George: Still a Lot of Upside

Karin Anderson: Hi. This is Karin Anderson, mutual fund analyst at Morningstar, and I'm here today with Whitney George, portfolio manager and co-CIO at the Royce Funds. Hi, Whitney. How are you today?

W. Whitney George: Good, Karin.

Anderson: Good. Thanks for being here.

George: Thanks for coming.

Anderson: OK. As co-CIO, you work with a lot of the portfolio managers. You manage several funds with them and you have value managers and growth managers here, across the spectrum. What aspects of the strategies would you say are common across the board?

George: We always struggle with value versus growth manager thing. I think it would be hard to find any manager that said that they weren't buying value, so we view it all as one common discipline that we all share, which is a focus on small companies that starts with a balance sheet and looks at absolute valuations as opposed to relative valuations, as a standard, and takes a long-term approach to those investments.

We invest with a three- to five-year horizon. And across all of the strategies, I think you would find that would apply. Now the level of valuation risk that one might tolerate might be different in a growth-ier, more aggressive product.

The level of quality requirement might be higher in a more selective product like Premier, as opposed to a more broadly focused portfolio. So those are the variations on the main core theme, which is small companies, great balance sheets, preferably high returns on capital, with a long-term investment horizon.

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Anderson: Now going to one of the funds that you manage, Royce Premier, could you talk to us about what kind of opportunities you've been finding recently?

Where this rally has been going on for several months, and I would add there that you were someone who was buying a lot of hard-hit areas coming into '08. Materials. You have a very big stake in mining companies at that time. I'm wondering, given the big run-up that some of those stocks in the industrial and materials area have had, how have you positioned the portfolio? Are those still good opportunities?

George: I think for the most part they are. I think, in Premier, which is limited to 70 stocks--and actually we did expand it a little bit in the fourth quarter of last year, because there were so many great companies trading at such great absolute valuations that we didn't really want to sell anything to be able to participate.

For the most part, in the fourth quarter of last year and the first quarter of this year, when the markets were falling, we found ourselves, in the Premier Portfolio, more refocusing, revisiting, companies that we had owned, some of which had grown out of our portfolios.

Valuations had come up, gone higher. They had not come back to be small-cap stocks again. Premier has a two and a half billion dollar market cap cutoff. And so we were really reinvesting in existing positions and going back to some old favorites, some of which we'd owned for 20 years, during that period, in that particular portfolio.

New ideas did tend to be in those areas that were most aggressively liquidated. That tended to be those owned by hedge funds. They would be categories like fertilizer stocks, where we added one name to Premier. It would be industrial companies, particularly those that are related to steel and, therefore, global infrastructure. A new name, for example, would have been GrafTech, which is, I think, a world leader in providing steel companies with graphite electrodes, which are consumed in the steel-making process as scrap metal is melted into molten steel.

So those were globally dominant businesses that were trading, in many cases, at fractions of their replacement values. Obviously, earnings visibility was non-existent, but some of these companies were able to get to break even at 40% of their capacity, which meant that the potential operating leverage recovery over the next couple of years would be tremendous.

Now, they may be up 100% or 200% off their lows, but you have to recognize their lows were set at a point where we had a global panic going on. So there's still a lot of upside. And again, we still have stocks in Premier that were put in the portfolio in 1992, when we began. Now, the size of the position may vary based on valuation. We may prune back or add to it.

The idea for Premier is to really find those great companies, kind of the Warren Buffett concept of only having 20 punches. If you can find those great companies, it's a lot easier to manage, because the companies are doing more of the work and your traders are doing less of it.