The Royce Funds: A Culture of Discipline and Consistency by Royce Funds
President and Co-Chief Investment Officer Chris Clark provides a comprehensive overview of our firm, including a look at our more-than-40-year history, our contrarian, disciplined value investment approach, opportunities offered by small-caps domestically and abroad, mitigating risk, and more.
See the video here.
On September 10, 2014, President and Co-Chief Investment Officer Chris Clark addressed shareholders and investors at Legg Mason’s Investor Day 2014 in Baltimore, Maryland. Following a panel discussion on investing in a rising interest-rate environment—which was moderated by WealthTrack’s Consuelo Mack and featured statements from Chuck Royce, Isaac Souede from The Permal Group, and Ken Leech from Western Asset Management—and opening remarks from Legg Mason President and CEO Joe Sullivan, Chris talked about the history of The Royce Funds, our investment approach, long-term performance, small-cap opportunities, and more.
“What I’d like to do today is just give you an overview of Royce and a little bit about our history, some hallmarks of our investment approach, and then cover some current challenges that we have experienced, as well as talk about the opportunities that we see for future growth in our business.
“Royce was founded in 1972 by our chairman and CEO Chuck Royce, who you saw earlier today, and we joined Legg Mason in 2001. Subsequent to that, we have seen very strong and stable growth in our business over that time period and have enjoyed a very strong partnership with Legg Mason. We have 127 employees, 33 members of our investment team, nine traders, 24 portfolio managers; importantly, all very experienced, mid-career or higher in their level of experience, and certainly one of the hallmarks of Royce and one of the things that I think we are most proud of is the retention that we’ve had in our investment team. We’ve had a very stable investment team. When people find their way to Royce, they tend to stay, and it really has a very meaningful impact on our domain knowledge and the collaboration that we see across our fund lineup.
“Over that time, we have maintained our exclusive focus in the smaller-company asset class. I think Consuelo pointed it out; it’s been an asset class that has evolved quite substantially since Chuck had the idea back in 1972, but it’s one that remains very large, very evergreen, and very inefficient in its level of institutional coverage in the opportunity set of ideas. In fact, one of the things that we obviously value the most is that really, if you look across the cap spectrum, small-cap stocks tend to be the most self-determinant in their success or failure, which in our minds, over time, really rewards the work that we’re doing.
“The firm began with one open-end mutual fund. We are predominantly an open-end mutual fund company. That fund was Pennsylvania Mutual Fund, but over the years, we have diversified our business and now have a range of offerings, segmenting the smaller-company space both here and, in a smaller way, but an opportunistic way, overseas as well. We have 15 Featured Funds that represent about 80% of our assets. We have four closed-end funds, and our areas of focus range from concentrated, more focused portfolios geared towards higher-quality businesses, but we also invest in dividend-paying companies, total return orientation, opportunistic, and special situation strategies. We have more diversified portfolios and, again, over the past seven or so years have begun to develop our capabilities in international and global.
“The opportunity set, again, is very large, just to touch on that a little bit. We think of the small-cap space as really up to $2.5 billion in assets, but that represents about 4,000 companies, about $2 trillion in market cap. Overseas, that number jumps exponentially, where there are 25,000 companies with over $7 trillion in aggregate assets, sort of just exemplifying what we see as a real opportunity for us going forward.
When people find their way to Royce, they tend to stay, and it really has a very meaningful impact on our domain knowledge and the collaboration that we see across our fund lineup.
“Maybe we will turn now to our investment approach. We, first and foremost, are risk managers, and really I think if you think about when Chuck founded the firm, I mean in the early ‘70s and really coming out of that, the emphasis was on not losing money, and that really has been engrained in everything that we do at Royce. We approach our investments with an absolute return and an absolute valuation orientation. We try to take a contrarian approach in things that we’re doing, and when we think about risk management, we really start with balance sheets, we really start with building in a financial margin of safety in the investments that we make, recognizing that, over time, having the ability to weather events, having the ability to, again, invest often in businesses that have had high-quality metrics in the past but are going through some challenges, and making sure that we give ourselves the luxury of time to see our investment perspective play out, that balance sheet, that financial margin of safety, has played a very important role.
“We have a long-term investment horizon. Increasingly we’re finding that a very interesting arbitrage in the market, as the market is increasingly shorter term in its orientation, and so if you look at turnover in our portfolios, it’s in the 15-25/30% range, so we are committed to businesses. We are making long-term commitments to them, but importantly, we’re doing everything we can to build in two margins of safety, including the financial aspect of it. The second one would be valuation, so recognizing that to get those two in combination often something has to be broken, especially in a higher-quality business. That’s really the sweet spot in what we’re doing, and Chuck talked a little bit about the opportunity set that we see currently in these more higher-quality, cyclically oriented businesses, which are really the ones that have been most disadvantaged, as it seems we’ve been anticipating the next recession now for going on five years.
