Legg Mason : Small-Cap Equity Market Rebound Appears Strong with Potential to Last

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Maria Rosati (212) 805-6036

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Small-Cap Equity Market Rebound Appears Strong with Potential to Last

After Many Quarters of Uncertainty and Uneven Performance, Small-Cap Stocks Poised to Shift Styles -

From Growth to Value

(New York, NY, April 25, 2016) - "Do we think the worst is behind us?" asked Steve Lipper, Senior Investment Strategist of Royce & Associates, as he opened a recent webcast on the fast-changing state of the U.S. small-cap equity markets. "We think probably."

On February 11 the Russell 2000 Index closed down 15.9 percent for 2016, "then had a strong rebound, but still closing the quarter down," Mr. Lipper reported. "Quite a wild ride. If we look back to the small- cap market peak, June 23, the decline was 25.7 percent to that February low."

Royce & Associates CEO Chuck Royce, a pioneer of small-cap investing, echoed his analysis. As Mr.

Lipper noted, "history has shown that value outperforms over the long-term."1

"We had a down third quarter but a very mixed fourth quarter and a continued decline in the beginning of this year," Mr. Royce said. "I believe it has set the stage for an important bottom. It had heavy volume, it had a breakdown of important sectors - healthcare - and a sort of giving up in certain ways almost across the board. And it felt like many other lows we've seen."

This could set the stage for an important style shift in the small-cap markets, from growth to value. As Mr. Lipper noted, "history has shown that value outperforms over the long-term."

"This is an important shift, one that I believe is going to last for some time," Mr. Royce said. "These cycles occur every so often over the course of time. The reversion to the mean, which is a very powerful phenomenon in the stock market, may only just be getting started."

These shifting conditions have led to domestic small-cap markets where a majority of Royce Funds benchmarked to the Russell 2000 outperformed that benchmark during the first quarter. In keeping with perceived style shifts, small-cap value has led the way, with growth lagging.

1 Based on the Russell 2000 Value vs. Growth annualized trailing 10-year relative returns, 1988 through March-2016.

"We're very proud of our results overall," Mr. Royce said. "We had a very sloppy period in the last three years, which was a market cycle. One of our worst underperformance periods. A similar thing happened in the late 1990s. But we're thrilled with the shift that appears to have started from the more recent peak in June, where 80% of our funds have outperformed."2

Royce Small-Cap Value Fund Portfolio Manager Jay Kaplan saw change bubbling up over the summer.

"We saw some trouble in the high yield market which led to some seizing up of the debt capital markets," Mr. Kaplan observed. "We've seen some seizing up of the equity capital markets, both of which have really caused the cost of capital to go up quite a bit. Traditional growth stocks have been bid up. It's been an environment where the economy is slow. Zero interest rates have led people to really stretch. We've seen companies with no earnings prospects, like biotech, those companies did very, very well for a long time. They started to roll over as interest rates started to go up. So there were a lot of forces that started to forecast a shift in market conditions."

His views were echoed by Royce Opportunity Fund Portfolio Manager Bill Hench.

"There was a momentum market, where select groups performed well because the perception was there was very little growth globally," Mr. Hench said. "No price was too high to pay for it. Positive things led people to do this to start. Whether it was biotech - where you had a lot of successful launches, especially in hepatitis - or media, where you have a lot of margin growth because of the internet, there was reason for the momentum. That seems to have played out."

With the market turning to potentially reward high-quality and financially healthy individual companies, the Royce team believes opportunities abound - in companies of all sizes.

"The microcap area is the most undervalued segment of our world and represents a tremendous long- term opportunity," Mr. Royce said. "We are committed to that space. Virtually all of our portfolios use microcap. I have found that to be an exceptional area of opportunity currently."

Another area of opportunity Mr. Royce pointed to was the upturn in the industrial sector.

"We have historically had an overweight in. Our industrials are typically very high quality. They tend to be global, but they are niche companies with important market positions," Mr. Royce said. "That entire sector did dramatically underperform in the three years prior, but stocks acted very strong in November and very strong in the first quarter. I think it is primarily an issue of the dramatic undervaluation that took place over time, and that is beginning to be corrected."

Mr. Kaplan attributed the recent success of his investment strategy not to change, but to staying the course.

2 References only Royce Funds benchmarked against the Russell 2000

"We really haven't done anything differently in this quarter than we've been doing for years and years and years," Mr. Kaplan explained. "Buying well financed, really good companies, at the right price: sometimes you have to hang in there. As a contrarian value investor you may have long periods of underperformance. But if you continue to work through a portfolio, accumulate those companies, the work you've done ultimately can have that payoff we started to see."

