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.
So, this is many of the disciplines that I use. I forgot the second part of the question, though.
Anderson: Maybe, you could talk about areas you avoid, like financials?
Dreifus: Exactly, OK. One thing that I am noted for at least distinguishes me from some others is that I do what I call a deep dive into the financials. I'm trying to ascertain whether the company's figures are conservatively expressed or aggressively expressed. And the joke that I use is that if I didn't have an assistant who printed out the documents for me, and I had to rely on a public library, I would hope to find the companies I own in the non-fiction section, rather than the fiction section.
So, that is part of it, but there are certain industries that I've never felt comfortable in making that judgment. Banking and insurance stand out. Well before the crisis of 2008-2009, I was on record saying that you never know what these companies earned until you shut them down. They have long tails. In the sense of banks, it's the loans; in insurance company it's the risks they've taken. And that's not to say there aren't people with skill sets that can make those judgments; it is just a skill set that I don't have, and I don't feel comfortable.
There are other industries that, just by that nature of that return on invested capital and the cap rate differential, don't work well. Heavy, capital-intensive industries, utilities, railroads, things like that, just generally don't work well, and I don't own.
In the financial arena, though, I have owned investment management firms, insurance brokers, service entities. I just don't own the people that actually write insurance or do banking.
Anderson: When you talk about your process, you really emphasize removing all layers of risk, so that you have these portfolios that are designed to hold up relatively well in downturns, and they have. Both did well in 2011, the small-cap fund did very well in 2008.
Now, coming into 2012, could you talk a little bit your outlook, and if we see a slowdown, what are your biggest concerns with the two portfolios, and what might be the biggest risks with them?
Dreifus: Well, that they can be out of fashion, because I'm not a contrarian just to be a contrarian, but if you truly are looking for those mispricings, you're led to areas or investment sectors that others have rejected. And if I'm buying them, hopefully they are wrong and I'm right, but sometimes I too am wrong, clearly. I have made plenty of mistakes in the past, and I'm sure to make plenty in the future.
So, I do have heavy weightings in both of the portfolios in industrials and retailers. ... [T]he retailers are U.S. centric, so what's going on in the rest of the world, other than the ancillary effect it has on consumers' confidence and so forth, really doesn't affect them.
Clearly, in the industrial space, to some degree, what's going on in the rest of the world, particularly in the multi-cap portfolio, does affect it--because to the extent that capital expenditures or economic growth in China or elsewhere slows down, it will have an impact.
The critical question is, in terms of my assessment of the current price, is that already adequately reflected. I believe so. Time will tell whether I'm right or wrong, but obviously, the issue that is of greatest concern currently is to what extent is what's going on in the world going to impact my companies, which would have a greater potential impact in the multi-cap than the small-cap fund.
Anderson: OK. And one last thing, just to clarify the stress test that you are doing, you mentioned as kind of a sign of the times being a little bit stricter in terms of a couple of valuation metrics in particular. What are those?
Dreifus: Well, as I mentioned earlier, what I do in terms of the valuation technique, it's an LBO M&A. I take earnings before interest and taxes, which is referred to as EBIT. I don't use EBITDA, which would include depreciation and amortization, which in and of itself makes it more conservative to start off with, because it's a lower figure.
But I have taken trailing 12 months in the past, and if there was a published lower forecasted number, I use that; it's the lower of--it's never a higher future EBIT number.
I find myself increasingly these days, a sign of the times, stress testing: Would the stocks still be attractive if I haircut that trailing 12-month EBIT by 10%, 20%, and so forth, just to see is that already discounted. And if I can find enough companies where that's the case, then look, I may be wrong, hopefully not on all of them, on some of them. But again in a portfolio approach, it's been my experience that if you take all of these cautionary steps, more likely than not, as a portfolio it will do fine. There will be individual missteps, but if you consciously try to--the analogy to an onion--take all those layers off, in this case layers of risk and layers of expectations, then it's less likely that you'll get hurt. You may make a mistake, and the stock may decline, but it's likely the decline will be more modest than others might expect because you've already discounted it.
Anderson: This has been a great chat. Thanks for your time Charlie.
Dreifus: Thank you, Karin.