A Conversation With Investing Legend Charlie Dreifus

Russ Kinnel: Hi, I'm Russ Kinnel, director of manager research for Morningstar. I'm very happy today to be joined remotely by Charlie Dreifus, a longtime manager of Royce Special Equity, Charlie inhabits the unfashionable corner of the style box, small value, and he's done so for a long time. Been through three bear markets at this fund to perform very well in all three of those. I thought this was a good time to check in with Charlie.

Charlie, how are you?

Charlie Dreifus: I'm great. Thanks for giving me the opportunity to speak with you, Russ. It's always a pleasure.

Kinnel: Maybe before we get into investing brass tacks, I'm just curious how has the pandemic affected your work in terms of, are you working at home? How has it changed the way you collaborate and the way you place orders? How is that working out for you?

Dreifus: Good question. And some have positives and negatives. Actually, I live in Manhattan. I live walking distance from the office, so I'm working remotely, but I have been back to the office occasionally to pick up things and drop things off. The thing that I miss the most and that has always been so exciting about this business is that you can continue to learn no matter how long you've been in it, is that dynamic of the exchange of ideas with your colleagues and others. And yes, we can do it via technology or phone, but it's not the same. And you're also missing those spontaneous discussions, the old notion of "around the water cooler" kind of concept. It's working fine. Our firm is planning on allowing people to start coming back a little after Labor Day. And I intend on doing that.

But the actual work, it's interesting. I love what I do, to take a quote from [Warren] Buffett, "I dance to work." And so I've always worked what I considered a full day, I get to the office at 7:00 or before in the morning and I'd leave shortly after the close. These days because I'm working from home, I start the day literally on the computer at 6:00, and I end the day generally around 5:30 or 6:00. I'm actually, interestingly enough, working more hours from home. Also, I'm printing out my own documents. I have been a bonanza to Staples in terms of ordering office supplies. At the office, I have my assistant who prints out my 10-Ks and 10-Qs and all of that. And so here, I'm doing some of that as well, but it's working. Technology is such these days that you don't miss a beat, really.

Kinnel: Sure, sure. I did want to get into this market environment. Your fund has performed much better than its peers in the three major bear markets, counting 2000 away and today. And so I'm curious, what is it about your strategy and the kind of companies you own that has enabled them to hold up in what are really three fairly different bear markets?

Dreifus: Yes. And actually, I think as you know, Russ, I've been plying this strategy for now 40 years. It started with the Quest for Value Fund at Oppenheimer in May of 1980 and then transitioned to Lazard Special Equity Fund. And now for 22 years, it's been the Royce Special Equity Fund. There's a long history of the kind of performance that you describe. Of course, the countermeasure is that it underperforms generally on the upside. But indeed we win by losing less, essentially. And the way we attain that is a very disciplined, some have called it rigid, and I plead guilty: I don't distinguish between disciplined and rigid. It's worked. It's based on the laws of economics and accounting. What we're looking for are companies that are absolutely inexpensive so that they stand up as a business. We would all buy the company because we would earn a return higher than it would cost us to finance the acquisition of that company.

And my observation, through not only the past three bear markets that you mentioned but going back the entire 40 years, is that when you buy absolute value, it doesn't get harmed as much, or in some cases harmed at all, when the market loses its bearings as to what the proper multiple should be. Absolute value, but good companies. Avoiding what Buffett had said to Ben Graham, "You bought cigar butts." Because you can buy companies that are absolutely inexpensive, but they have a blemish in their business model. I try to combine that absolute inexpensiveness with a high return on investment capital, low leverage, and a high cash conversion. Meaning what they report in earnings, they actually produce in cash. Now all of this--aided by the same principle that I use to distinguish whether a stock is absolutely inexpensive--gives me a very good map as to where the market stands.

So, right now it's very popular to say, "Don't fight the Fed," because we have this expansive monetary situation. What I am now saying is, "Don't fight the screens." The screens themselves are saying nothing's out there inexpensive to replenish the portfolio with. And quite the contrary, some of the names I own have gotten expensive enough that I should start selling them and possibly, if they go higher, reduce them. So, there is an ebb and flow to the cash level in special equity, but it's self-governing. It's not Charlie Dreifus making a market call. It's what the market is telling me based on the valuation and the attractiveness.