"We were hurt by biotechs for a long period of time, companies that are very reliant on the capital markets to keep going. They need more cash all the time. Our companies don't. They self-finance. Cash flow is good. Capital allocation is very, very good. The market has changed. It has come around to realize the value of those kinds of companies, businesses we've invested in. It's put the heavily speculated lottery tickets on the side for a while. That's been very good for us."

Mr. Hench was similarly optimistic in his assessment of the small cap market's trajectory.

"If you look at what we've lived through in the last couple of years - questions about European growth, Chinese growth, oil and commodity moves, as well as interest rate moves or perceived moves - what you have is great opportunities to buy stocks at very, very depressed levels," Mr. Hench said. "That's what we get paid to do. It's what we've done. We've always tried to position the portfolio as cheaply as we possibly can, and to gain the most when the wind is at our back. We think we've assembled a terrific portfolio with a lot of very cheap stocks that we hope will perform when the wind does come to our back."

The broad pickup in merger and acquisition (M&A) activity has impacted small caps as well.

"We've made pretty sizable investments in M&A advisory banks," Mr. Kaplan reported. "Some of the small boutique investment banks are just really focused on M&A, and those are areas that we're pretty strong on in the portfolios right now."

When asked about the outlook for small-cap energy, Mr. Hench responded, "It's a huge area. You have energy, you have exploration and production (E&P) and services. You also have tankers, which are incredibly cheap and have been for a while. You have construction names, industrial manufacturing companies. There's many ways to play energy without direct exposure to E&P."

Mr. Royce added, "One of the areas within energy we like is intellectual property companies, that have special techniques or databases and provide 'the secret sauce' to better outcomes."

Asked about the enormous flow into exchange traded funds (ETFs), away from active managers, Mr. Royce said, "We believe as active managers that we can add value. We are convinced we can. We certainly have historically. The shift to value is actually part of this whole reversal out of passive into active, which also started probably late last year and strongly in the first quarter of this year."

Many actively managed firms have experienced outflows, which require careful management.

"It's an issue of capital allocation," Mr. Kaplan said. "It's an opportunity, for better or worse. You understand that if I'm suffering from outflows, anything I don't sell to meet a redemption, I'm effectively buying. It keeps you honest and it makes you have a little more discipline probably. Do we like it? We don't, but we've shown over the years that we are capable of dealing with it."

"People think flows are a leading indicator of performance," Mr. Lipper added. "Last year was one of the largest of outflows for the firm, and this first quarter was one of the best quarters of relative performance. Hopefully that puts to bed the idea that it's some sort of leading indicator."

It was also noted that health care was among the worst performing sectors in the first quarter.

Mr. Royce answered, "Health care obviously has been a very successful area. Drug discovery is the theme. It's not a zone we have historically done a lot in. We are not trying to figure out which drug will do better. We only want to use health care companies that have real earnings and broad product lines."

Mr Hench added, "Those types of situations would be facility based providers, device makers, some of the small pharmaceutical names. Things with real good cash flow, that are being effected by volume, by employment. There's a very, very long list of things that don't necessarily come to the top of one's mind when you think about health care. But the opportunities are pretty big."

Important Information Average Annual Returns as of 3/31/16 (%) for Investment Class

Average Annual Total Returns(%)					Annual Operating Expenses(%)
Royce Fund	QTR*	1YR	3YR	5YR	10YR	SINCE INCEPT.	DATE	GROSS	NET
Capital Small-Cap	9.13	-6.55	7.56	6.24	5.76	10.84	12/27/96	1.05	1.05
Dividend Value	5.13	-1.72	5.24	6.17	6.71	8.28	05/03/04	1.29	1.29
Global Financial Services*	1.88	-5.46	7.69	7.67	5.48	7.30	12/31/03	1.93	1.74
Heritage	4.90	-2.96	4.05	3.58	5.30	12.29	12/27/95	1.17	1.17
Low-Priced Stock	-0.64	-11.26	-1.20	-3.90	1.89	9.78	12/15/93	1.17	1.17
Micro-Cap	-1.08	-14.02	-0.89	-2.51	2.52	10.54	12/31/91	1.48	1.48
Micro-Cap Opportunity	-0.94	-20.79	0.86	3.83	N/A	9.55	08/31/10	1.56	1.28
Opportunity	2.08	-12.74	3.60	4.73	4.67	11.39	11/19/96	1.15	1.15
Pennsylvania Mutual	6.22	-6.99	4.67	4.92	4.87	N/A	N/A	0.92	0.92
Premier	4.41	-8.34	3.75	3.64	5.79	11.11	12/31/91	1.10	1.10