Charlie Dreifus Takes on Large-Caps

Charlie Dreifus

Can you describe the Royce Special Equity Multi-Cap Fund's portfolio, how it differs from the traditional Royce Special Equity Fund and why the launch of the fund made sense at the end of 2010?

Royce Special Equity Multi-Cap Fund is a concentrated portfolio of up to 50 positions (38 as of June 30, 2011). Although the Fund has no market cap restrictions, a significant portion of its assets will be invested in mid-cap and large-cap companies with market capitalizations of more than $5 billion. As of June 30, 2011, the fund had a geometrically calculated average market capitalization of $23.8 billion and a weighted average market capitalization of $44.9 billion. We don't expect many of the companies to have less than a $5 billion market cap and therefore, expect little overlap with our Royce Special Equity Fund. The benchmark for the Multi-Cap fund is the Russell 1000.

In my opinion, the large-cap asset class has looked cheap for a long time. I started investing in the space personally during the crisis of 2008-2009 and believe that over the next 10 years, there will likely be rotation in leadership from small- to large-cap. Rate of return is a function of entry price and right now prices in large-caps are very attractive as many large-caps are underappreciated.

This is not to say that I don't still believe we can find attractive small-cap companies that can provide good returns. In fact, to the contrary, the current environment is ripe for increased merger and acquisition and other transactional activity which can bode well for small-caps and can drive them to potentially outperform over the next one to two years.

What experience do you have with large-cap investing?

During the '70s and '80s, I was Director of Research at Oppenheimer Capital and Director of Research at Lazard Asset Management. At both firms, the stock selection process focused on large-caps.

In researching large-cap companies, is your process of finding undervalued companies different from how you apply it to small-caps?

No, it's really not. The methodology and metrics are the same. I still look for high, sustainable returns on invested capital and strong levels of free cash flow from operations, among other attributes. I'm still going to buy companies on an absolute basis and it won't be uncommon to see many household, "dividend aristocrat" type names.

There is an area where I must loosen one of the quantifiable metrics. In comparing the two asset classes and their balance sheets, there is a tendency for large-caps to be more leveraged than small-caps. This may come as a surprise to some since a common misconception of small-caps is that they have more debt than their large-cap counterparts. In reality, if you were to look at the Russell 2000 vs. the Russell 1000, you'd see an asset to equity ratio of 1.9 vs. 2.2 as of June 30, 2011. This shows that, in aggregate, the large-cap universe uses more leverage.

One advantage of investing in small-cap companies is that the pool of companies is quite vast and most are underfollowed allowing managers to find inefficiencies. Large-cap companies are quite the opposite, how will you overcome this challenge?

It's undeniable that the sell side analysts who follow large-cap stocks will inevitably know more than me with regard to the business lines of these larger companies.  However, the non-quantifiable aspect that I bring to the table as an active manager is the "deep dive" I take into the financial statements to better understand management's accounting veracity. This practice contributes to one of my core tenets — not overpaying — and tells me whether a company, be it large-, mid- or small-cap, is inexpensive on an absolute basis. This is how I believe I add value as an active manager.

Speaking of financial statements, what do you look for in your examination?

Well, it has taken me 40 plus years to develop my secret sauce, so I'm not going to give it to you all at once. What I will say is that the financials become a mosaic of the company for me. I read them from back to front starting with the footnotes. It's rare that one item will prevent me from investing in a company, but more often than not, management is consistent. If they are aggressive in one place, they are probably aggressive throughout. So the financials help me gain an understanding of the culture of the company which will either support my belief in whether earnings will persist into the future, or it will not. As I mentioned, it has been more than 40 years and this practice allows me to "hear" what the financial statements of a company are saying. And for me, it began with Abe Briloff's teachings and writings throughout the '60s, '70s, and '80s during which he tore companies apart for their aggressive accounting practices.

It is often noted that two of your major influences have been Ben Graham and Abraham Briloff. Who were they and what lessons did they give you?

Ben Graham is best known for margin-of-safety investing, for reducing risk wherever possible so as to not lose money. He was a mentor to Warren Buffett and incidentally, it is from Buffett's search for franchises or companies with moats that return on invested capital took its importance in my methodology. Though not a direct metric of Ben Graham's, the way I deploy his concept is to attempt to add layers of risk aversion as I value individual securities and construct my portfolios. I like to equate it to the Hippocratic Oath for doctors, that being "do no harm". For me it is, "try not to lose money".

Abe Briloff was my accounting professor at Baruch College and at 94 years old, a friend and mentor to me today.  During the height of his career, Abe was the preeminent critic of the accounting profession and believed audit firms were too liberal in allowing companies to portray financials as they wished rather than what was appropriate.  He taught me how to discern between those companies that used aggressive accounting and those that used conservative accounting.  I like to believe that if I went to the public library, the financial statements of the companies I own would be found in the non-fiction section while those using aggressive accounting would be in the fiction section.

You have seen substantial inflows into Royce Special Equity Fund over the last two years. Has it been difficult to put the cash to work?

I'm mindful as to the limitations of the Fund and I won't consciously allow it to get so large as to impair the integrity of the underlying product. In fact, the Fund was closed to new investors from March of 2004 to June of 2006 exactly for that reason. I weigh the opportunities while being cautious and mindful of the Fund's size. Events over the course of this year – Middle East unrest, Japan's natural disaster, financial concerns in both the U.S. and Europe – provided me with buying opportunities. Even with several takeovers of names in the Fund, I've been able to put cash to work, taking advantage of the headlines by finding new names and adding to existing names. So you'll see that cash has actually come down from 15.1% at the end of last year to 8.2% as of June 30, 2011.

What do you think of the market's recent volatility during the month of August?

No one knows or fully understands what's going on in the market and anyone who says they do is misinformed or wrong. The reality is that opportunity presents itself during periods of rising risk such as what we saw in August. At the same time, the uncertainty demands that I intensify my standards and ask more of a company before I buy shares of it.

Ten years from now, what will people say was the theme of the decade?

The next decade can be paralleled with the early 1970s in that, in those years there was a group of companies coined the Nifty Fifty. These companies were blue-chip, large-cap American stocks with strong earnings growth that outperformed the broader market during the early part of that decade.

Today and for the unforeseeable future with interest rates low, there is a need for a bond surrogate. The aging population is and will be searching for stability and income and there are very few alternatives. I suggest that the Nifty Fifty of the next generation will be a portfolio of companies who have the capacity to, and have had a history of, increasing dividends. These companies are high quality with stable earnings and cash flow such that they have the capacity to pay and grow dividends over time.

Of the 38 names in the Royce Special Equity Multi-Cap Fund, more than one third of them have consecutively raised their dividend for more than 31 years in a row and only one of the companies does not pay a cash dividend (it has bought back shares aggressively, though). A growing dividend can serve as a tailwind to performance, while also moderating market declines.

Morningstar FundInvestor 500

Both Royce Special Equity Fund and Royce Special Equity Multi-Cap Fund have been selected from a list of more than 7,000 available funds for the Morningstar FundInvestor 500 List. While the original fund has been on the list for years, the fledgling large-cap fund was selected in July 2011, with just a six-month track record. When Russel Kinnel, Director of Mutual Fund Research at Morningstar, made the announcement, he said "I'm a big fan of what Dreifus has done at Royce Special [Equity]. He takes a deep dive into companies' accounting and invests only where the accounting is clean and the balance sheet is healthy."