Royce European Smaller-Companies Fund Manager Commentary

European stocks enjoyed a strong second half, though they still could not quite match the blistering pace of returns shown by their U.S. peers. Nonetheless, returns for the calendar year were robust. Many of the ever-present headlines about the eurozone’s still knotty debt issues were overshadowed by renewed investor concern over the health of certain emerging market economies and the impact of the U.S. Federal Reserve’s decision to taper the pace of its monthly bond purchases, the mere mention of which sent global markets into a brief tailspin in June. Royce European Smaller-Companies Fund, with its charter to invest in the highest conviction ideas we find in our research and analysis of European companies, had a solid absolute showing but disappointed on a relative basis. The Fund advanced 20.8% in 2013, lagging its benchmark, the Russell Europe Small Cap Index, which increased 36.6% over the same period.

The first quarter saw the Fund gain 2.5% as it fell behind the European small-cap index, which gained 5.2%. Markets experienced a significant spike in volatility in the second quarter—the year’s most eventful—as fragile eurozone economies came to grips with the potential for a reduction in U.S. monetary stimulus and higher interest rates. April and May were bullish, continuing the positive momentum of the first quarter, while June turned decidedly bearish. European Smaller-Cos lost 0.2% in 2013’s second quarter compared to a slightly better performance by the benchmark, with the Russell Europe Small Cap Index gaining 0.5%.

Although they were slower to rebound than their U.S. cousins, European stocks enjoyed an explosive third quarter, which saw a resumption of the more straight-ahead bullishness that characterized the first. In this environment, it was not surprising to see the Fund, with its disciplined value approach, underperform. As was the case in the U.S., the rally for European stocks was led by lower-quality companies (as measured by returns on invested capital). For the third quarter, the Fund advanced 11.7%—a more than respectable showing—while its benchmark rose an impressive 16.9%. While not as unsettled as the second, the fourth quarter saw the return of volatility and results that were more modest though still very strong. European Smaller-Cos was up 5.7% in the year’s final quarter compared to a 10.5% gain for the Russell Europe Small Cap Index, capping a dynamic second half of 2013. While we would have preferred to see better short- and intermediate-term relative results, we were pleased that the Fund maintained its performance advantage over its benchmark for the since inception (12/29/06) period ended December 31, 2013. In October, we made changes to the Fund’s portfolio management: David A. Nadel and Mark Rayner co-manage the Fund. David began to manage the Fund in 2011 and served as assistant portfolio manager from 2009 through 2011. Mark served as the assistant portfolio manager from May 1, 2013 through October 21, 2013.

Seven of the Fund’s nine equity sectors posted net gains for the year, with only Materials and Energy detracting from performance. We reduced our exposure to the former sector in 2013. Unhappy with ongoing share price declines over the past year, we sold our shares of Hochschild Mining. This U.K.-based gold and silver mining company with operations primarily in South America saw its shares begin to fall sharply in the first quarter, closely tracking the steep losses experienced in the physical gold market. Mining companies also faced increased operating costs, creating a nightmarish scenario. We felt better about the future prospects for Paris-based Parrot. the Fund’s seventh-largest holding at year-end, Parrot specializes in technologies involving voice recognition, such as Bluetooth hands free car kits, and signal processing for embedded products. It also makesdrones for gaming and more serious uses. Its shares suffered from a product life cycle trough as sales declined for automotive semiconductors, part of a more general weakness in Europe’s automobile market and the timing of Parrot’s new product launches. We continue to believe that Parrot’s for 2014 and beyond are bright and that the stock was attractively priced at year-end.

Top contributions came from some of the portfolio’s larger holdings. Boiron is the global leader in homeopathic remedies, a branch of medicine which is considered mainstream across much of Europe. We have been shareholders in the company since shortly after the Fund’s inception and we have long admired its strong competitive position, high profitability, and conservative balance sheet as well as being attracted to the stock’s low valuation. This patience bore fruit in 2013 as the stock price doubled. As this move was driven primarily by strong earnings growth, the stock remained cheap in our view, leading us to hold our shares throughout the year. Recordati is a family owned and run pharmaceutical company, with a focus on cardiovascular and urological treatments. It also has an increasing exposure to very rare (known as “orphan”) diseases. In addition to its attractive valuation, we were initially drawn to its impressive profitability and strong balance sheet several years ago. We reasoned that this compelling valuation was related to its being headquartered and listed in Italy, one of the countries then in the eye of the euro storm. Our contention was that Recordati’s domicile created a perception of inefficiency, especially since the majority—and an increasing share—of its revenues were derived from outside its domestic market. Operationally the company continued to execute very effectively, and as Italian stocks have come back into favor, its shares performed consistently well during 2013.

Top Contributors to 2013 Performance
Boiron 1.41%
Recordati 1.19
Azimut Holding 1.13
Clarkson 1.04
Lets GOWEX 1.02
1 Includes dividends

Average Annual Total Returns as of Quarter-End 12/31/13 (%)

Top Detractors from 2013 Performance 1
Hochschild Mining -1.69%
Parrot -0.58
Spectrum -0.46
Mardin Cimento Sanayii -0.41
Koza Altin Isletmeleri -0.38
1 Net of dividends

Annual Operating Expenses: Gross 2.16% Net 1.72%

Current month-end performance may be obtained from our Prices and Performance page.

All performance information in this Report 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 180 days of purchase may be subject to a 2% 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 here. Gross operating expenses reflect total gross annual operating expenses and include management fees, 12b-1 distribution and service fees, other expenses, and acquired fund fees and expenses. Net operating expenses reflect contractual fee waivers and/or expense reimbursements. All expense information is reported as of the Fund’s most current prospectus. Royce & Associates has contractually agreed to waive its fees and/or reimburse operating expenses to the extent necessary to maintain the Fund’s net annual operating expenses, other than acquired fund fees and expenses, at or below 1.69% through April 30, 2014 and

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