How Charlie Dreifus' 'Risk Allergy' Shapes His Work

Kevin McDevitt: I'm Kevin McDevitt for Morningstar, here at the Morningstar Investment Conference. I'm joined today by Charlie Dreifus from Royce. Charlie, thanks for coming.

Charlie Dreifus: Good morning, Kevin. Thank you. Honored to be here.

McDevitt: Great. So you're the portfolio manager on Royce Special Equity, and one of the interesting things, I think, about your process and philosophy is you're very vigilant about debt, and companies that have large debt loads you tend to avoid. Tell us a bit about where that vigilance came from? What are the roots of that?

Dreifus: Well, it goes beyond debt, but I'll certainly discuss that. I got an award from my boss, Chuck Royce. It's a caricature of me wearing belts and suspenders. I'm that risk-averse. The origins, I can really trace to two influences. My parents were German refugees who came to the States in the late 1930s without anything. It was sort of a lifestyle. Another interviewer once said to me, "Charlie, you're so risk-averse. You have a refugee mentality." And while I was born here, I said, "Bingo, my parents were refugees." So that's something that I think people either have or don't have.

But mine was aided and abetted by my mentor and close friend, the late Abraham Briloff. Abraham Briloff was a forensic accountant, he was a CPA, an educator. I encountered him in a Ph.D. program. What he had published in Barron's over many decades, scathing articles about companies embellishing results, and taking to task the auditors for permitting it. In all instances, he was sued, and in every instance he prevailed.

Now, in one of the teachings of Abe, besides the overall cynicism and desire to carefully examine financials and governance, was the notion, which is not often shared ... If you think about it, let's take a balance sheet that on the left-hand side, the asset side, has a $100 of assets. If it has $20 of equity, it has $80 of other people's money. That's leverage. It may not be leverage with a due date, and it may not be leverage with an interest rate affixed to it. But it belongs to other people. Even deferred taxes owed to the U.S. government can eventually have to be paid. So take my example where I said it's only $20 of equity and $80 of other people's money. That would be a highly leveraged company. Whereas, if you flip it, if equity is $80, and everything else is only $20, that makes for a very underleveraged company. So those are the kind of companies I seek to invest in.

McDevitt: So what does that mean in terms of--if you had a company that's not very levered, that has a strong balance sheet--what does that mean in terms of other risks? I mean, you invest in small caps, for one thing, you also invest in a fair amount of cyclical companies, too, a lot of industrials. Does having a strong balance sheet allow you to take more risks in other parts of your portfolio? Not that you'd necessarily think of it that way, but does, let's say, not having a lot of financial leverage offset the cyclicality of a small cap?

Dreifus: Well, certainly on an individual stock basis, if you have a lot of cyclical exposure, you prefer to have lower leverage so that they can withstand a severe economic downturn. So on a case-by-case basis, the consequences tend to be many of these companies have such a strong balance sheet because, particularly in small-cap land, they have a niche business that is a cash cow. It's the prosaic business, nothing glamorous about the companies I invest in. But they have a good business without the reinvestment opportunity. So the cash flow ... we examine one of the other sort of things people should look at is cash conversion. Cash conversion means how much ends up in cash as compared to the amount you report in earnings. So if you increase cash by $120 and had earnings of $100, cash conversion ratio is 120%. That means, companies can pay dividends, can buy back stock, could make acquisitions. But, ofttimes, when these companies that have just one great business, you don't necessarily want them to buy something else.

McDevitt: So is that also part of the reason--if you've got a small-cap company, it's got one line of business, it's in a niche--is that one of the other reasons why it's so important to not have a levered balance sheet when you're talking about companies like that?

Dreifus: Yeah. It gives, for lack of a better term, but I think it's a good term, optionality. What's important, and I think could be a big driver in the years ahead: Costs have been removed from companies over that 10-year slowdown we had, such that, if we do have cost pressures, which we haven't had, admittedly, but if we have pressures on margins coming up--because we are at peak profitability--if margin pressure exists, there's an incentive for a competitor to buy one of my companies. Why? They're inexpensively priced, so you get the accounting accretion. The strength of the balance sheet allows the acquirer to use my company's balance sheet to fund the acquisition because not only do I have net cash, but I probably have unencumbered assets.

Then, if you're in the same business as contrasted with private equity or a financial buyer, you have the opportunity of injecting synergies. An underleveraged company has a holding cost. So there's clearly that, but the optionality that it presents and what happens if you do that in combination with other things. I try to buy absolute value. So the fund that I manage happens to have really, very good upside downside capture ratios. I've been managing public mutual funds now since May of 1980, so that's nearly 8,000 NAVs; I've seen a lot of different market outcomes. When the market is searching for what the right multiple is, the strength of the balance sheet, and the absolute attractiveness of the company helps keep that stock at a level in better stead than the market.

McDevitt: Let's turn that around, though, a little bit. You've talked about how, in the coming years, we're going to have a massive wave of refinancing because there's so much corporate debt out there, right?

