operations all helped to draw investors to its stock.

Along with Industrials, Consumer Discretionary also had a small net loss in the first half. We increased our position in multiline womens fashion business Ascena Retail Group as it endured a generally awful market for retail businesses. The company was more specifically challenged by depressed holiday results that did not improve as the year went on, particularly at Justice, a brand in the promotion-driven teen fashion space. The company is aiming for better results in the second half with revamped products for, and reduced inventory lead times at, Justice, increasing profitability from their plus-size brands, and cost reduction realizations.