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.
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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 put them in business. Maybe the customers need them more than they need the customer. You never know until you peel the onion.
TG: What do you think of the reflection that Warren Buffett had at one point in the last couple of years? In evaluating his performance, he focused on a single factor that he felt had matched across all of his greatest stocks; which is that those businesses were able to raise prices over time.
Chuck Royce: Sure. I don’t have a problem with that comment that if you’re a high-quality company and if you have high returns on capital, it is probably because you have pricing power. Usually that’s a primary source to high returns. That’s always part of the dialogue, and we would want to go deep on that.
TG: When you say high rates of return on invested capital, high rates of return on assets, is there a hard and fast number that you’re looking for? Or is it directionally? The company has a return on assets of 4.7%, but it’s up from 2.8% two years ago. Is that more attractive to you (obviously there are many other factors involved in evaluating a company) than, say, a company with a double-digit return on assets that’s declining?
Chuck Royce: Great question. The rate of change is important. We have to be sensitive to rate of change. In general, though, we’re looking for companies that have pre-tax, pre-interest returns on capital in the 20% range. We’re not talking about single-digit. And rate of change is important. A company that is increasing returns is potentially much more attractive.
TG: How do you evaluate the internal culture of a business? There’s a service now online called Glassdoor, where past and present employees can review their companies anonymously. You can go out and read about virtually any public company out there. The most highly rated public company and company of size, culturally, is Facebook. The people that are going to work at Facebook are incredibly passionate about working at Facebook. It has very high reviews.
I view that as a positive; but that’s a struggle for me as an investor and for investors (particularly retail investors) to try and figure out what’s going on inside of that business. Are people excited to come to work? Is that a factor that really matters, or do you see that showing up in a quantitative…?
Chuck Royce: Surveys are really complex. You get a lot of noise. You get a lot of this and that. It’s very difficult. I’d say you need a much longer, longitudinal conversation with key people who have stayed with the company for a period of time and not necessarily joined them ten minutes ago. You need to have an in-depth conversation. It can’t be single-factor. It can’t be, “Do you like going to work?” It can’t be, “Do they have cool Friday afternoon beer parties?” It has to be much deeper than that. And we do attempt that. That is critical. Having a culture that is sustainable, that’s real, that’s authentic is a great idea. Usually, that comes with the kitchen when you have high returns.
TG: I’m going to say something I think you’re going to disagree with, but I’m going to say it for the fun of it because I’m curious what you think. I believe that […] if I simply invested in every small public company with the highest rate of employee retention (versus competition, because it’s not fair to compare it to a fast, casual restaurant or to a software business) that would be a single factor that I think would correlate with market outperformance.
Chuck Royce: I wouldn’t fight you on that. Now, there’s too much of a good thing. Retention could mean that you are not actually optimizing the company. It could mean that. But, in general, I think it’s a good thing.
TG: Dividends in small-cap companies. I love doing historical research. I remember looking at Wal-Mart. They became public, I think, in 1972. Two years later, their stock had been cut in half with many other stocks in the 1974 bear market. At that point with [what I think was] a market cap of about $15 million, they began to pay a dividend. What does a dividend signal to you? Not a required dividend or not a 7% yield as a small cap, but a 1-3% or 1-4% dividend from a small company. What are some of the things that management is telling you by paying…?
Chuck Royce: I think it’s extremely important. I think it is more than symbolic. It is actually telling you that they believe in a corporate governance principle [where they are willing to share with you] the wealth they are creating so that you have the opportunity to reinvest that any way you want. As opposed to, “We know everything. We’ll retain everything. We will reinvest it, because we know about everything.” To me, that’s an invitation for ego issues [and bad decisions] from a corporate standpoint. I think a much healthier environment is a company that understands they have a responsibility and a social contract that the wealth they’re creating is ours.
TG: What about leverage and small-caps? Do you simply eliminate companies above a certain debt equity? Are there certain levels that you’re not interested in? There’s a [company that’s now mid-cap] that I’ve really enjoyed following. It’s a commercial oven business called Middleby. They’ve used leverage to acquire other small technologies. It’s all been very focused. I have a natural resistance to acquisition as the driving force of growth, but they have been an acquirer that has used leverage effectively over the last 15 years. It’s an outlier for me as an investor; but do you pretty much avoid those companies outright?
