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The Royce Funds’ Jay Kaplan On Small-Caps, Value Investing, Dividends And More

jwolinsky — Mon, 19 Apr 2010 15:34:15 +0000

Jay Kaplan

Jay Kaplan’s Bio from Roycefunds.com

Jay S. Kaplan, CFA, is a Portfolio Manager and Principal for Royce & Associates, LLC, investment adviser to The Royce Funds.

He serves as Portfolio Manager for Royce Capital Fund—Small-Cap Portfolio, co-manages Royce Value Fund with Whitney George, and Royce Dividend Value Fund with Chuck Royce. He also serves as an Assistant Portfolio Manager of Royce Pennsylvania Mutual Fund and Royce Total Return Fund. He has 20 years of investment industry experience.

Prior to joining Royce & Associates in November 2000, Mr. Kaplan spent 12 years with Prudential Financial, most recently as Managing Director and Portfolio Manager of the Prudential Small Company Value Fund.

He holds a bachelor’s degree from the State University of New York at Binghamton and earned a Master of Business Administration degree from New York University.

Value investing is contrary to human nature, how did you get started in value investing? Also on a similar note there are many different schools of value investing, which school would you say you adhere to the most? Who has had the greatest influence on your investment philosophy?

I am not really sure that it’s contrary to human nature. Everyone likes to buy stuff on sale and nobody likes to pay full price. From that perspective, value investing is not contrary to human nature at all. Buying a good asset at a discount is something that everyone can relate to.

I started out as a credit analyst. There are really two ways you can look at credit. You can look at assets or you can look at cash flow and how a company meets its financial obligations. So you’re looking at stress testing and the volatility of cash flows, and how bad things could be before a company can’t pay its bills.

Applying that to stocks, it’s like looking at a margin of safety. It is about how bad things can get before you lose money. My core philosophy is that if I buy stocks where expectations are low to non-existent, and those expectations are met, I probably won’t lose money. And if those expectations are exceeded, there could be a nice upside.

I also adhere to Royce’s core principles, which consist of finding companies with pristine balance sheets, high returns on capital and buying them at attractive prices. However, my core approach comes from my experience as a credit analyst and buying stocks based on cash flows.

I was also a junk bond analyst for a few years, which gave me a good fundamental underpinning for my current value approach. My core focus on credit and cash flows have had the largest impact on me.

What does a typical day look like?

There really is no typical day. There is a typical start of the day, which consists of waking up early and commuting. We check positions and prices and more often than not the news dictates what the rest of the day will be. If the day does not contain much news, we will focus on looking into new holdings. If the day is full of news, then it could be a day of maintenance.

During the course of the day, there are usually meetings with management teams, often several of them. There are client meetings, though we have less here than at other firms. We spend more time managing money.

So the early part of each day is pretty similar, but the second part of the day you never know. That is one thing that makes the job so fascinating. You don’t know what each day will bring.

Several of your funds are run with other portfolio managers; do you all have to reach a unanimous decision before buying or selling a stock?

We don’t always reach unanimous decisions. Some Funds are set up differently. We tend to take larger positions in companies in which there is widespread agreement and smaller positions when there is less of a consensus.

You co-manage several funds with Charles Royce, are you ever able to convince your boss of your convictions when he does not agree with you initially? There are times where he’ll ask me, “Why are you buying or selling XYX Company?” and I will tell him why, and then he will go and make his own decision. In many organizations, the object of the game is to convince someone senior to you to do what you want. That is not how we operate. When Chuck sees something, he will ask about it, not to tell me not to do it, but rather to see if I want to do to it. I will tell him what I think and then he will do what he thinks. Sometimes he agrees, and sometimes he doesn’t agree. Everyone is entitled to his opinion here.

Since all Royce Funds are diversified how are you able to keep track of so many securities?

As a firm, we are very focused on the small-cap market. So we know a lot about lots of small-cap securities. The managers here also tend to be very experienced. We usually don’t hire people right out of college on our investment staff. Most of the people come with significant experience and know a lot of companies. So when you have been doing it long enough, you are able to keep track of a lot of companies.

