Newly Reopened Small-Cap Fund a Compelling Investment
Risk-averse small-cap investors can feel good about Royce Special Equity under Charlie Driefus, says Morningstar's Alex Bryan.
Risk-averse small-cap investors can feel good about Royce Special Equity under Charlie Driefus, says Morningstar's Alex Bryan.
Alex Bryan: Royce Special Equity is a defensive small-cap strategy that was recently reopened to new investors. Managers Charlie Driefus and Steven McBoyle scour the small-cap universe for companies with strong returns on invested capital; durable competitive advantages that will allow those returns to persist; conservative accounting practices and balance sheets; and attractive valuations. They won't pay up for future earnings growth, which currently places the fund in small-value territory.
The managers' preference for profitable, conservatively managed businesses is evident in the portfolio's high average return on invested capital and low debt/capital ratios relative to the Russell 2000 Index. They aren’t afraid to make concentrated bets, and typically hold between 40 and 60 names, and will allow the portfolio's cash balance to climb when they can't find bargains.
This compact portfolio tends to look very different than the market. For example, the fund currently has no exposure to energy, healthcare, or financial services stocks, and is considerably overweight consumer cyclical stocks, which represent nearly 46% of the portfolio. Despite its concentrated bets, this fund has distinguished itself during market downturns. Over the past decade, the fund only captured 72% of the Russell 2000 Index's downside performance and has exhibited considerably lower volatility. It fared particularly well--on a relative basis--in 2008, earning Charlie Dreifus Morningstar's manager of the year award. While the fund will likely continue to hold up better than its peers during market downturns, it has tended to lag in bull markets. But over a full market cycle, it should offer a better risk/reward trade-off than most of its peers and could be a compelling investment for risk-averse small-cap investors.
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