Rediscovering Royce Discovery Fund

George Necakov with Chuck Royce

George Necakov is a Portfolio Manager and Royce's Director of Quantitative Analysis. Yet these titles don't fully describe his considerable contribution to our investment efforts. George is a key behind-the-scenes investment professional, bringing a wealth of expertise in quantitative analysis that does far more than inform portfolio decisions in Royce Discovery Fund or Royce Total Return Fund, where he serves as Co-Portfolio Manager and Assistant Portfolio Manager, respectively.

His quantitative work plays an invaluable role in helping our other portfolio managers to find companies with the kind of solid fundamentals that we like, including strong balance sheets, high returns on invested capital and long-term histories of free cash flow generation and earnings. His work also entails some proprietary factors that we believe provide critical added value in our search for financially strong, well-managed and attractively valued smaller companies. In addition, he runs a group that prepares vital quality control reports for our portfolio managers. George also oversees the preparation of monthly in-house attribution and analysis reports for all of our portfolios, which give a detailed picture of precisely how our portfolios have fared at the sector, industry and company levels.

When Royce Discovery Fund debuted in October 2003, it was run as a quantitative portfolio that invested primarily in micro-cap stocks. In August 2010, we decided to further 'Royce-ify' the fund, by adding Jim Harvey as Co-Portfolio Manager. Jim manages Royce Select Fund II, serves as Portfolio Manager for Royce Heritage Fund (with Charles Royce as Lead Portfolio Manager) and also serves as Assistant Portfolio Manager for Royce International Micro-Cap Fund and Royce Micro-Cap Trust.

George and Jim were in some ways a natural pairing. They share an important distinction at Royce as the only two members of our investment staff to have worked closely with our four most senior portfolio managers, Chuck Royce, Whitney George, Charlie Dreifus and Buzz Zaino.

In their qualitative work on RDF's portfolio, they began applying some of the more subjective criteria that we typically use in conjunction with the Fund's proprietary security selection model. For more than a year, they have examined purchase and sale candidates in light of what the model produces as well as using other tried-and-true methods utilized in other Royce portfolios.

We sat down recently with George and Jim to discuss how quantitative analysis works at Royce and for an update on how the Fund has progressed since making the change.

George, how was the model used in the Fund developed?

George: Not long after I began to work at Royce in 1994, I worked on various back-testing projects for Chuck Royce. This led to developing a model that would capture fundamental factors more effectively.  Chuck and I worked to refine it over the years.  It's important to point out that this work never focused on technical analysis, such as looking at price movements and volume patterns. The quantitative work that we perform at Royce has always focused on Royce's tried-and true, bottom-up fundamental factors that we believe reveal underlying company characteristics that we are attracted to in terms of quality and valuation.

How long have you been managing quantitative-based portfolios?

George: In 1998, I began to run an institutional portfolio that used an earlier version of the model. It screened for fundamental factors such as strong balance sheets and established earnings histories. My work on this and a small hedge fund led to Royce Discovery Fund being introduced in 2003 as a mutual fund that used our proprietary model to select mostly micro-cap stocks. Of course, the model evolved quite a bit between 1994 and 2003, and it continues to evolve today. I'm always trying to improve it. Currently, the model is set up to capture three key attributes—valuation, profitability and earnings yield.

It is important to note that we are always thinking about the durability of the model and whether we can improve it. We've looked at other metrics and variations of our existing factors to get a sense of how a portfolio containing companies with certain attributes achieved its results at particular stages in the business and/or economic cycle. This helps us to understand, for example, why many stocks with low P/B (price-to-book) ratios did so well in bull markets and why those with high returns on invested capital and returns on assets defended so well during downturns.  We then try to apply what we've learned to the Fund's existing screens for micro-cap stocks, such as those that show us companies with strong balance sheets and sufficient liquidity.

Without giving too much away, what are some of the advantages to using quantitative elements in running the portfolio?

George: It gives us the advantage of processing large amounts of data quickly. Our hope is that, beyond some of the basic screens that all of our investment staff use, the model's proprietary features get us fairly close to the kind of portfolio that we really want to own.

Jim Harvey

Jim, what is your role in co-managing the Fund?

Jim: I bring two things: The first you might call the human element. Although I've made ample use of George's screens over the years, I've also relied a lot on more subjective, qualitative factors, such as gauging the talent of a management team or determining whether or not a company's products and services are going to be in demand going forward. What industries are likely to do well in a globally uncertain economy? These are issues that the model is not really set up to handle, so a large part of my role is to answer these kinds of questions for micro-cap companies that the model sees most favorably. We think that looking at qualities that can't be incorporated into the model can have a meaningful impact on performance by adjusting position and industry weightings. I think it also gives the Fund a more decidedly long-term orientation. The second is additional familiarity with certain industries or sectors such as energy companies and precious metals and mining stocks.

I think the strength of the model is in providing critical backward-looking data at a very deep level, while the strength of introducing a qualitative overlay has more to do with thinking about a company's long-term potential in light of our trust in its management team and its overall business model.  This is where applying Royce's 'enterprise conviction' really comes into play: What is the structure of a company's market? What is its competitive position?  Is this a sustainable franchise?  It's an interesting exercise to go through this analytical checklist when looking at the output of the model. 

With its more extensive use of quantitative models, Royce Discovery Fund is unique in the Royce line-up. Can you describe how the two of you work together in managing the Fund?

Jim: George and I meet to discuss what the model is showing and how we might fine tune its selections. In many cases, the model suggests buying a company that we own or are looking at in other parts of the firm. Since we see so many companies each week here at Royce, I'm usually well informed as to what the company's more subjective strengths and weaknesses are. These meetings also provide important data in terms of industry trends, global demand etc. From there, we discuss a larger or smaller position in the stock based on the information that we've gathered outside of what the model gives us.

What are some of the most important non-quantitative factors now used in the Fund?

Jim: The human element is definitely an important factor. The model is an incredible resource for idea generation but as valuable as it is, it can't do everything. Probably the most important qualitative factor comes from meetings with company management teams, attending conferences and speaking to strategists. These really give us a sense of how the people in charge or with deep knowledge see the business and how they plan to make it grow. Sustainability is very important, especially when investing in micro-cap companies because they can be so volatile. So our ability to evaluate management's plans to effectively and responsibly run the business is probably one key qualitative factor.

George: Another important factor is the close examination of the quality of a company's earnings, which has long been a major consideration for Charlie Dreifus's analyses. Jim immediately brought those concerns to his work on RDF, and now we're working on incorporating that type of analysis into the model as testing it has shown that it should serve to enhance the overall model. 

Why do you think the Fund has lost less than its benchmark, the Russell Microcap Index, so far in 2011?

George: We certainly built the model so RDF would be as risk-averse as other Royce Funds, so we expect it to do well on a relative basis in a poor market. The Fund has also done well historically against the micro-cap index. Our goal is to try to build strong absolute returns over the long term.