Most companies’ fundamentals don’t change very much. When companies do change materially, that is what you focus on. It is the 80/20 rule; you spend 80% of your time on 20% of the names because a lot of things do not change much in a short amount of time.

How do you manage risk?

First, let me tell you how we define risk. A lot of people define risk as the amount your portfolio deviates from an index. We do not think of risk in that way. We think about risk as not losing money. We hate losing money.

So we like to think about our performance in terms of risk adjusted terms relative to an index. With that in mind, we run diversified portfolios because there is a lot more risk in small-cap companies. Another core component of our philosophy is that we invest in companies that have very strong balance sheets, which we think provides good protection against the company going to zero.

You know, when you’re a value investor you invariably run into problems, whether it’s an industry problem, a company-specific problem or something else. When we see companies at what we think is a good price, the company usually has problems. So between diversification and buying companies with strong balance sheets, we try to manage risk.

Do you ever meet with management?

All the time. With small companies, we meet with the most senior people and discuss strategy and any issues in the company. We like continuity of message and we want people who do what they said they were going to do. This is very important to us. If they tell us they are going to do xyz, and we meet with them six months later and they have not done xyz, that makes us uncomfortable.

How do you go about finding stocks? Do you look at the 52 week low list? Do you use a screener for stocks with high dividends and low payout ratios?

I do not look at 52-week lows, or high dividends or low payout ratios. I screen based on balance sheets, return on capital and valuation. In valuation, we look at operating income instead of P/Es.

We also meet with companies, as I mentioned earlier, and we watch news flows. Most small-caps are relatively less liquid, but when there is news they tend to become very liquid for a short period of time. Because of our knowledge of companies, we are good at acting on news. But at the end of the day, it comes back to those three principles: balance sheets, return on capital and valuation.

One argument for buying stocks with dividends is that a dividend will cushion a stock’s fall as bargain hunters see an attractive yield and start buying the stocks. After the peak of the financial crisis where many companies dramatically lowered or eliminated their dividends do you think this argument still holds weight? Or do you see the events of the past few years as an anomaly unlikely to repeat itself anytime in the near future?

As we saw in late 2008 and early 2009, it’s tough for any stock to be fully cushioned in a financial crisis. However, most companies that we owned are now back in good financial shape and didn’t experience dramatic dividend declines.

In our funds that have a dividend-paying component, we don’t chase high dividends. We think about dividends as part of the menu of items in a company’s capital allocation toolkit. There are a few things a company can do with its free cash flow: they can reinvest it in the company, they can do mergers and acquisitions, they can pay down debt if they have it, they can buy back stock, or they can pay dividends.

So when we look at dividends, we frame it in the context of what is the best risk-adjusted use of capital for the company—could giving some of the money back be part of that? If you do not have a good way to use that money, maybe you should give it back.

When companies decide to pay a dividend, we see that as a commitment on their part. Companies almost never want to cut or eliminate dividends. I see dividends as more like a marriage than a date. It is easier to break up when you are dating than after you’re married. So when a company decides to pay a dividend, it is using one of its capital allocation tools.<

If we just chased the highest dividends, it would probably lead us to companies under stress where the market doesn’t believe those dividends are sustainable, which would set us up for those dividends to be cut. Or it leads you into Master Limited Partnerships, REIT’s or Utilities, which are areas we tend to avoid, because, those companies often don’t meet our balance sheet and return on capital criteria. So we don’t hunt for the highest paying dividends we can find.

I think dividends are good capital allocation tools, and are a sign of good discipline. This tends to lead me to more mature companies. Most of our dividend-paying stocks tend to be even more conservatively managed than many of our other stocks because the companies tend to be more mature.

With interest rates at record low levels do you think stocks that pay dividends are even more important?

No, but it is nice to get a better yield. But I am not sure it is a factor for us. We are really trying to find good investments—and if it has a dividend that is a plus. If you look at the small-cap universe (and it’s also true for large-cap companies) during the rally that began in March 2009, stocks that don’t pay dividends have significantly outperformed stocks that do. In general, we think companies that pay dividends are higher quality, and the rally has so far been led by low-quality stocks. Hopefully in the next phase of the bull market (whenever that is), higher quality, dividend-paying stocks will outperform.

