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By Karin Anderson | 05-23-2012 05:00 PM

Peeling Back the Layers of Risk in Stock Investing

Former Morningstar Manager of the Year Charlie Dreifus of Royce Funds says he's increasingly stress-testing his investment theses.

Karin Anderson: Hi, I'm Karin Anderson, a mutual fund analyst here at Morningstar.

I'm here today with Charlie Dreifus, who is the portfolio manager of the Royce Special Equity Fund as well as the Royce Special Equity Multi-Cap Fund.

Hi, Charlie thanks for being here.

Charlie Dreifus: Hi, Karin. Thank you. My pleasure.

Anderson: Can you maybe tell us a little bit more about the valuation metrics that you really rely on in the company characteristics that you look for, and maybe to follow-up on that you mentioned there are certain companies that you just can't value and you are very well-known for never touching financials.

Dreifus: Fair enough. There are a couple of key metrics ... there are many metrics that I use ... but the key metrics: My valuation metric is very much an LBO or merger and acquisition kind of metric, where I look at the return, in the parlance of the industry what they call the "cap rate," versus the cost of capital, and there I use as a proxy, a junk bond yield, and I'm looking for companies where based on current trailing 12 months or a lower number, if I believe the earnings are destined to decline. There is this differential between the cap rate and the cost of capital. So, as an entrepreneur, I would have incentive to buy the entire company.

Now, to make sure that I'm not buying terrible companies, I want them very much in the spirit of Morningstar's moat approach, to have a high return on invested capital. I want some degree of niche-ness, pricing power, something that distinguishes these companies and makes them attractive.

I also require a high cash-conversion cycle such that over a business cycle, the funds from operations minus capital expenditures are a large proportion, if not greater than reported net income.

I also feature companies with low debt. I also feature companies who raised their dividends consecutively, or at least often if not consecutively.

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