Small Talk: 20 Questions with Co-CIOs Chuck Royce and Whitney George

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"Small Talk: 20 Questions with Co-CIOs Chuck Royce and Whitney George"

1. What makes Royce unique among investment managers?

Chuck We think that we offer two related advantages, one rooted in our culture and the other in our process. First, investing in small companies is our core business. We have a large and highly experienced investment staff of more than 30 professionals. It consists of many portfolio managers and analysts who have multiple decades of small-cap expertise. In our view, we're bringing a formidable amount of knowledge and experience to a part of the stock market that is not always well understood or effectively followed.

Whitney The second, process-based component can be distilled down to three key elements—we pay at least as much attention to risk as we do to potential returns; we have an absolute return orientation that allows us to frame realistic expectations for the stocks that we buy; and we have a long-term investment horizon for both the securities that we own and the portfolios that we manage.

2. What are the most important qualities you look for in a small-cap company?

Chuck Essentially, we are interested in three things—a strong balance sheet, a record of success as a business and the potential for a profitable future. Small-cap and microcap companies can be very fragile; therefore, we look for growing businesses that produce free cash flow which we think can survive potential difficulties in either the stock market or in the overall economy.

Whitney We employ a bottom-up stock selection approach and focus our efforts on looking for good stocks that are trading at a discount to our estimate of their worth as businesses. It's easier and more productive for us to concentrate on individual companies. Trying to predict future macroeconomic patterns and their ensuing impact on specific companies is very difficult.

3. How would you describe your investment approach?

Whitney We would describe ourselves as contrarians, which to me is synonymous with being a value investor. More often than not, it means standing alone. It requires an enormous amount of self-confidence to buy securities when the rest of the world is telling us these are bad ideas. Every day, we might be doing things that other smart people are insisting are wrong, so we have to believe strongly in what we are buying. We do take comfort in knowing that most of these companies are not likely to have an immediate payoff. We're comfortable that a significant part of current performance is based on what we did two or three years ago.

4. What is your time horizon for an investment?

Chuck Our mindset is focused on the long term. Other organizations may be more interested in short-term, relative results, such as beating the index, but we are not. Even if a company talks about using a long-term strategy, there still may be pressure on managers for short-term positive performance or not to be out of favor for a while. Here at Royce, however, we don't concern ourselves with short-term performance, whether it's positive or negative. In fact, every one of us has endured out of favor periods over the course of our careers. That's perfectly all right. Others may not always love it, but I think it's key to building an organization where long-term performance is what matters.

5. What can you learn from a company's annual report?

Chuck The annual report tells us a great deal about a company's past and present. It also provides clues about the future. It's really a portrait of the company, and one must be prepared to look long and hard at the picture. We are focused and diligent readers, and not simply for the numbers. We examine what a company is saying and what they are not saying, and compare that to previous years' reports. We think that it's one of the most important and under-appreciated sources of information on a business.

6. How do you weigh your own evaluations versus those of outside analysts?

Whitney It's only through doing your own work that you develop confidence and conviction. Much of Wall Street's research is directed toward those companies that provide opportunities for making money through trading or investment banking. So when we use outside research, it's generally for basic information and/or context purposes.

7. Are the quantitative or qualitative aspects of your research more important?

Chuck Both play an important role in the research process. Quantitative research remains a cornerstone of what we do—looking at balance sheets, cash flow levels, earnings histories. However, the qualitative aspects become increasingly important as we move forward in the security evaluation process. Information has become a commodity—it travels to everyone at equal speed, so being the fastest reader or collector of documents is no longer the advantage that it used to be. We believe that we add the most value with qualitative research—such as meetings with company management—which, incidentally, is also the most fun.

8. What happens when you meet with a company's management team?

Whitney We listen carefully to their plans. We want to get a sense of their vision for the company. It's also important to assess the feasibility of their plans. As cautious value-oriented investors, it's critical that we are able to trust management and have confidence in their ability to help the company grow. In addition, we often talk to a company's customers, suppliers and even their competitors. You can never know too much about a company, yet this type of detective work is not universally done on Wall Street.

We look for managers who are motivated by growing the company's business, and whose ideas are consistent with the goals of the shareholders. Honesty is paramount, both in words and actions. We look for integrity in corporate actions. We devote a great deal of time to reviewing proxies for potential conflicts and governance issues that another manager might gloss over.

9. How do you find new ideas for the portfolios?

Whitney We look anywhere and everywhere for good companies. This means shopping for information at the big Wall Street companies, the smallest regional firms and even at "garage sales," where there's no analytical coverage. We also try not to exclude any industry. For example, we worked hard, particularly in the mid-'90s, to improve our understanding of technology companies. It's a very broad category and has obviously evolved to be a huge part of our economy, arguably too big to ignore in its entirety. Many industries in the sector have matured. For example, a semiconductor capital equipment company has cycles and you can look at the fundamentals over long periods of time and normalize through cycles, the same way that you can a pump and valve company. They tend to be more volatile, and in many respects that creates opportunity for us.