I have seen studies that show that on an after tax basis dividend stocks barely outperform non-dividend stocks? Do you believe these studies are flawed? If not, do you think dividend stocks are best to hold in a tax-free account?

I have not seen the studies, so I can’t comment on it. All things being equal, it may be better to hold taxable income-producing securities in a tax-free account.

Large cap stocks are usually more able to withstand economic downturns without eliminating or decreasing their dividends. How do you ensure when you buy small-cap stocks that the company can keep paying the dividends and increasing them in the future?

We can never be sure. There are no guarantees, and there’s always risk. For us, it always goes back to good balance sheets, good free cash flow generation, and high returns on capital. We think these things give us a margin of safety. These things also mean the company has a good chance of being able to keep paying the dividend.

We understand that when times get tough, it sometimes makes sense to cut the dividend. For us, it is all about capital allocation management. And if you think about it, when people give us money to manage they are giving us capital to allocate. When we invest that money in stocks, we are entrusting the companies to allocate that money well. The whole dividend question is really about efficient capital allocation.

Small-caps have outperformed large-caps this past decade. Do you believe there will be a reversion to the mean, and large-caps will outperform small-caps in this next decade?

I can’t predict what will happen over the next ten years. But if history is any indication, small-caps have outperformed over very long periods of time and there is no reason to expect that to change. There are cycles, of course. Small-caps have had a pretty good run. But when you come out of recessions, small-caps tend to do very well, so maybe this is not out of the ordinary.

If I knew what the future would be, I could just retire. Everyone in this business tries to prognosticate—half will be right and half will be wrong. We come in every day and look at our portfolio and look at the market and try to get a good risk-reward return, and we hope to deliver long-term satisfactory results. Sometimes large-cap does better and sometimes small-cap does better. Right now, small-caps are outperforming. Will that continue? I am not sure.

To read the rest of the interview on Guru Focus Click here

Jacob Wolinsky Interviews David Nadel Portfolio Manager Of Royce Global Select Fund And Co-Portfolio Manager Of Royce Global Value Fund

admin — Thu, 11 Feb 2010 23:39:01 +0000

David Nadel

Royce Funds are a family of approximately 20 funds devoted to small cap value investing. Nearly all the funds have far outperformed their indices (the Russell 2000), since their inception. The family of funds was started by legendary value investor Charles Royce over 35 years ago. The Royce Funds has recently opened a few funds devoted to international small cap value investing.

One particular fund that opened in 2005 is the Royce Global Select Fund (ticker RSFTX) managed by David Nadel. Here is some information about Mr.Nadel from Roycefunds.com.

David A. Nadel is a Portfolio Manager for Royce & Associates, LLC, investment adviser to The Royce Funds. Mr. Nadel serves as Portfolio Manager for Royce Global Select Fund and the co- portfolio manager of Royce Global Value Fund. Mr. Nadel joined the firm in 2006 and previously was a Senior Portfolio Manager at Neuberger Berman Inc. (2004 to 2006) and a Senior Analyst at Pequot Capital Management Inc. (2001 to 2003). He was also named to the 1999 and 2000 Institutional Investor All-American Research Teams. Mr. Nadel holds a bachelor’s degree from Williams College and a master’s degree from Harvard University, as well as a Master of Business Administration from Harvard Business School.

Royce Global Select Funds has a spectacular record. The fund has a five star rating from Morningstar. Below is some data regarding the fund’s returns:

Average Annual Total Returns

As of Quarter-End 12/31/09

4Q* YTD* 1YR 3YR
RSFTX 10.57% 56.11% 56.11% 6.57%
Russell 2000 3.87% 27.17% 27.17% -6.07%
MSCI World Small Core 2.83% 44.12% 44.12% -5.49%

Since Incept
RSFTX 12.52%
Russell 2000 0.85%
MSCI World Small Core 2.72%
Annual Operating Expenses

0.75%

David Nadel also co-manages Royce Global Value Fund. The Royce Global Value fund (ticker RIVFX) like the Royce Global Select Fund has a phenomenal record. It has a four star rating from Morningstar. Below is some data regarding the fund’s returns.

