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.
We want to be very clear: We are not seeking companies that pay the highest dividends. Our desire is for consistent dividend growers with supporting, solid free cash flow generation. We believe that investors will continue to seek out stocks that look like growth bonds. This has always been important to us, but it has taken on even greater emphasis as yields on investment alternatives have fallen so dramatically during the past several years. Ideally, our portfolio selections will provide safe and rising income with the additional potential for capital appreciation. It is somewhat easier to find the consistent dividend growers--commonly referred to as dividend aristocrats--in the large-cap sector.
4. What economic problem is keeping you up at night? How are you positioning your portfolio to mitigate this risk?
I am a worrywart by nature. I am always working through possible scenarios and the resulting likely outcomes. Excluding the global shocks caused by headline events such as the problems in Europe, Iran, other Middle Eastern countries, natural disasters, terrorism, and, most importantly, the implications for the world economy of any of these events occurring, the economic problem that I think about most--regardless of its ostensible cause--is that the economy pauses or declines again.
I think I can rightfully say that with our time-tested, real-world, economic approach to investment, we are able to act prudently and decisively in a world of uncertainty. In fact, these very disciplines have allowed us to be opportunistic when others might be frozen into inaction. Not to be forgotten also is the additional margin of safety we believe we build into our portfolios by our deep dive into a company's financials. Given concerns these days about pension plans, lack of sufficient auditor skepticism, and so on, these accounting veracity initiatives, which some have described as our "secret sauce," add another dimension to our attempt to manage risk.
Specifically, addressing the issue of less robust economic growth goes to the heart of our basic valuation metrics. We have always tried to squeeze out the excesses caused by high expectations. In valuing a company, we have always used the lower of the trailing-12-month earnings before interest and taxes, or EBIT, figure or the future-12-month figure.
These days, we find ourselves stress testing more of our holdings or candidates to see how the valuations look if we trim the trailing figures and use a lower prospective EBIT figure. We'll still make the mistake of overestimating the EBIT figure on occasion, but, combined with the battery of other hurdles a security needs to pass in order to make it into our portfolio, assessing and possibly trimming the EBIT figure at least helps us to sleep more comfortably at night.
5. What do you like about consumer cyclical names such as Bed, Bath & Beyond BBBY and American Eagle Outfitters AEO?
I understand the concern that the U.S. economy is very much consumer-driven. I'm also mindful that even though the consumer currently feels better as a result of the improving economy, employment rate, and stock market, there is the possibility for a consumer setback as a result of an economic pause or decline, as well as the toll that higher gasoline prices might have on other consumer spending. However, we remain comfortable with our consumer cyclical exposure. For sure, share prices are not at the levels we saw in late 2008 or early 2009, but some skepticism already looks priced into many consumer cyclicals.
Although we do not comment on individual holdings, we think that the sector is priced at reasonable levels, particularly given the fact that culturally we Americans are shoppers. We are also witnessing a decline in retail square footage in the United States, for example, the recent announcements by Sears Holdings SHLD of Sears and Kmart store closings. Our retailing landscape continues to become less overstored and thus ultimately more attractive to the remaining companies.
The consumer cyclical area traditionally has been a fertile field for transactional activity. Given the possible higher income taxes, particularly with dividend and capital gains income, and the often considerable family holdings present in some consumer names, we would not be surprised to see more transactional, shareholder-value-creating activity during the next year or so.
I have also often wondered why the Chinese manufacturers of so many goods that are sold through these channels have not sought to pick up the next margin--that is, the retail mark-up--by purchasing the U.S. retail customers of theirs. This seems even more plausible as the Chinese continue to state that they wish to own fewer U.S. Treasuries and more real assets. That type of transaction might be a remote possibility in the short term and therefore might be too much to expect. However, all in all, with or without any transactional activity, we are currently comfortable with our consumer exposure.