How was the deep value strategy first developed?
The deep value strategy at Royce was started by Buzz Zaino about 20 years ago. I joined him close to 16 years ago. But it’s something that he had been doing for a couple of decades before he joined us.
The deep value approach is pretty straightforward. We look for names that are, we say, statistically valid for value funds. We populate a portfolio, a diverse portfolio, with very, very cheap names. That's the first part of the act.
The second part is seeing it, is there something that’s going to happen? Is there a management change underway? Is there a change in the sector? Is there a change in the broader economy? Is there something that’s going to happen that’s going to turn that cheap value stock into something that gives you better returns?
In other words, will it get back to a normalized valuation instead of one where it's considered cheap? And what we found from doing this, for a really, really long time, is if you can capture that change, you're going to capture the performance in the stock.
What's distinctive about your approach?
I think we have, number one, a frame of reference that is probably a little unique. And, number two, I think that we have patience. And the frame of reference is one where we've seen this act before, we've seen this movie before.
Businesses are cyclical. The economy is cyclical. And there's not a lot of magic to, to finding those patterns. You use history to, to sort of see can this thing happen again? And, if so, can you profit from it? And I think a lot of these companies are really subject to what everybody else is subject to, right? Subject to cyclicality.
And if you could take advantage of that, and if you know where to look, if you know how companies act when things are going well, and when they act when they're not going so well, you should be able to take advantage of that.
How do you identify a cheap stock?
Its two metrics that we look at: primary price-to-book and price-to-sales. We use price-to-book, a classic value metric. What are we doing? We're trying to make sure that we buy our assets as cheaply as we possibly can.
It helps you with a little bit of downside protection, although we don’t ever get defensive but you'd want to buy something as close to book as you can, because when you make your mistakes, which you do, you want to make sure that those aren't going to kill you. And it's a lot easier to recover from things that are selling at one times book and get beaten up, try to get back to one times book, than it is to buy something at four or five, six, seven times book, and getting clipped in half and then begging that you get back to break even and promising you’ll never do that again.
On the price-to-sales, it's a great metric, because it's something that we could figure out what earnings might be if things get better. If margins get better you could always take a revenue number and multiply it by the margin, divided by the shares, and you can come up with a reasonable earnings number, give it a reasonable multiple and there's your valuation.
Why is it important that a cheap stock have a catalyst?
But we're looking for something; it doesn’t have to be an event, per se. And it's usually not going to be something that's overnight. It's not going to be a flash in the pan type of event. It's usually a whole series of things that have to, that have to occur, right?
So, you're going to have to fix whatever it was that made you a value stock, then you're going to have to sort of implement some sort of program or strategy, and that strategy has to work, by the way. And then the market's got to recognize it. So, it's a long process. So, we tell people, many of the things that we buy today aren't going to start working, if you will, for a year and a half, two years.
What you're really looking for is, is there a possibility that this asset, something is going to happen, either with, with a new management or an economic situation, or a new product, whatever it is, that that's going to happen. And if that does happen, you're going to get a better valuation. So, you could call it a catalyst, but I just don't like people to think that we're looking for a magic bullet to sort of change.
Why is it important to buy turnaround stocks when they're cheap?
We've been doing this a long time, and many of these problems that companies run into, aren't unique, okay. Many of these things we've seen cycle after cycle after cycle, right, whether its companies affected by interest rates or recessions, or new technology, or perhaps difficulty with an acquisition; not a lot of new troubles, if you will.
There's new technologies, there are new competitors, there are new names, new faces, et cetera. But a lot of the problems are not unique.
And what you learn over time is that, number one, these things sometimes take a little bit longer than, than you'd like or expect. Number two, they sometimes get worse before they get better. But, number three, most of these things get fixed. And if they don't, if you were right on your initial assumption with valuation, you're either not going to get hurt too much because it didn't work out or, or someone's going to come in and bail you out because we do not have a unique lens. Other people see what we see as well.
So, if we truly identified an asset as being cheap, and even if you don't get that execution of what it was that you thought needed to happen to get better, you're still left with a cheap asset and there's value in that.
Please describe the four investing themes and what you're looking for in each?
Four investment themes have remained the same, and will remain the same going forward: asset plays, turnarounds, undervalued growths, and interrupted earnings which is sometimes referred to as our broken IPO categories.
They've remained relatively the same percentage of the portfolio over the years, which tells you that that's probably what the market looks like as well. But they each have their own little characteristics. Many of them have more than one of those attributes.
The asset plays are your value investors' dream. You get to buy a dollar's worth of assets for less than a dollar. Many times, that's perhaps two assets in one company, and one isn't getting any value for whatever reason. It could be that part of the business isn't throwing off cash, or it's looked as non-growth; whatever it is, what you're trying to do is see, is there something going forward that's going to change that, where the value of that asset is realized.
Turnarounds, in many instances, for us at least, involve a new management coming in and cleaning up an existing business. Many of the companies that we buy are still run by their founders. Many of those founders either decide to do something else; many of them are entrepreneurial and will start something else.
So, a lot of times you'll see a professional management team brought in to take over and sort of be that first outside group that has a chance to get things back to what became, to get that company to look much more like it did when it became public and had those appealing attributes of growth.
The undervalued growth stories are usually names in industries or sectors that perhaps at the time we're looking at them; don't feel like growth areas, right? So, different parts of cycles, different things might be thought of as growth areas like, you know, a lot of cyclicals, especially, depending on what part of the economy they’re in when they get very, very robust periods of outperformance, all of a sudden, they're not looked at as cyclicals, but perhaps growth stocks.
And these are companies we're looking at with double-digit growth and double-digit closer to 10 to 12 versus other double digits, but are looked at as companies that aren’t able to do that.
The last group is the fun group, if you will, the busted IPOs. Many of these things are companies that are growing, probably 20 percent plus. And, if you get to get them at significant discounts, because you've had an event, a negative event, either a missed earnings number, or perhaps a change in perception of what they're able to grow at, you could really make a, a nice return on these things.
Article by The Royce Funds