As of Quarter-End 12/31/09

4Q* YTD* 1YR 3YR
RIVFX 9.01% 61.89% 61.89% 3.59%
MSCI World Small Core 2.83% 44.12% 44.12% -5.49%

Since Incept
RIVFX 3.58%
MSCI World Small Core -5.48%
Annual Operating Expenses

Gross Net
2.27% 2.02%

Mr. Nadel was kind enough to speak with me about the two funds he manages. Below is our conversation.

I would like to thank Joanne Newgard the Director of Advisor Services and Media Relations at Royce & Associates for arranging this interview.

There are many types of value investors who use different metrics such as P/B, P/E, looking for situations that causes forced selling’s among institutions. What do you use to evaluate a stock?

For most sectors I feel return on capital is the single best metric to judge how much value a company is creating for shareholders. If a company’s return on its capital is paltry, particularly if it falls short of the cost for that capital, than essentially not much can redeem that business in my eyes, not even spectacular growth. In Royce Global Value and Royce Global Select, we hold companies to a fairly punishing standard on this. We look for companies with sustainable returns on capital of 25% or more. At the same time, value-creating companies should ideally be self -funding. So, we like companies with equity-heavy balance sheets that generate enough cash to not only fund their operations internally but also to take market share during market downturns from their debt-laden competitors. Lastly, we are fans of Warren Buffett, so we look for businesses with a strong “moat” protecting them from competition.

We are not catalyst- driven traders. We are not attracted to turnarounds, or blue-sky stories. We just try to invest in quality and try to invest at a discount to what we believe it is worth.

In regards to the schools of investing, value investing has many different subcategories. I would say Benjamin Graham and Warren Buffett have very different styles. Which investor would you say has had the greatest impact on your investment style?

I have been fortunate to have a number of helpful influences. Two which spring to mind are my father who taught me to avoid debt, to trust gold more than paper money, and to stick to my studies because education provides a more certain return on investment than anything else! And Chuck Royce from who I learned the value of patience, as well as many important principles for valuing the strength of business models.

Both Royce Global Value Fund and Royce Global Select have a high concentration in the natural resource sector. Given the massive increase in natural resource stocks, what value are you finding to explain such a large allocation of the fund’s assets to this sector?

In general we are concerned with what appears to be an addiction to on the part of the US and EU governments to printing money, which unfortunately tends to debase their currencies. While there seems to be a limitless supply of paper money these days, there is a finite supply of natural resources- especially precious metals such as platinum, silver and of course gold. Over the next year or so I think you may see the better mining companies such as the mid-tier South African platinum producers, and the London-listed silver producers evolve from being asset plays to actually being valued on cash flow and earnings.

The other side of our natural resource commitment is energy service companies, many of which are based in Canada. Canada has been a consistent innovator in energy technology. These companies compete globally and although they are very cyclical at least they have strong balance sheets to cushion the cycle.

Royce has been invested in precious metals and other natural resources for over a decade now. There was a time people looked at us as if we were slightly nutty for this; I think that skepticism will fade. Gold is catching the attention of some of today’s shrewdest investors: John Paulson launched a gold fund, and David Einhorn and Dan Loeb often sing its praises. The other precious metals will start to be embraced by more investors, I think.

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I wrote an article regarding the large decline in BRIC stocks during the financial crisis and their subsequent returns since their trough. The BRIC indexes are still far below their highs reached in 2007. Are you finding any value in these countries?

Yes. What’s remarkable about the economic crisis is how much less relevant it was fundamentally to the BRIC markets than it was to the US and Western Europe. Sure the interruption of global capital flows and the capitulation of US consumers did have a very damaging short-term effect on the BRIC countries. But these countries are evolving quickly and their consumers are becoming a force to be reckoned with. In India, discretionary spending has gone from 35% of household consumption 15 years ago to 65% today. They added 125 million mobile subscribers last year. Their middle class is ballooning. So the fact that BRIC markets are below pre- crisis levels continues to create opportunities with us. Of these four markets we are focused mostly on China and Brazil and ramping up our commitments to India.