Dreifus: Right.

McDevitt: I've heard an estimate that, over the next three years, it'll be $3.5 trillion in corporate debt that will need to be refinanced. What is that going to mean to the types of companies, or for the types of companies, that you own? Could that be an opportunity for those companies that are underlevered?

Dreifus: It could be an opportunity for them to acquire a competitor. You're absolutely right, Kevin--between now and 2021, the amount of maturities double on an annual basis, and they continue to go higher in '22 and '23. So there's a wall of maturities heading. The issue is, Where will interest rates be, and what will be the appetite of lenders? We don't know that sitting here in May of '19. However, again speaking to the optionality, a company that is a competitor that may have issues about refinancing would be more amenable to conversations regarding being taken over. Certainly, the good news is, my companies won't have to borrow. So they're not going to be in the midst of this. I probably had one of the few portfolios in the United States that over the last 10 years got hurt by lower interest rates because not only do my companies not borrow--and a borrower's benefited, particularly if you had variable rates--but, my companies have excess cash, which they invest in T-bills and munis, and they got lower other income.

McDevitt: Right. It's paid to be levered the past 10 years.

Dreifus: Right, exactly.

McDevitt: So I want to ask you, though, about a company that, to me, sticks out as a potential anomaly, but it may not be. It's your top holding, I think, it's Meredith magazine publisher, as of March of this year.

Dreifus: Correct. Levered.

McDevitt: It's levered. So your portfolio overall has an average debt/capital, only 20%, very, very low. But Meredith seems to have a debt/capital of about 60%. So what's going on there? Tell us the story.

Dreifus: Meredith is a company that I invested in for many, many years. Actually, the current CEO, when I first invested ... and then the current chairman was CFO when I first invested in this company. Everyone knows Meredith is a company that owns magazine properties and television stations. They acquired in January of '18, Time Inc. So they're in a June fiscal, so on June 30 of '18, they had debt, which was 3.5 times EBITDA. They already paid down debt through cash flow--big cash flow generator--plus asset sales of things they bought from Time, like Time magazine and Fortune magazine, such that now the ratio is 2.7. They expect by June of 2020, based on just cash flow, to be down to 1.9. Leverage will be obliterated by that.

McDevitt: That's kind of your magic level, right? Two times leverage.

Dreifus: Yeah, or less.

McDevitt: Or less, or less. At least.

Dreifus: Right. Now, that still assumes conviction that they will get this done. So what you have to do in cases like this, you have to go back in history and see what they did. They had a series of acquisitions of TV properties in Phoenix and elsewhere that levered it up. They quickly paid it down. I'm not averse when there's an opportunity to seize that opportunity and lever it up, if there's a clear path, a believable clear path as to how you're going to pay that down. Furthermore, there's some evidence that you actually did that in the past.

McDevitt: Last question, I want to ask you about cash in your portfolio. Right now, or at least as of March, it was about 20%. I don't know if it's an all-time high, but I know it's close. So you're obviously not finding a lot to buy in the market. Is there any area, though, that does look attractive? Is there any area where you are still finding opportunities?

Dreifus: Right now, I'm actually not. The last 12 months have been very strange. If you go back from the end of March of '18 until the end of September, we had rising values and rising interest rates. My approach, in terms of valuation, is that, of private equity or M&A, you examine the cap rate--the return the buyer gets by buying the business--against the cost of borrowing to buy the business. With the market rising, cap rate comes down, but yet interest rates were rising. So it squeezed my portfolio. My portfolio--the cash position has nothing to do with the temperament of Charlie Dreifus. It's not that I personally am bullish or bearish, I have a view, but that does not influence the cash position. It's the opportunity set that's out there.

As the market rises there are fewer opportunities, and that's compounded, obviously, in an environment where interest rates are rising. I had built up to 18.6%, I had in March, something around 9% in cash, of '18. By September of '18, I had nearly 19%. In the fourth quarter, I found, indeed, five new names. My portfolio is very concentrated, so it only had 37 or so to start off with, so five is a decent addition to the portfolio. But, after the first week in January ... So, at the end of December, cash had gone back down to a little over 9%. Because I have a concentrated portfolio and I've been in the business long enough to know that redemptions come at the absolute worst time, I generally keep 8% to 10% in cash. That's my normal range. So by the end of December, it was back down to 9.3. As you mentioned, at the end of March, it's 20.7 again. So the market rallied. Now, interest rates weren't going up, but the market rally... I had things that I had to lighten or things that I actually had to sell, including one that I bought in the first week of January. It had gone up so much. It was a small position, but I already sold it, which is not typical. My fund generally holds stocks for five years.

McDevitt: You're not used to owning a hot stock.

Dreifus: I'm not used to ... That doesn't happen often, if ever.

McDevitt: Great. Well, Charlie, listen, thank you so much.

Dreifus: Thank you so much.

McDevitt: I really appreciate it. Thank you for watching.