Chuck Royce shares Royce’s culture and philosophy. See video here: Roycefunds
Tom Gardner: Tom Gardner here with Chuck Royce, the founder and manager of the Royce family of funds and Royce & Associates. This is a group of funds that focuses on small-caps.
I just want to start with some discussion about your investment principles and what you’re looking for. I know that the small-cap range for you is around a $2.5 billion market cap, and you invest in micro-caps up to small-caps. What are a couple of the factors that you’re looking for? I know a strong balance sheet and high returns on assets. What are a few of the factors that cause you to like a company that has a strong balance sheet versus others?
Chuck Royce: We’re in the risk/reward business. Ultimately, although most people would say we’re a value investor, I think we’re a risk manager. In the first place, “value” is sort of a chewed-up word. It’s overused. Who isn’t a value investor? I prefer a different vocabulary of risk management.
Risk management is triply important in the small-cap space because these are fragile enterprises. These are typically first-generation companies in their management style. Typically they may have gone through some difficult transition moments. Typically they are vulnerable. They are thin in management. And they might be a one-product company. So, they’re fragile. We have to employ all the tools available to manage these inherent risks which are higher than a large company.
TG: Is the volatility of a stock a factor in your risk assessment? People out there equate the gyrations of a stock price with whether or not that investment is risky. Do you view risk that way?
Chuck Royce: Not really. Not at all, really. We want to use volatility to our favor. We want to take advantage of volatility; certainly in the general market and in specific stocks. We’re not going to avoid a volatile stock. In the first place, historic volatility may have nothing to do with future volatility, so we don’t really look at those factors. They are, as a group, more volatile. There’s no question about it. We, as a manager, want to use that volatility to our favor. We’re trying to take advantage of the natural or specific volatility in the group.
TG: So, there’s a tension that exists at a retail fund between trying to take advantage of the volatility of the stock price while trying to manage the investors in your fund and their anxiety that may be predictive…
Chuck Royce: Well, that’s a real question. How do you manage expectations? We try hard to do that. [We never assume] that the investor can be as comfortable with underperformance as they should be. It’s a dangerous word, dangerous territory, and a dangerous subject to talk about underperformance; but it’s a natural consequence of trying to be a little different.
TG: Do you think that the average retail investor is more nervous about losing to the index or losing capital? Losing principal?
Chuck Royce: Losing principal—absolutely. And I would agree with that. Losing principal is not a good idea. Our first job is to protect principal. Our first job is don’t lose the money. The whole idea of indexes, and all that, is a relatively recent phenomena—one that I don’t absolutely share as the goal. The real goal is absolute returns, perhaps on a risk-adjusted basis, but absolute returns are the goal. It’s the only plate you can eat from. You cannot eat from the plate of relative returns.
Chuck Royce: Are you concerned, within a fund, about the number of holdings that are profitable? When you talk about not losing principal, is that trying to tell your teams, “Please don’t pick any stock that loses money and we sell at a loss.” Or, “Please don’t give us one year of down performance where we lose money over a 12-month.” Or is it three-year or five-year? What’s the time frame?
Chuck Royce: Well, neither. The idea of risk management is to be highly conscious and very intentionally conscious of the risk factors in the company and in the potential investment; to set up a risk/reward profile and monitor that carefully to make certain we’re up-to-date on changes and to continue to manage the portfolio on a risk/reward basis. That does not mean ever you get linear, absolute returns. You will have absolute negative returns from time to time. You’ll have plenty of relative underperformance periods.
TG: So, a few risk factors that you look at in the business—I’ll just give an example. Is it a risk factor for you if somebody owns 40% of the stock?
Chuck Royce: No. That might even be a healthy factor. That might even be a positive. Let’s say that 40% owner is the founder. Let’s say it’s the founder or the control group. We would certainly want to understand how they got there (their motivations, their culture, their philosophy). That would be a factor, but I wouldn’t assume it’s a risk factor. It’s just a factor.
TG: How about the risk factor of declining margins and a new competitor showing up in the marketplace?
Chuck Royce: Well, that’s a risk factor. The idea of what’s going on in the context of that company (in their environment, in their neighborhood) is very important, and we are deep believers that all we can do is get deep knowledge on the strategic forces that affect that company. We cannot be faster than the next guy in getting the actual information from the company. We get it at the same time as everyone. We can’t be more up-to-date than what everyone else has on quantitative information.
But on qualitative things, we could [make an assessment]. Let’s say we had a feeling that margins were declining. We would talk to competitors. We would talk to this new competitor. We would talk to their customers. We would talk to their employees and ex-employees. We would try to get to the bottom of that.
TG: I know that you all talk to customers of the companies that you invest in. How do you go about doing that?
Chuck Royce: Well, that’s a difficult process, actually; to get to the bottom of the truth and the reality principle of [whether you intend] to continue doing business with this company and why. Is it because you have no other choice? Is it because you have to? Is it because they bribe you? Is it because etc., etc.? We need to know not just their pattern of behavior but why; and therefore is it fragile? Is it sustainable?
TG: If you found a small-cap that is fragile in nature, had an excellent growth rate, excellent return on assets, and had a founder in place—but six customers made up 57% of their business—is that a no-no and would you cross that off your list because of that customer concentration? Or would you just watch those eggs in the basket of their customer base very closely?
Chuck Royce: Yes. Great question. That’s not a no-no, but it would be a concern. Customer concentration is a risk factor. Now, it can be a positive, if they’re good customers. Maybe the customers