How did Royce Pennsylvania Mutual Fund perform in 4Q21?

Chuck Royce We were pleased that the Fund enjoyed a strong fourth quarter, advancing 7.0% and beating its benchmark, the Russell 2000 Index, which was up 2.1% for the same period.

Which portfolio sectors made the biggest positive impact on 4Q21’s performance?

Jay Kaplan Eight of the portfolio’s 10 equity sectors made a positive impact on quarterly performance, led by Industrials, Information Technology, and Financials. The only negative impacts came from Health Care and Communication Services while Energy made the smallest positive contribution.

What about at the industry level?

Andrew Palen We had the most success with semiconductors & semiconductor equipment in Information Technology, as well as two groups in Industrials—building products and machinery. We also saw the biggest detractions from IT services in Information Technology, health care equipment & supplies—Health Care more generally had a rough quarter—and software, which is also in Information Technology.

How did the Fund perform versus the Russell 2000 in the fourth quarter?

JK The Fund’s advantage over the benchmark came almost equally from stock selection and sector allocation decisions in the quarter. We had lower exposure to Health Care, which helped relative performance. We also received a smaller lift from our stock selection in that same sector in the quarter. Both our overweights and stock picking gave us advantages in Industrials and Information Technology, our two largest sector weightings.

CR On the other hand, both Real Estate and Utilities did well in the fourth quarter, so our underweight in the first sector and lack of exposure to the second hurt relative results—and our stock picking in Real Estate was a positive, though not enough to make up for our lower weighting. Something close to the opposite happened in Financials: Our higher weight helped versus the Russell 2000, but our stock picking gave us a modest net negative for the quarter.

Turning to the calendar year, how did the Fund perform in 2021?

AP The Fund advanced 22.0% in 2021 and outperformed the Russell 2000, which was up 14.8% for the same period. In addition to its calendar-year advantage, the Fund beat the benchmark for the 3-, 5-, 20-, 25-, 30-, 35-, 40-year periods ended 12/31/21, all under Chuck’s leadership. Penn’s 40-year average annual total return for the period ended 12/31/21 was 12.4%.

What happened at the sector level in 2021?

CR Nine of the portfolio’s 10 equity sectors made a positive impact on calendar-year performance. The sectors that made the largest positive contributions were Industrials, Information Technology, and Financials while the only negative impact came from Communication Services. Health Care and Energy made the smallest positive contributions to 2021’s performance.

Which industries did best and worst in 2021?

JK As in the fourth quarter, semiconductors & semiconductor equipment led, followed by banks, which are in Financials, and machinery from the Industrials sector contributed most in 2021. We were pleased to see strong results from this trio as they were our largest industry weightings during the year.

AP There were some disappointments, too, of course. Software in Information Technology, health care equipment & supplies in Health Care, and diversified telecommunication services from the Communication Services sector were the largest detractors for 2021.

What was the Fund’s top-contributing position in 2021?

JK It was Kulicke & Soffa Industries, which primarily supplies equipment for semiconductor wire bonding assembly and other capital equipment. The proliferation of demand for semiconductors is accelerating growth for Kulicke’s bonder equipment, in particular because 80% of the world’s semiconductor packages use wire bonding—while its new product innovations in advanced display and electronics has broadened its overall addressable market and improved its gross margin mix.

What as the Fund’s biggest detractor?

CR The largest detractor was Upland Software, which provides cloud-based enterprise work management software. Its shares fell on mixed revenue performance following outsized presidential election-related growth in 2020 and disappointing execution of the transition of its go-to-market strategy. Profit margins contracted as the company sustained elevated investments in advance of an improvement in revenue productivity. Although we still appreciate much about the strategic allocation of capital, these factors led us to substantially reduce our position during the fourth quarter.

What sectors helped or hurt the Fund versus the Russell 2000 in 2021?

AP The portfolio’s advantage came mostly from sector allocation decisions in 2021, with our significant underweight in Health Care helping most—it was the biggest detractor within the Russell 2000. We also benefited from both our higher exposure and savvy stock selection in Industrials, and primarily from the latter factor in Information Technology.

JK Conversely, our underweight in Energy, which was strong within the Russell 2000, hurt relative results, as did the Fund’s cash position. Our effective stock selection didn’t outweigh the negative impact of our overweight in Materials, which also detracted from relative results in 2021.

What’s your outlook for 2022?

CR Our outlook is very positive for small-cap value but it’s more nuanced for small-cap as a whole. The Russell 2000 enjoyed a third consecutive year of double-digit positive returns in 2021, which is rare for any equity index. It’s happened only twice before since the inception of the Russell 2000 in 1979: from 1991-1993 and 1995-1997. In each instance, a fourth year of double-digit positive performance failed to materialize. We always place a lot of weight on history, and this pattern, along with the likelihood of a less accommodative Fed, makes us think that performance for the Russell 2000 will be more muted in 2022. History also tells us, however, that small-cap value and cyclicals do well, particularly on a relative basis, during periods of improving economic growth. This is consistent with the encouraging signs we’ve been seeing on a company-by-company basis. We also are optimistic of the relative performance outlook for high-quality stocks— which we primarily define as companies with high returns on invested capital and stable returns on assets. We think the Fund’s combined focus on high-quality and value should be supportive for attractive returns, particularly relative to its benchmark.

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