Royce's Charlie Dreifus notes that investors will likely continue seeking out stocks that look like growth bonds, and large caps are where they might have better luck.
1. Where on the market-cap spectrum are you finding opportunities today?
I manage two portfolios, Royce Special Equity, which focuses primarily on small-cap and micro-cap companies, and Royce Special Equity Multi-Cap, which is a newer product that invests mostly in companies with market caps more than $5 billion.
For some time, we have found the larger small-cap names more attractive. Some of that no doubt is because of the significant price appreciation in the smaller, lower-quality small-cap issues off the March 2009 bottom. This is the usual pattern after a decline and often leaves the larger quality names relatively neglected, which has historically worked well for us.
With both funds, one of our goals has been to create a portfolio of companies that pay dividends and have a consistent history of increasing them year over year. This is typically more easily accomplished with large-cap companies.
At the end of 2011, 37% of Royce Special Equity Multi-Cap's holdings had raised their dividend consecutively for 31 years or more. In the long run, a company generally cannot pay, let alone raise, a dividend if it is not earning money. So the ability to do so represents an inherent sign of earnings quality embedded in these companies.
We should also mention that, effective after the close of business Feb. 29, Royce Special Equity is open only to existing shareholders and existing relationships. We did this once before, from March 2004 to June 2006. Royce Special Equity Multi-Cap remains open to all investors.
In each fund, we use a disciplined process to identify and ultimately invest in what we think are high-quality, inexpensive, financially productive, cash-generating companies with attractive accounting practices.
2. The health-care sector is often described as being defensive, why do you have a relatively small stake in the sector?
Royce Special Equity Multi-Cap holds a number of mid-cap and large-cap companies the health-care sector. In our small-cap portfolio, however, we have sold most of our health-care names as they became increasingly expensive to us, so our attraction in that sector is predominantly in larger companies.
3. How important are dividends to your investment process?
You have touched the heart of what we believe will be a powerful theme for the future. Our basic hypothesis is that companies with a moderate current yield, increasing dividends, and reasonable valuations and are also financially productive are more likely to produce market-beating returns. The alpha we see coming from increasing dividends is a function of several factors. One, sovereign debt downgrades have caused investors to seek high-quality substitutes. Two, an aging population is seeking income. Three, ongoing and rising dividends are a layman's shortcut to determining earnings quality. All of these speak to the increasing importance of the dividend component of total return.