And what I should also add is that return to the buyers. I use the term cap rate, similar to in real estate, when the investor buys a parcel of real estate, you get a cap rate in return. We have that. That moves down as the stock price moves up. And depending on where the interest rates have moved, you may be raising the separation, in which case you're finding names. But if the separation between the cap rate and the cost of borrowing is narrowing, that's a time to raise cash. And that has successfully helped me do what we were all told to do: sell high and buy low. And it really works.

Kinnel: How did that work out in March and April when stocks were briefly very cheap, by some standards anyway, but at least cheaper than they've been for a while. How did that process work? Did you find some new names?

Dreifus: Yes. I thought you might ask that. So I have the statistics to give you a sense. What happened was that on the end of the year, on Dec. 31, I had 12.7% in cash. Special equity generally has 8% to 10% in cash, more or less, as a base. The 12.7% was already elevated. On March 31, it got as high--actually, by February already it was 16%, and it peaked at 16.9% at the end of February, the cash position, and it went down in April to 13.6%. So, I spent cash. There's the constant ebb and flow as this works. The problem is now obviously the market has come back with a vengeance, and there's nothing that I can find that looks attractive. And frankly, I've been raising cash again. And there's a very long history.

You may recall the classic example of that spread narrowing. If we go back to 2018, we had a very robust market, and starting in the summer, the Federal Reserve started raising rates, something unheard of these days. The market was expensive. On June 30 of 2018, I had 12.6% in cash. Over the summer by September, I had 18.6%. Again, that was even more dramatic because prices rose but interest rates rose, so you squashed that differential. But then by the end of the year, cash was down to 9.3%. If you remember, that was a Christmas Eve sell-off the likes of which we hadn't seen in a long time. I learned a long time ago, you can't buy cheap stocks with other cheap stocks. It's best to have cash. And I'm not suggesting that I'm a market-timer, but the system itself, it self-governs the amount of cash based on the attractiveness of the market and individual stocks.

Kinnel: Something else I wanted to ask you about is one of the reasons the last decade that growth has outperformed value significantly is that Google and Amazon are out there eating the lunch of a lot of value companies. Retailers are maybe the most prominent example, but they're not the only ones. In other words, there are a lot of value traps out there who may not see their business continue. And therefore obviously, past earnings are not so helpful. How do you factor that in to your work?

Dreifus: It's a great question. And retailers in particular were names that I sort of grew up with. Earlier in my career, I was initially a special-situations analyst and covered a lot of retailers in the late 60s and early 70s when the notion of same-store sales was a new concept. And so over the years I had made a lot of money and thought I knew retailers, but something dramatically changed in terms of the disruption. These days I have very little exposure. And on the broader issue of value traps--and that's very important that I said one way is to screen, not only for your inexpensive but for high returns on invested capital, suggesting some kind of moat and pricing power. But my colleague Steve McBoyle plays devil's advocate. What he does, before we buy a name, one of his main roles indeed is to tear apart the idea. Obviously he's younger and has a better sense of technology than I do.

We examine every company for essentially what Buffett termed "the Amazon effect." Just disruption. Because businesses in general, business models--and we see it, you open the newspaper every day and yes, it's mainly retailers, but the bankruptcies and closings of corporations, many of whom have been around forever. Lord and Taylor goes back to 1842. One has to be very mindful of that. And knock wood, I haven't had any of those in recent times. And part of that was also reducing. We had as recently as probably three, four years ago, a significant portion of the portfolio in retail, and we still have a lot of consumer discretionary, but it's auto replacement tires, it's auto replacement parts, it's other things. And even there, we are mindful of people who sell auto parts and tires online and what's happening in the various channels. And again, this goes back to something I mentioned initially, in terms of the beauty of this business and what keeps it so exciting is things change and you continue to learn new ways of looking at things as compared to the way you used to.

Kinnel: Well, Charlie, thanks so much for taking the time to chat with us. This has been really great. I appreciate it.

Dreifus: Well, my pleasure. And as always, thank you and everyone at Morningstar. I appreciate your coverage and your support over many years.

Kinnel: You're welcome. Thank you for joining us. I'm Russ Kinnel.