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    Chuck Royce: Value Investing In A Sector Fund

    Chuck Royce – Royce Global Financial Services: A Sector Fund With A Difference by The Royce Funds

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    A conversation between Chuck Royce and Chris Clark.

    Unique among our firm's product lineup, Royce Global Financial Services Fund (formerly Royce Financial Services Fund), as its name suggests, focuses on what we see as superior business models across the global financial industries. CEO Chuck Royce and President Chris Clark talk about why we chose this area for a sector-specific fund, our history with financial services companies, our preferred businesses in the industry, and recent changes we made to the Fund to increase our opportunity set.

    Chris Clark: Chuck, this is a little bit unusual for Royce to manage a sector fund. Why don't you discuss a little bit about your history with financial services and financial services companies and why we decided to choose this area for a sector-specific fund to offer our clients.

    Chuck Royce: We have a history of using a lot of financial services. Financial services are a very important part of the economy, a very important part of the small-cap space, and we have a long history of doing it somewhat differently than others.

    Our own preference has been to use the non-leveraged components of the space: the agents, the asset managers, the brokers, the service sectors in this area, and we have historically done less in banks.

    That whole bank issue is not something that we feel against banks, but we have the point of view that sometimes, especially during credit difficulty, it's very hard to separate the good ones from the bad ones.

    So historically we've used less banks, but we've used plenty of other stocks, and I believe I have had a recently good record with that.

    Chris: Should this be considered a non-bank financial services fund, or are banks something that—at moments of credit expansion or credit stability—you would consider using in the fund?

    Chuck Royce: Yes, I would not want to think of it as a non-bank fund. We have successfully used banks, just less than others.

    At the moment I actually feel quite positive towards banks, and I suspect we will be using more banks. We're entering into a period of higher rates, a period where spreads will be more available, and where I think there will be more opportunities for lending.

    So I believe banks will continue to have a role here, probably it will never be overweighted, but we would contemplate using more banks currently.

    Chris: I think financial services are really intertwined, obviously, with economic activity. Is this a cyclical opportunity because we are moving into a period of rising interest rates, or are there also secular opportunities that exist across the range of companies that are in the sector?

    Chuck Royce: This is a very real and, I believe, permanent opportunity. The world is changing. Banks have been in a phase here of more regulation. There has been created whole new sectors of financial service activity. The BDC space—Business Development Companies—is brand new to the space. It is entirely possible they will have a stronger loan origination role in the years ahead.

    In the asset management field, private equity firms, almost across the board, have gone public. They're often global companies, often headquartered outside the United States. These are great opportunities.

    There are a variety of service companies that service the financial sector. I believe we're entering into a period where financial services, broadly defined, will remain an extraordinarily good opportunity for making money.

    Chris: So recently the firm decided to expand the capabilities of the fund into a global context and rename the fund. It's not a very large increase in the global component that is now accessible to the fund, but talk about why you decided to make the change, and what are the opportunities overseas in financial services?

    Chuck Royce: The name change to me was just being consistent with what we're doing. For some time, for many years, we've been using non U.S. stocks, recently about slightly under 35%. This renaming expands that to 50%, but I really believe it's business as usual.

    The opportunities abroad are very parallel to the opportunities here. Banking of course remains somewhat of a local business, but the asset management field has always been global. The specialized service companies are global. We see tremendous possibilities abroad.

    We have used Swiss asset managers. We have used very high-quality Hong Kong asset managers, and we will continue to do that. We have a substantial position in an emerging market fund that's headquartered in London, but really is a global company.

    So we see this as just a slight broadening of the original concept here, and we've been doing it, really, for some time.

    Chris: Now historically you've also used exchanges in the fund. Are there any interesting opportunities both in the United States or globally in exchanges, especially given the fact that markets are changing, the way people invest is changing, the use of derivatives is changing, and the way all those things are transacted are changing as well?

    Chuck Royce: Our first investment was a Toronto stock exchange some time ago. I'm going to say as much as 10 years ago. We have recently put that investment back on. They have new management, they've gone through some restructuring, and we are very impressed with the new management and are really starting all over again. Now they have obviously a somewhat local exchange, but they are broadening what they see as their mission into derivatives as a clearing mechanism, and this is a very good business.

    We have a much smaller investment in the Mexican stock exchange which has similar opportunities. That country is going through many reforms. Although we can always argue that it's not a safe spot, but, in fact, I think they're going through very serious financial reforms, and there's a new opportunity in oil offshore where they're going through a substantial restructuring on that.

    So we're optimistic with that exchange. We've made investments in another three or four smaller exchanges that have very particular circumstances, but I like the exchange business.

    Chris: Talk a little bit about the margin of safety and how you apply a risk management discipline in financial services. Do you have a preference for certain types of companies in this area and, again, coming out of the financial crisis, where obviously financial companies were at the epicenter and there was an enormous amount of wealth destruction that occurred in this space. How do you guard against that in the financial services fund?

    Chuck Royce: It does come back to the first statement that by and large we've underweighted banks. Banks are the most difficult structure to analyze, so one of the first lines of defense in risk management is understanding the business model.

    The business models we tend to favor are really much simpler business models, typically without any leverage at all. So we would start with that. In addition, we are going to be very cautious about valuation, and these stocks are some of which I'd like to own for a long time, some of which are playing very specific opportunities.

    Chris: Talking about sort of tactical exposure in the fund and something that's been very topical, bond proxies, REITS, Utilities—obviously its own sector—MLPs though also in this space, how do you approach that area of financial services? It's a very large component and it's one that's obviously performed very well coming out of the financial crisis period.

    Chuck Royce: I have not had a strong interest in either one of those. We've done very moderate amounts of both, and almost none in the MLP sector here, some REITs. But in general I don't love the REIT sector. I find the capital structure for REITs in general an unfavorable one. There is no capacity for retained earnings.

    For an MLP or a REIT to grow, they have to either borrow money or raise equity, and both, I think, sort of works against a shareholder mentality. They've been very good in the interest rate decline. They performed very well. We probably could have done more but, frankly, the structure kept me away from those two.

    Chris: In terms of the opportunity, is it just a cyclical opportunity now in financial services, or how should investors think about using financial services in the context of their asset allocation?

    Chuck Royce: I could dream up a scenario that financial services are such a critical part of any investment program that an investor should consider having a small portion just dedicated to financial services, because it remains a source of tremendous growth possibilities and tremendous opportunity for compounding wealth.

    Royce Global Financial Services Fund [RYFSX]
    Average Annual Total Returns as of Quarter-End 3/31/15 (%)

    Global Financial Services 2.69 4.62 16.42 12.94 8.36 8.52 12/31/03
    Russell 2000 4.32 8.21 16.27 14.57 8.82 8.89 N/A
    Russell 2500 Fnl Svc 3.66 12.34 17.13 13.71 6.54 7.05 N/A
    Annual Operating Expenses: Gross 1.93% Net 1.74%

    * Not Annualized