Chuck Royce: We have a general principle which we try not to violate unless we really have strong reasons. And the general principle is that assets to equity shouldn’t be more than 2:1. Now, we’re not just talking debt here. We’re talking about leverage that could relate to all sorts of short-term leverage [including] payables, etc. So, we have a more universal standard. Debt, obviously, is important. We don’t want to have the double risk of operating leverage and financial leverage.
In the first place, if you have high returns, you probably don’t need that leverage. Now, should companies use leverage from time to time for true, strategic opportunities? Of course. We’re not black and white. But when we wake up in the morning, we are very much avoiding leverage in our space.
TG: Can you determine what percentage of your evaluation of a company is quantitative versus qualitative? Do you think that way at all? I just think that the average retail investor thinks it’s primarily a numbers game and whether they have the ability to read financial statements or not. Obviously, that’s a key and important part. Is there a weighting that you see?
Chuck Royce: We, of course, do financial statement analysis. Of course we’re looking at the numbers, the history, etc. But that’s, at the end of the day, a commodity. Everybody else is doing it. Everyone has the same skill sets, more or less. So, that is important; but you [have to be able to] come to grips with some of these other factors [like whether their return is sustainable]. Is this culture someone I want to invest with? If you can’t come to grips with those things, you can’t make a high-conviction bet.
TG: I’d like to talk a little bit about the holding period within your funds. In general, I’d say an investor is looking at retail funds. It’s just the average person out there is trying to figure out which one to pick in their 401(k) plan. If they focused on a low turnover, they’re getting in a zone of people who are probably a little bit more focused on business analysis, a long-term thinking culture, etc.
Chuck Royce: Absolutely. I think if an investor did nothing else but focus on low-turnover funds, they would be doing themselves an enormous favor. And in general, low-turnover funds do very well. They have fewer costs. They probably are spending more time on business fundamentals as opposed to market fundamentals or market technicals, and I think they have a better shot at making a lot of money.
TG: What would happen if you gave a directive at Royce: “We are going to extend our average holding period to eight years. I want us to do that.” Do you believe that would be a smart thing? And do you believe (I guess it’s the same question) it could lead to higher returns?
Chuck Royce: We don’t have a mandate like that. When I’ve asked the question (when I’m beginning to look at a company) of what is your sight line for that company—and it’s forever—I like to own companies that I would feel comfortable owning forever. That’s the goal. That’s the aspiration. The reality is “things go bump in the night.” Things are never as good as they look. Things change, etc. So, holding periods come down from forever to a lesser number.
But we have many stocks we’ve held for a long time. The goal, the aspiration absolutely for us is a long sight line. We want the compounding effect. There’s nothing like owning a $10 stock that you’re buying with a 15% compounding power and just having it go on and on. Nothing like it. Now, it doesn’t work out that way every day.
TG: It’s almost absurd for me to ask you about length in the time horizon because you all are at the edge of the continuum…
Chuck Royce: We try to be…
TG: That’s one of the many things that I deeply admire about Royce. Have you ever looked at the performance of the companies that you’ve sold? The reason I ask that is we carried that analysis out at The Motley Fool. We’re only a 20-year-old business, but really in tracking our investment returns we’re a little bit more than a decade.
What we found in that period of time is that the stocks that we sold are outperformers. We’re often selling after something has happened and the prices come down to a level that it may actually be attractive for a turnaround. But for different reasons, we didn’t like the business anymore. The leadership wasn’t being honest in some way. They had over-promoted themselves. Have you ever done analysis on just sells?
Chuck Royce: No. I think it’s a great idea, though. And you do end up selling for different reasons. Your conviction is waning. You can’t get the kind of access to the management that you once had. There’s been a change in something. So, you sell. That might be a good reason or not. I do think it’s a good discipline to move on when things have changed. If you bought it for this reason and then you’re holding it for another reason; that’s usually a danger sign.
So, there are reasons to sell, and it would be interesting to look at whether sells work out. People have often asked whether our largest positions are our best performers (or some other in the spectrum) and I don’t have the information on that, either. One would hope the largest positions would be the best performers; but they may not be.
TG: Yes. I can see reasons that it could play out in different ways. What is your evaluation of the attractiveness of small-caps versus large-caps? I remember Peter Lynch had written that when the Russell 2000 is at a multiple of 1.2 times the multiple of large-caps, or lower, that’s an attractive time to buy small-caps. When it gets to two times the multiple of large-caps or the S&P, it’s no longer attractive to buy small-caps. Do you have a methodology for evaluating whether small-caps are going to be in favor for the next three to five years or not?
