Over a span of 40 years, Charlie Dreifus has developed a disciplined, time-tested approach that utilizes accounting cynicism to identify good businesses that he believes to be undervalued. With the launch of Royce Special Equity Multi-Cap Fund at the end of 2010, Dreifus expanded his universe to include mid-cap and large-cap companies while continuing to manage Royce Special Equity Fund, which focuses on small-caps.
Royce Special Equity Multi-Cap Fund (RSEMX) completed its first full year of performance on December 31, 2011. His practice of investing in high-quality, dividend-paying large-cap and mid-cap companies rewarded shareholders with a return of 7.2% in 2011. Additionally, relative to the Fund's large-cap benchmark, the Russell 1000, Royce Special Equity Multi-Cap outperformed by almost 600 basis points. Charlie explains why he thinks the Fund did well last year.
"I think there were two reasons why Royce Special Equity Multi-Cap Fund performed so well in 2011. First, it is a general fact that as an asset class, large-cap stocks currently are statistically more attractive than small-cap stocks. Second, with this Fund, what I attempted to do was assemble a portfolio of companies that not only pay dividends, but many that also have a consistent history of growing their dividend year over year. In fact, 37% of the names in the fund have raised their dividend consecutively for 31 years or more. In the long run, a company generally cannot pay, let alone raise, a dividend if it is not earning money. So the ability to do so represents an inherent sign of quality embedded in these companies which have consistently raised their dividends.
In the current environment, investors are searching for stability and income. I believe this will be an ongoing theme for the next several years as interest rates remain low or near zero. Further, a rising stream of dividends is beneficial whether we have inflationary or deflationary conditions. Investors are making their preference for dividends clear, and we are seeing managements increasingly respond to this demand."
Charlie's penchant for dividend-paying companies applies to his small-cap portfolio, Royce Special Equity, as well. For some time, he has advocated the idea that companies with moderate current yield and growing dividends that are financially productive can produce market-beating returns. Indeed, Royce Special Equity accomplished just that in a very volatile year for small-caps. With the Russell 2000 down 4.2% in 2011, Royce Special Equity gained 0.1%.
Historically, Royce Special Equity Fund, which invests in companies with market capitalizations of less than $2.5 billion, has tended to outperform in down markets and capture less of the upside in bull markets. Over the long term, this has served the Fund well, providing investors with an annual return of 8.7% since inception (5/1/98) versus 4.5% for the Russell 2000.
Charlie's "secret sauce" is the same for both of his Funds—intense scrutiny of the accounting veracity of each company in which he invests. The practice contributes to one of his core tenets—not overpaying—and tells him whether a company, be it large-, mid- or small-cap, is inexpensive on an absolute basis.
The launch of Royce Special Equity Multi-Cap Fundrepresents an extension of Charlie's work into the large-cap area. Although many large-caps now look statistically less expensive than their smaller siblings, it's important to note that those small-cap companies that Charlie seeks forRoyce Special Equity Fund, those with high returns on invested capital and strong balance sheets, are currently cheaper than many large-caps.
Charlie's "secret sauce" is the same for both Funds—intense scrutiny of the accounting veracity of each company in which he invests. The practice contributes to one of his core tenets—not overpaying—and tells him whether a company, be it large-cap, mid-cap or small-cap, is inexpensive on an absolute basis.
"The small-cap companies I buy in Royce Special Equity Fund are U.S.-centric both by nature of being headquartered in the U.S. as well as having most of their revenues generated from domestic customers. Thus, they are somewhat isolated from the turbulent foreign issues that we see in the headlines. Having relatively little exposure to non-U.S. revenues contributed to the Fund's relative outperformance last year. Going forward, I expect to see a higher level of M&A (merger & acquisition) activity this year as it becomes harder and harder for companies to generate earnings gains.
The companies owned by Royce Special Equity Fund are inexpensive on an absolute basis, with strong balance sheets that should allow not only for synergies to be harvested through an acquisition, but also an improved financial profile for the acquiring company. That would be catalyst number one. Catalyst number two for increased M&A is that at some point we will likely see higher taxes on dividends and capital gains. This may prompt owner-managers—many of my companies have a high degree of family ownership—to consider an exit or other transactional strategies before those higher tax levels go into effect.
For many, it is hard to invest with conviction in a world of negativity and uncertainty. However, Charlie's time-tested, economic based methodologies applied to small-, mid- and large-cap companies enable him to be opportunistic when others might be frozen into inaction.
In an era when previously