Exploring Compelling Investment Themes in an Atypical Market - Royce Funds Commentary

The current market rally has provided fewer buying opportunities for value investors such as ourselves. Portfolio Manager and Principal Chip Skinner discusses areas of the market that he believes are providing attractive opportunities, companies that exemplify the themes he's been developing, and three stocks that have enjoyed some success so far in 2013.

Do you think the current small-cap bull market can keep going or are you expecting a correction?While a rising market is encouraging from a performance perspective, a pullback at some point would logically make sense. There seems to be a rush to risk assets, particularly now that investors have watched certain market segments do quite well on an absolute basis over the last couple of years, so I think we're about due for a correction given that there are still a lot of unknowns with regard to the federal budget and related matters.

We've gotten sort of a head-fake from the Federal Reserve on tapering. We still have some level of global political tension. But I do feel sure that interest rates are heading higher over the longer term. So while a correction or even periodic corrections will occur, long-term, I remain very bullish on small-cap stocks.

What sectors and industries have you been looking at most closely lately?One theme I've been exploring over the last year or so is "Machine to Machine" (M2M) technology, also known as the "Internet of Things."

Much of this technology involves placing a sensor or other piece of technology on one piece of equipment to capture information that can be relayed through a wireless or wired network to a computer that translates what's gathered into meaningful data.

This data can then be analyzed to make appliances and other things run more efficiently and effectively. Gartner, a leading information technology consultant, thinks this area can grow at a 23% compound annual growth rate through 2016.

This data can then be analyzed to make appliances and other things run more efficie! ntly and effectively. Gartner, a leading information technology consultant, thinks this area can grow at a 23% compound annual growth rate through 2016.

Through M2M technologies, businesses can make a lot of manual functions more automated, and most would benefit from the ability to save time and labor not just on manual data input and measurement, which is often on a delayed batch basis, but also on inventory reporting, maintenance and parts replacement on heavy equipment, meter readings, etc.There are many factors driving this theme, but the biggest—and perhaps most evident—is the pervasiveness of communication networks. Another important driver is cost-reduction opportunities.

Through M2M technologies, businesses can make a lot of manual functions more automated, and most would benefit from the ability to save time and labor not just on manual data input and measurement, which is often on a delayed batch basis, but also on inventory reporting, maintenance and parts replacement on heavy equipment, meter readings, etc.

There's also a service element whereby companies can build stronger customer relationships. With more precise, real-time information, they can quickly detect changes in consumer trends and monitor customer behavior or usage more effectively.

Can you give us a couple of examples of companies that are taking advantage of M2M technology?Sure—we've had an investment in Pason Systems (PSI) for almost 10 years now. Based in Canada, Pason has created an entire business model around M2M by automating certain oil well drilling functions and production data so that it can tell when something's going haywire. It also has a number of additional applications that it's selling, including a sensor that attaches near the drill bit to help navigate where an operator should be drilling. The company has penetrated the U.S. in a big way, and now it's looking to expand internationally.

Sierra Wireless, which is a position I first bought in January and have been buildin! g in Royc! e Value Plus Fund's portfolio since then, is now a pure play M2M company after having sold its laptop wireless device business to NETGEAR earlier this year.

The company has a well-respected management team, a lot of cash on its balance sheet, and sensor and communication technology. The company is now eager to make an acquisition to create a complete solution—Sierra still needs an enterprise side dashboard side for its collection analysis and interpretation of data, and that's what it's on the hunt for.

Are there any other themes that you've been developing?I think the enterprise software area is pretty interesting right now, particularly cloud-oriented companies and software businesses that either help track assets or reduce corporate expenses. Tangoe is a leader in the telecom expense management space—both wired and wireless. The company helps enterprises track and manage mobile devices of all types.

With the introduction of laptops and smart phones, corporate intranet security and access have become more complicated, particularly with all the different mobile phone vendors and telecom plans a company's employees typically have.

Historically, most companies have not tried to manage this process. Tangoe (TNGO) helps companies consolidate and renegotiate contracts by using the buying power that's already there to help companies better manage this end of their business.

A second company that makes enterprise software is SciQuest (SQI), which provides procurements and spending management software on a subscription basis. Unlike one of its chief competitors, which targets everyday supply purchases made by big companies, SciQuest provides automated purchasing to a different segment by focusing on universities, hospitals, local and state governments, etc.