Chuck Royce: Our sight line on whether they will win or lose versus large-cap is no better than tossing a coin. We will have cocktail-conversation thoughts about that; but it doesn’t mean they’re true. The beauty and the wonder of small-caps is it’s such a big universe. I can construct a portfolio any day of the week that has the opportunity to outperform anything because of the vastness of this universe. This is domestically 6,000 to 8,000 companies and globally five times that. So, to construct a 100-company portfolio that has extraordinary risk/reward I can do every day of the week.
TG: Can you talk through an example of your favorite investment (or one of your greatest investments) and one of your biggest mistakes at any point over the last 40 years? Something where these factors came together: you saw it, you invested in it, and it delivered outsized returns over a long period. And then one that did not play out as you had hoped.
Chuck Royce: Sure. A great example of one that’s been successful (and we have plenty of losers, but we’ll get to that) is Lincoln Electric. Lincoln Electric is a niche company (we love niche companies). A single product. They’re in the welding equipment business. One would think that is a small business. It’s not at all. Globally it’s a big business with tens of billions of dollars of business. It’s a consumable business. It is somewhat cyclical. It is extremely high quality. They have used their free cash flow in appropriate ways to acquire competitors. They have been very active globally; so they’ve reached beyond the shore.
They have a very strong Midwest culture. We love Midwest companies. I like to think we are a New York-based investor that is culturally Midwest. They have an exceptional opportunity set. They have high returns, free cash flow, and no net debt. They represent all the good things. And we have our investment to compound well over 10 years.
TG: What about one that didn’t work out?
Chuck Royce: We had a recent one last year—Knight, the great over-the-counter trading company. We had a long-term investment in Knight. We were very thrilled with Knight’s strategy as a dominant market maker. Very high returns on capital. And it’s a great example of how things can go “bump in the night.” Out of the blue, there was new technology. Pressed a button. Things blew up literally overnight, and we lost a lot of money.
TG: Is that something where you look at that and think, “You know what? You just have to build a portfolio that can withstand a failure, because it’s going to happen.” Or is that something you look at and say, “Yes, but we can learn from this and apply our evaluation of a company that relies on technology, or a trading business that has this potential exposure, and we need to institutionalize that knowledge.”
Chuck Royce: Certainly it’s a great wake-up call that things can go wrong. And that risk factor of having a technology infrastructure—we certainly were aware of that. But we, in no way, assigned a probability to that happening, and it did. So, it is another reminder that a portfolio is better than an individual stock. I definitely believe in portfolio construction as an important risk management.
TG: Just a few more questions. One of them is about portfolio construction. Let’s just take an individual who has a few hundred thousand dollars to invest. Let’s say they’re 50. Let’s say they’re a small business executive. They’re familiar with business and financial statements. They’re investing in stocks. How many stocks should be in their portfolio? If you were having a dinner-party conversation with them and they said, “I’ve got 57 stocks,” or, “I’ve got seven stocks,” what number sounds like a good range for somebody in a situation like that?
Chuck Royce: I believe in a bigger number than would be typical, but I believe in both principles, so some concentration. We manage in our broadly diversified funds (like Penn Mutual and Total Return) hundreds of stocks. We have an R&D section of the portfolio where [we’re waiting for the right price] for stocks that we like. Or we’re starting to sell it and we’re not finished selling it. Stocks that go in and out are a component of what we do. Now, as an independent investor, that would be silly to have all of that. But I would be in the 25 plus stocks, and I would be thinking he should be using mutual funds.
TG: What I just heard you say is interesting to me, that you would buy a stock here, even if it was overvalued. If you love the business, take a small position to learn about it and hopefully find an opportunity to get a better price over time.
Chuck Royce: That would be true. We do try to separate what we call the enterprise conviction (the understanding of the company from the valuation) because it’s too easy to mesh those all up. In our internal conversation, we do try to separate that, and I will buy something that is somewhat overpriced in order to begin to understand its valuation pattern and with the knowledge that I’m taking a 20 basis point position. To have a full conviction for us, it would be 100 basis points. So, we’re a long way from that, and we would be waiting. Worst case, it continues to go up. Best case, it goes down and we get to buy more.
TG: Do you have an assessment of your results, stock by stock, in terms of the percentage of, let’s say, profitable investments out of every 10 that you would expect to make, and the percentage of market-beating investments out of every 10? In other words, let’s say you bought 100 stocks. Do you have a sense, looking back over 40 years or over a 10-year period, that 71% of them were index beating and 77% were profitable? Do you have any assessment of how many winners, per 10 stocks, you need to deliver the performance that you have?