10. Do you invest in Initial Public Offerings (IPOs)?

Chuck We are generally not significant investors in them. While IPOs represent a wonderful source of new ideas, our interest in them tends to be six to 18 months after the initial offering, when they disappoint enough investors and drop in price to levels that are more to our liking. This helps to create a constant replenishing of the small-cap universe, which makes it totally different than the large-cap world.

11. How do portfolio managers interact with assistant portfolio managers and analysts?

Whitney We have substantial interaction between our analysts, assistant portfolio managers and portfolio managers. When we are interested in a company, we run a systematic, quantitative analysis on the company's basic financial information. Multiple people examine the balance sheet and income statement history, cash flows and comments from management to assemble a snapshot of the company. This ensures that we have several sets of eyes viewing every company under consideration. Our analysts are generalists, not industry specialists. This is in contrast to most firms that assign analysts to a particular sector or industry group. We want our people to be able to spot a well-run company regardless of sector.

When companies pay us a visit, we'll typically have at least two or three investment professionals meeting with the company. That's a tremendous advantage in that people with different ideas and outlooks are able to analyze the same business. That's one benefit of Royce having a large investment staff, and we want to keep that edge.

12. What is the time frame between discovering a company and buying its stock?

Whitney It can take hours, days, weeks or even months, depending on the situation. The initial purchase may be done quickly, following the initial analysis. These small positions then incubate while we move through a longer, more comprehensive examination that may entail additional research. It usually takes some time for us to gain enough confidence to want to build our position in a stock. We generally set a price range that we are willing to pay, and it occasionally requires a lot of patience and discipline to wait for a stock to arrive at that price. We are looking for companies trading at discounts of at least 30% and preferably 50% to our estimate of their value as a business. It can be frustrating when, during the course of our research, these attractive discounts disappear. Nonetheless, it's important to exercise discipline as we buy and sell.

13. What happens once you have made the decision to buy?

Whitney We do not worry about getting into or out of a stock at the so-called 'best' price. We tend to dollar cost-average, looking for what we think is an attractive average price when buying and selling stocks. Charlie Dreifus, one of our portfolio managers, likes to describe it as wading into the shallow end of the pool.

14. How important is trading execution?

Chuck Execution is critical because trading costs are often higher for micro-cap and small-cap stocks than they are for large-caps. Spreads between bid and ask of five percent or more are not uncommon, although as an institutional investor, we attempt to buy and sell within the spreads. Many stocks in our universe are thinly traded with very low daily volume, so the work requires a lot of patience. We believe that our many years of experience give us an edge in this area.

15. How do you track a company once you own it?

Whitney We stay in touch with management, we carefully examine the financial statements when they're published on a quarterly basis and we look for developments both within the company and in its industry that may affect its business. Contrary to what people think, companies do not change very much on a quarter-to-quarter basis. Prices, on the other hand, change all the time, and we watch them every day.

16. What do you do when the price of a stock you own goes down?

Chuck Stocks that go down after our initial purchase teach us a lot about the importance of patience and confidence. We often go back and review our research to see what the reasons for the decline might be. Sometimes we may have missed something; sometimes we may have bought too soon. Sometimes, however, after reevaluating the situation, our confidence is reaffirmed and we average down, i.e., we buy more shares as the price falls.

17. Do the Funds ever buy stocks that they have held previously?

Chuck Absolutely. Since we tend to develop deep knowledge bases about our companies, we think that there is nothing better than to return to familiar territory if the opportunity arises.

18. How do you distinguish between growth and value companies?

Whitney The words growth and value are not polar opposites and at some level have become irrelevant. Unlike a lot of managers, we do not separate the universe into growth and value companies—we actually select companies for our portfolios from the entire universe. We are not against growth as an attribute; it's really about what price you pay for growth, not whether growth is good or bad.

19. Where do you make mistakes?

Whitney I've probably overestimated an individual manager's ability to turn around or fix situations that in hindsight simply weren't fixable. In small companies, the CEO is incredibly important. Typically, they dominate the company's culture. If it's a difficult situation, he has to create a new culture in the process of turning the business around. And so I've probably committed one of the sins that Warren Buffett warns against: When a good manager meets a bad business, it's the business's reputation that remains intact. I've had to re-learn that lesson more than I would like to admit. The other error would be a company that we like which fits our model and becomes overly aggressive by making a strategic acquisition. The lesson is, don't make an exception when the balance sheet gets stretched beyond our margin of safety. It's a rule that needs to be constantly kept in mind.

Chuck Sometimes a company which I thought was very inexpensive on an absolute basis disappoints in terms of profitability. Fortunately, if you buy the companies inexpensively enough, the penalty for being wrong tends to be much less severe than it would be buying companies with higher valuations.

I've also bought under-earning companies with low returns on assets in the hope that they'll improve, that somehow something will get better because I believe in the company's management and wind up trapped by its prospects. It does happen, but it doesn't happen often. I'd have to say that's my favorite way of losing money.

20. What should investors expect from an investment manager?

Chuck We believe that investors should look for a manager who seeks reasonable returns and uses an approach that stresses absolute, not relative, performance goals. Although relative performance comparisons are useful, they should not be unduly influential; you cannot eat from the table of relative performance. We also think that managers should communicate openly; they should willingly discuss their failures as well as successes with their investors.