While some might say these areas are the weakest segments a company can target, SciQuest would contend that these are highly cost-conscious entities, which to me is a pretty compelling argument.

More recently, I! 've been ! looking at alternative energy. As the U.S. moves toward energy independence, I believe there are a lot of opportunities in solar, geothermal, and natural gas.

There are two companies that I'm gradually easing into at the moment; one is in the process of becoming a pure play lithium producer and one takes an interesting approach to power generation.

Can you discuss three stocks that have been successful this year? What did you initially like about them and what helped them turn around?Methode Electronics (MEI) is an automotive component supplier, with automotive customers accounting for about 60% of its revenues. The company classifies the other 40% of its revenues as non-auto, which includes home appliance touch screens and sensors.

To say it had a rough go in the last 10 years is an understatement, especially during the downturn for the automotive industry. However, the company was able to develop a center console product that includes a touchscreen which acts as an interface for navigation systems, entertainment, etc.

Methode first got this console into Ford vehicles, and about two quarters ago it started a very large rollout with GM for their trucks and SUVs. The ramp-up has gone better than expected, and the stock has been beating expectations. It was sort of forgotten by other investors for a while, but it's got an interesting product that looks like it's got some legs.

Immersion Corporation, which manufactures and licenses technology that enhances digital devices with touch interaction, has a lot of intellectual property around haptics, which is technically defined as tactile feedback or the vibration or other physical response a user gets when pressing buttons on an electronic device.

The technology is being adopted in cell phones and gaming consoles, but the company also plans to enter the automotive console area. I also think we're likely to see its technology in iPads and other tablets.

The company has owned this technology for a while. When I first be! gan to bu! y this stock in April 2012, the company was spending a lot of money on litigation to defend its intellectual property.

In the last nine months, the company was able to convince Motorola Mobility, which Google now owns, to pay back royalties and to sign a new royalty agreement. Around the middle of the spring the company also signed Samsung. It looks like the dominoes are starting to fall now, which is why the stock has gone up so much since March. And at some point the legal expenses will come down. Immersion has a very high margin revenue stream, and the company has more end markets that it wants to target.

The last company I want to mention is HealthWays (HWAY), which was once a small-cap growth stock favorite. Due to increasing changes in the U.S. healthcare industry, as well as confusion around the implementation of ObamaCare, the company recently expanded its business to not just physical wellness but to social and emotional wellness, health, and nutrition.

Like its original business, which was more along the lines of disease management, HealthWays helps insurance providers, as well as governments and consumers, redesign their product offerings to provide the same or better outcomes at lower costs. Its stock became attractively cheap to us when the company announced that it had lost its largest contract, Cigna, and its operating profit predictably fell. It's since endured a decline in revenues and an even bigger decline in profits.

But more recently it's won arguably the same or more business than what it had lost with Cigna. Unfortunately for HealthWays, there are some up-front costs when bringing on large customers, and that's blunted profits. However, as the company moved past that anniversary, its revenues are starting to grow again, and I expect this will continue to improve further down the road.

How do you feel about the recovery of Royce Value Plus Fund? Are you happy with its recent performance and is it acting the way you intend?It took some time for our effo! rts to be! ar fruit in regards to the performance challenges we encountered with Royce Value Plus Fund in the second half of 2010 and in the early part of 2011.

That being said, it's becoming clearer that those efforts have resulted in improvement through solid absolute returns, better stock selection, and an emphasis on a "growth at a reasonable price" (GARP) investment approach.

By targeting robust, multi-year growth themes and focusing on what we see as quality companies benefiting from those themes, we think the Fund has done well in the current slow-growth economy.

While we have more groundwork to do with respect to performance relative to our benchmark, I firmly believe we are on the right path.

Royce Value Plus Fund (RYVPX)
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Important Disclosure Information

Chip Skinner is a portfolio manager and principal of Royce & Associates, LLC, investment advisor to The Royce Funds. He serves as portfolio manager for Royce Value Plus Fund (RVP) and serves as an assistant portfolio manager for Royce Low-Priced Stock Fund (RLP). The thoughts expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Royce Value Plus Fund invests primarily in micro-cap, small-cap, and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets in foreign securities, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.)

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