Jim Chanos recently made headlines with his prediction about a massive bubble forming in China. Do you have an opinion on the matter, and if so how does this effect your investment decisions in China and Asia in particular?

Yes, there sure has been a lot of hand-wringing about China as of late. And it has even become fashionable to compare China today to Japan two decades ago- both being seen as export driven Asian economies with excess savings and a reticent, cautious consumer. Sure there are signs of a bubble in China- the A-Share market is a bit of a Wild West, and housing affordability looks strained for the average person. But I think maybe Jim Chanos and the other China bears are missing some key differences. For one, the Chinese are becoming real consumers; retail sales are climbing at a high-teens pace annually. And China last year became the world’s number one passenger-car market. Perhaps more importantly, unlike our consumer bubble, Chinese consumer power isn’t dependant on easy credit. Only about a quarter of car purchases involve a loan, and average loan-to-value on home purchases is running at only 45% or so. In fact about a quarter of Chinese homes are bought for cash.

We have been orienting Royce Global Value and Royce Global Select towards the Chinese consumer- their future consumption needs involving healthcare, education, food, luxury goods and even money management. I think this will be one of the big surprises over the next two to three years- the increasing importance of the Chinese consumer and the decreasing importance of exports.

With the rise of the emerging markets as a larger percentage of world’s GDP, how important do you think it is that American investors gain exposure to emerging markets?

It is extremely important. The wealth transfer from the West to the emerging markets is arguably the most important investment theme of our age. The developed markets are ironically the most troubled parts of the world economically, and investors simply can’t afford to be exposed too much to the developed world with all its problems. I am not advocating selling all your US holdings and pilling into emerging markets when they are hot. Nor would I recommend committing more than a tiny portion of your investment dollars to the so called “frontier markets” in which Royce Global Value does not invest.

But when it comes to the “mainstream” emerging markets like the BRIC countries, South Africa and the Gulf States, we are really talking about economic champions. These are really the elite countries that are busy growing, rather than licking their wounds like we are. I think any long term investor should look to have 10-30% of their equity assets invested in these economic champions, with that number being towards the high end of the range exactly when all the talking heads on the TV channels are advising to cut risk!

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Changing exchange rates can have a large effect on returns of foreign equities. Do you hedge for currency risks?

No. Sometimes I wish we did! But overall I think our investors want that exposure and are smart enough to figure it out.

Do you have an opinion about the dollar and future exchange rates?

I am not a dollar bull. I do not think we are in for a normal recovery. The consumer is just too burdened: consumer deleveraging is in the early innings, and companies are either not hiring at all, or re-hiring at sharply reduced wages. Against this backdrop don’t rule out the possibility the government starts entertaining ideas for another round of stimulus, and that would mean more money printing and more currency debasement. At some level politicians can’t help themselves; money printing is like political catnip!

In fairness, the money printing mindset is not unique to the American government and the dollar, the EU is guilty too. So the point isn’t so much what the euro-dollar cross or pound-dollar cross will be. Those currencies are all troubled to varying degrees. It is more about which currencies might have a brighter future and I think that is a short list. It might be the Norwegian Krone or the Canadian Loonie because both those countries have natural resources the world wants and in general their economic house is in order. Or maybe it will be Singapore dollar. So much of the world’s wealth is being created in Asia. Ten years from now Singapore may be a money center like Switzerland once was. But to be clear we are stock pickers not currency speculators. We don’t organize Royce Global Value or Royce Global Select around currency bets.

To read the full interview look at my column on GuruFocus.com by clicking here

David Nadel of Royce Funds

admin — Mon, 01 Feb 2010 22:44:16 +0000

David Nadel

Royce Funds are a family of nearly approximately 20 funds devoted to small cap value investing. I am amazed how practically all their funds beat their respective indexes by wide margins. If this feat does not disprove the Efficient Market Hypothesis I do not know what does. The family of funds was started by Charles Royce over 35 years ago. The Royce Funds has recently opened several funds devoted to international small cap value investing.

One particular fund that opened in 2005 is the Royce Global Select Fund managed by David Nadel. Here is some information about Mr. Nadel from Roycefunds.com

David A. Nadel is a Portfolio Manager for Royce & Associates, LLC, investment adviser to The Royce Funds.