“We are bottom-up in everything we do. We strive to be as active as possible; you will see very high active shares in all of our portfolios, and we remain committed to that. We’re also benchmark and style agnostic, so our portfolios will look very different than the benchmarks that we measure ourselves against, typically the Russell 2000, micro-cap indices, the Russell 2500, and again, we don’t limit ourselves to the value component of the market, perhaps as defined by consultants. We look at the entire universe but certainly bring a very strong value orientation to that analysis.
We recognize that to outperform over long periods of time, you always have to be different than the market, and if you are different from the market, you are not going to perform in lockstep with the market, so that is something that we actively embrace.
“One of the things that this investment team—and sort of our history of exclusive focus on the small-cap space—has earned us is a very deep domain knowledge in our asset class, in this very large, labor-intensive asset class. Often times investors will think that small-cap stocks either become Google or go out of business. I think we all know that that is not the case, so that frequently, over time, previously owned companies become some of our best sources of ideas as we are investing over long periods of time. We have had experience with management teams, seen lots of cycles, and had the opportunity to invest productively in companies over a multitude of cycles over time.
“Then finally, just the consistency of the application of our approach, that is something that has been a real hallmark of ours as well. Through thick and thin we have approached the market with this highly risk-focused discipline, this focus on high operating leverage at the expense of financial leverage, and making sure we pay the right price. What that has meant and what we, candidly, actively embrace is fallow periods in our performance. We recognize that to outperform over long periods of time, you always have to be different than the market, and if you are different from the market, you are not going to perform in lockstep with the market, so that is something that we actively embrace, and that is probably a good segue into some of the performance challenges that we have had. Chuck alluded to them; I will elaborate on them briefly.
“There was about a 20-month period beginning in the fall of 2011 and through the spring of 2013 where we meaningfully underperformed our benchmarks. Interestingly enough, we have done a lot of study on that and self-reflection on what that period meant and what were the drivers, and that was also sort of consistent with the peak moments of QE, the peak falls in interest rates, and, obviously, a huge benefit to lower-quality, more financially levered businesses. Over that time period, we saw these businesses—more highly levered businesses—really be able to lower their cost of capital, and it was a realm of the market that we were not participating in. But importantly, to sort of that consistency, our investors know, and I think we have done a very good job of partnering with them in this analysis, that they should expect that from us. They should expect that we are not going to chase what might be opportunistic in the market, recognizing that, over time—and we have obviously a lot of history and a lot of outstanding performance over 42 years—that our approach has been very productive and typically has generated very good outperformance over multiple market cycles.
We believe that there will be a resurgence in active management, both in terms of performance and in terms of investor preference, and we are obviously optimistic that we will participate in that.
“We believe very strongly that the active portfolios that we have created, when you compare them to our passive benchmarks, are really no comparison. The Russell 2000, unlike some of the larger-cap indices, is a low-quality portfolio of companies, and that certainly has been exacerbated by the outperformance that we have seen subsequent to the financial-crisis lows in that low-quality, non-earning, highly levered segment of the market.
“We believe that there will be a resurgence in active management, both in terms of performance and in terms of investor preference, and we are obviously optimistic that we will participate in that.
“What will drive that? It is hard to know. What will the timing be? It is certainly hard to know, but we are going to be around to find out and we are committed to it. Certainly, normalizing the rate structure will be a tailwind for us, and lower stock correlations, which we have actually begun to see, will be a tailwind as well.
“Just quickly on performance—we have seen a nice pickup in performance since that May of 2013 sort of end date of that period I described to you. Higher-quality businesses have been doing well, so now we’re in a position where we have a significant portion of our portfolios that are outperforming on a year-to-date basis and on a one-year basis.
“Then finally, we are a business of people, and one thing that I say to everyone at Royce Funds and will say to all of you is you should hold us to investing in the best people, the best people will drive the best cultures, and that is what will drive the best outcomes for our shareholders.
“With that, thank you for your time, and I look forward to your questions.”
Royce Featured Funds Average Annual Total Returns as of Quarter-End 9/30/14 (%)
|Average Annual Total Returns
|Special Equity Multi-Cap
|Russell 2000 Index
|Russell Microcap Index
|Russell 1000 Index
|Russell Global Small Cap Index
|Russell Global ex-U.S. Small Cap Index
1 For Pennsylvania Mutual, the average annual total return shown is for the 40-year period ended as of the date shown above rather than since the Fund’s inception.