A Buffett-Graham-Plus Approach

John Coumarianos: Hi, this is John Coumarianos, senior mutual-fund analyst at Morningstar, and I'm happy to be coming to you today from the offices of The Royce Funds in New York City. And I'm thrilled to have Charlie Dreifus with us, who manages the Royce Special Equity Fund.

Charlie is, of course, our Manager of the Year for 2008. We were thrilled to give him that award, not just for his great performance in a difficult market, but also for his entire tenure on the fund, which is about 11 years now, and Charlie has returned about 150%, cumulatively, for his investors. Charlie, thank you so much for joining us today.

Charles Dreifus: John, thank you. And thank Morningstar for the incredible honor they've bestowed on me. It's incredible.

Coumarianos: Well, you're very welcome. Charlie, let's jump right in. Tell us a little bit about your approach to stock-picking. I know you emphasize balance sheets very much. You've also emphasized how much you've learned from Benjamin Graham, who, of course, was Warren Buffett's teacher, and from Abe Briloff, who was your teacher in graduate school.

Dreifus: Yes, John. The approach is a very disciplined, value approach to the small-cap area. I'm very mindful of the price I pay because, ultimately, rate of return is a function of entry level.

But beyond the price, there are other elements that come into play. In terms of pricing, I do use a merger and acquisition metric rather than a conventional P/E metric. But balance sheets and financial statements are important to me. I screen for candidates based on return on invested capital. I want good businesses. On free cash-flow generation, I want free cash flow to be a significant portion, if not greater than, reported net income. I like companies that have little leverage.

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So, a lot of this, as you mentioned, John, is taken from, basically, three people, only one of whom I really know. The other two I've read a lot about.

The roots of this margin of safety, for lack of a better term, but it's an excellent term that Ben Graham introduced in his initial edition of "Security Analysis," was basically the concept of "don't lose money" and figure out ways to do that. Around the same time, actually, he was saying that, Will Rogers was going around the country saying that, you have to understand, this was the '30s, he was more concerned about the return of his money than the return on his money.

So a lot of the techniques and attitude about trying to be very mindful of reducing levels of risk wherever possible has its roots in Ben Graham. And of course, Ben Graham was the mentor to Warren Buffett. And Warren Buffett's addition, or adaptation, to Ben Graham's work, among other things, was he really wanted great businesses.

Buffett's terminology, franchises, or companies with moats. You guys have done an excellent job, research-wise, for incorporating the notion of moats. Basically, niche businesses that have high returns on capital. So I took that concept, the franchise, the niche, from Buffett, because you can find a lot of companies that screen inexpensive, but maybe they should be because they're not really great businesses.

Coumarianos: I think Buffett called them "cigar butts."

Dreifus: Right, exactly. So then, the person that I actually did spend time with, and to this day speak to weekly, was my graduate school accounting professor, a gentleman named Abraham Briloff, who, though 92 years old now and blind, still publishes somewhat. He was, certainly in the second half of the 1900s, the preeminent critic of the accounting profession in that his view was the accountants were really too liberal in allowing companies to portray numbers as they wished to rather than, necessarily, what was the most appropriate given the circumstances.

So, in graduate school, I was an accounting-major undergrad. But in this Ph.D. program, Abe taught me how to discern aggressive accounting from conservative accounting. I like to say I have, obviously, an assistant here who prints out all the documents, the SEC filings, when I'm looking at a company, but if I had to go to a public library, I would hope to find these documents in the nonfiction section rather than the fiction section.

So, it's that additional element. I'm told by many that not everyone enjoys reading financial statements. I've been doing it professionally for 41 years. I was educated to do it. It's not a task for me. I actually enjoy it. If there is such a thing, the documents sort of talk to me. I mean, I can draw from the documents more than they're saying. I can picture, as I'm reading the footnotes, sort of what the culture of the company is like.

Coumarianos: And what's going on in the business.

Dreifus: Yes. Yes.

Coumarianos: Yep.