Mr. Nadel serves as Portfolio Manager for Royce Global Select Fund. Mr. Nadel joined the firm in 2006 and previously was a Senior Portfolio Manager at Neuberger Berman Inc. (2004 to 2006) and a Senior Analyst at Pequot Capital Management Inc. (2001 to 2003). He was also named to the 1999 and 2000 Institutional InvestorAll-American Research Teams. Mr. Nadel holds a bachelor’s degree from Williams College and a master’s degree from Harvard University, as well as a Master of Business Administration from Harvard Business School.

According to their website “Royce Global Select Fund (RGS) seeks long-term growth of capital and is designed for “qualified investors.” The Fund invests in both long and short positions in equity securities. The long portion of the Fund’s portfolio is invested in a limited number (generally less than 100) of U.S. and foreign micro-cap, small-cap and mid-cap companies that Royce believes possess excellent business strengths and/or growth prospects, high internal rates of return, and low leverage. The Fund may also establish up to 35% of its net assets in short equity positions, and may employ leverage. We believe that investors in the Fund should have an investment horizon of at least three years.”

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Top 10 Positions As of Quarter-End 12/31/09

% of Net Assets (Subject to Change)

Major Drilling Group International 3.3%

Value Partners Group 2.8%

Burckhardt Compression Holding 2.8%

Hochschild Mining 2.7%

Mayr-Melnhof Karton 2.6%

Semperit AG Holding 2.5%

Partners Group Holding 2.5%

Sipef 2.5%

Pfeiffer Vacuum Technology 2.3%

Tesco Corporation 2.1%

Top 10 as % of Total 26.1%

Click on the following link to read the rest of my article GuruFocus.com

Wisdom From The Royce Funds Part I : Interview With Guru Charles Royce

admin — Tue, 05 Jan 2010 04:19:00 +0000

Charles Royce

I am a shareholder in several Royce Funds, and receive their newsletters periodically. I like to follow what is happening at the fund family to gain better insight into small cap value investing. I hope to start a regular series with useful updates from the newsletters.

For the first of my series I will sum up a Q and A with Charles Royce. Charles M. Royce is President and Co-Chief Investment Officer of Royce & Associates, LLC and President of The Royce Funds, a position he has held since 1972. Charles Royce’s flagship fund The Royce Pennsylvania Mutual Fund has returned 16.5% per annum over the past 35 years.

Mr. Royce believes that the case is getting stronger that the worst of the financial crisis is behind us. Charles is concerned about the unemployment rate and believes that it may not significantly improve for as long as a year, however he is focusing on increasing consumer savings, corporate liquidity and stock market gains as better barometers of the country’s economic health.

Mr. Royce is concerned about the disconnect between Main Street and Wall Street due to the current economic crisis. He explains that most people tend to distrust Wall Street due to its involvement in the current financial crisis. This distrust truly started during the Tech bubble when some firms gave buy recommendations on tech stocks, even if their research did not support that conclusion. However, we have had various bear markets, scandals and events like 9/11 and the market has survived. Mr. Royce states “I think that stocks will remain consistent with their historical role of building wealth over the long term and that diversified investments are the soundest method for investors to try to realize their goals.” Charles Royce believes the massive stock rise since March is ending. In the future stocks will provide returns in the high single digits. Although this rally was marked by low quality stocks producing high gains, Mr. Royce believes that in the future investors will be more discriminating with their stocks and choose higher quality companies with strong balance sheets.

Mr Royce believes it is a good idea to hold small cap stocks that have operations outside the US. He believes the most successful companies are ones that have become global. He says this trend has been going on for years, and shows no signs of stopping.

Major Drilling Group International	3.3%
Value Partners Group	2.8%
Burckhardt Compression Holding	2.8%
Hochschild Mining	2.7%
Mayr-Melnhof Karton	2.6%
Semperit AG Holding	2.5%
Partners Group Holding	2.5%
Sipef	2.5%
Pfeiffer Vacuum Technology	2.3%
Tesco Corporation	2.1%
Top 10 as % of Total	26.1%