About a year ago we were in the middle of an ugly financial meltdown. How did you position Royce Value Plus Fund in such an uncertain environment?

Let's just say it was a rough patch for anyone in the investment business, including those of us who work in the small-cap arena. Not much was working, and investors weren't doing much besides trying to preserve cash and capital. It seemed that all of the financial companies were pre-announcing really dire earnings news. It reminded me a lot of the period right after 9/11 when business confidence went immediately to zero.

We decided that, rather than just sit on our hands and agonize over the whole thing, we would position the portfolio for whatever might be coming next. We did this in two ways: First, and most importantly, we wanted to own stocks of companies that we thought would benefit early in any economic recovery that we believed would eventually materialize. There was no way to know when it would come or how robust it would be, but an expansionary period has historically followed every economic depression or recession. By the way, that didn't take a lot of looking—several of Royce Value Plus Fund's holdings already fit this criteria. RVP had a substantial weighting in industrial companies, for example, going into the recession, which actually detracted from the Fund's performance in the second half of 2008. In our view, these were great companies that were highly sensitive economically. Our second strategy was to add certain companies to the portfolio that hadn't been within our reach in the past, mostly because their share prices had been too high for our liking.

What types of companies became newly available to you?

"There was no way to know when it would come or how robust it would be, but an expansionary period has historically followed every economic depression or recession."

With equity prices falling across the board, suddenly a lot of the branded growth-type of companies became cheap by our definition, and we tried to take advantage of the dramatic stock price declines. Coach is a good example. While we haven't really seen a retail recovery yet, we like what we have seen with this company—they've refreshed their product line, and expanded into new markets. They are also working to increase their high-margin handbag revenue mix with modest price reductions, making the product more affordable but selling a lot more units. They have reassessed their markets, deemphasizing their U.S. store growth, given what's going on with the U.S. consumer, and stepping up store growth in China—with immediate success there.

What's your approach now that the crisis appears to be behind us?

We are still on the lookout for those areas that are likely to benefit in the early stages of the recovery. Besides retail, we think that well-managed trucking companies, automotive parts retailers, and industrial services companies all show promise. W.W. Grainger and MSC Industrial Direct are two very high-return, low-debt business models that got very cheap in the downturn. Temporary employment agencies are also interesting, with the thought that temporary hiring will be at the forefront of a re-employment trend. In fact, it was recently announced that MPS Group, which we owned, will be acquired by a larger competitor.

Most investors are still leery of financial companies. What's your view on financial companies, and banks in particular?

Having worked in a commercial bank, I have seen similar cycles before. It's historically been a four-to-five year period during which the stuff hits the fan, problems are identified, then worked out, things finally stop getting worse, and eventually start getting better. I think we are probably mid-way through this kind of cycle. Construction lending is starting to happen for the first time in two years. High-end housing, a market that's been frozen, is starting to revive. But there are still risks out there; worries about commercial real estate, concerns over C&I (commercial and industrial) loans, and concern that regulators may go further in terms of capital requirements for banks to be considered "well capitalized."

RVP is still underweight financials, but not to the same degree it was a year ago. We have added a few banks to the Fund's portfolio. Our focus is mostly on large regional banks that have come into our capitalization range. Most of the ones that we chose have shown an ability to raise capital in the last year or so, which has given us some confidence that there is a market for these entities. They aren't going to disappear because they lack capital, unlike the 100+ small and/or regional banks that have gone under in the past year. One of the first that I took a larger position in was Northern Trust, which really isn't a commercial bank, but rather a trust company and back office securities transaction processor. They also have a great private wealth business. It's a high quality bank and seemed like a good place to dip my toe in to the financial sector. And that tends to be the way that we buy and sell with any industry—we like to move in and out cautiously and opportunistically as we try to navigate market volatility.

Important Disclosure Information

Mr. Skinner is a Principal and Portfolio Manager of Royce & Associates, LLC, investment adviser for The Royce Funds. His thoughts in this interview are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. In addition, there can be no assurance that the securities mentioned in this piece will be included in the Fund's portfolio in the future. As of 9/30/09, Coach represented 1.1%, W.W. Grainger 1.5%, MPS Group 0.6%, MSC Industrial Direct 1.1%, and Northern Trust 0.8% and of the portfolio's total net assets.

Past performance is no guarantee of future results. Royce Value Plus Fund invests primarily in micro-, small- and/or mid-cap stocks, which may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus). This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Russell 2000 is an unmanaged capitalization-weighted index of domestic small-cap stocks. Distributor: Royce Fund Services, Inc.

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