Chuck Royce: It’s a great question. I don’t. That is not the goal. The goal is not to beat the index. The goal is to deliver sufficient, appropriate absolute returns and close to 15% would be my internal goal. You’re asking a different question. Is each individual stock..?
TG: Well, that’s your primary end. You’re not trying to get a certain number of stocks to win…
Chuck Royce: And we would never buy a stock because of its relative possibilities.
TG: This is a strange and perhaps unfair question, but it is a curiosity of mine. Does that mean if the Russell 2000 were up 17% a year, and you were up 15% a year over that five-year period, is everyone high-fiving at the Royce barbecue that summer? Or is everyone saying, “We lost by two percentage points to the Russell, but we hit our 15% marker?”
Chuck Royce: I would be drinking champagne and sharing it with the folks.
TG: So, when the market is down…
Chuck Royce: And of course, one year is never the right measuring period, but I hear your question.
TG: I actually meant over a five-year period. If you looked out over a long period of time and you had hit your 15% mark, but over that three years or five years it had fallen below the Russell, you’re fine with that.
Chuck Royce: Totally fine.
TG: Totally fine with that.
Chuck Royce: We would be punished in the relative standings, but that’s life.
TG: Yes. I wanted to just talk briefly about the Penn Fund acquisition, and purchase and founding of the business along with one or two questions about the culture that you’ve developed. You called it a Midwest culture and we’ll go back to that in a second. But just when you made the decision to go into this business, can you reflect on any of the factors and thoughts you had as you made that jump? What the fund looked like that you acquired and how it’s changed over the last 40 years?
Chuck Royce: I was in the research world. In the late sixties, you could be a researcher and a broker; so I was both. I had a client who was very knowledgeable in the investment process, and we stumbled across the opportunity to buy the management contract of the Pennsylvania Mutual Fund from a firm that was going…
Chuck Royce: …bankrupt. And we did. He ran it for three or four years, and then I took it over from him. I had confidence that we could do it, because some of my clients were mutual funds. I met a lot of these PMs and I basically [decided that] if they could do it, I could do it.
TG: The Midwestern culture of a mutual fund business in New York City. From everything I know about Royce, one would assume you’re in New York. From everything I know about Royce, I’m surprised you’re in New York. How is the culture different than a Wall Street firm or different than a high-frequency trading business? If you take the retail investor, he’s seen a lot of headlines over the last five years and just paintbrushes all of these businesses as the same. They’re all using leverage. They’re all speculating. They’re all looking for short-term rewards. How is the culture distinctly different here? How is the compensation structure different here? How is the evaluation of investors different here than it is at some of the firms that we saw run into crisis in 2009?
Chuck Royce: We have a very long-term approach. We hire seasoned PMs who have successful backgrounds, who have figured out they are where they want to be. They are desirous of being in a dedicated culture, which we are. We’re dedicated to our zone. They have matured in all the other ways—not just in their investment process, but in the conduct of their [lives]. We have that advantage, which I think is a significant advantage and a very attractive advantage. And yet, we’re in the epicenter of the investment world.
TG: Eighty years from now none of us are going to be here in this room. What is it about Royce [that will make it] successful decades from now? Succession is a potential sell factor for me on the companies that I love—when I see the founder stepping away and he’s run the business for 27 years as a public company. That worries me.
When Costco’s CEO stepped down, it didn’t worry me that much because the announcement was in paragraph eight of their quarterly earnings report. It wasn’t big fanfare. It was “this business has been built to last and I’ve been a part of it, but it’s going to succeed for decades beyond me.” What are the one or two factors that you see here that cause you to think, “This business is going to flourish, and I look for this when I look to invest in companies where succession is an issue over the next 25 years.”
Chuck Royce: I’m glad you asked that question. I think it ultimately will be the integrity of the process. The process is well screwed in here. I do not have the kind of high-ego needs to require that everyone perform exactly the way I do it, but I absolutely insist on a substantive, high-integrity approach to risk/reward (which is the underlying theme) and a deep conviction and passion for the business and a long-term orientation.
TG: The Royce family of funds. It’s been a group that I’ve learned from. I’ve enjoyed following your work and the work of your team, and being able to read about your approach in your letters to shareholders. And I’ve certainly followed a lot of companies that you all followed. I’m always happy to see that Royce is a shareholder in a small-cap that I’m looking at. Thank you so much for spending time with us. We learned a lot, and I really enjoyed it.
Chuck Royce: Great. I did, too.