The Gannon Report

The long summer days have only brought more anxiety to the equity markets. The price of oil has dropped more than 16% since the beginning of July, while natural gas prices have fallen 33% since the beginning of the same month. Housing data continues to show massive oversupply, credit conditions are tight and getting tighter, and the labor market is weakening. Meanwhile, previously shunned financial stocks enjoyed their largest one-day gain since 1995.

In the midst of a summer overheated by market volatility and ongoing economic uncertainty, curling up with a good book sounds like a welcome distraction. To lose oneself in a great novel or classic mystery is always enjoyable, especially in a year like this. Yet somehow we never seem to stray too far from our favorite subject of investing, no matter what the investment climate is like.

This summer at The Royce Funds, Chuck Royce recently gave each member of the investment team a copy of Pat Dorsey’s, The Little Book that Builds Wealth as mandatory reading for the summer of 2008. In his book, Mr. Dorsey, Director of Equity Research for Morningstar, Inc., outlines many of the themes that we focus on every day. Like us, he focuses on companies that can consistently generate above-average returns on capital and have “economic moats” that enable them to compound cash over long periods of time.

In fact, we enjoyed the book so much that we asked Pat to come and speak to our investment team. So on a hot day in July, Mr. Dorsey graciously agreed to come to New York and spend an hour discussing his book, his thoughts on “economic moats,” and how they apply to different asset classes such as smaller companies. It was a lively discussion centering on how we seek to confidently identify companies that can generate sustainable returns on a consistent basis.

The conversation focused on other means of identifying “economic moats” and included some spirited exchanges on the importance of management, notably its role in allocating capital, especially in smaller-cap companies. We have always believed that the role of management—coupled with strong structural business characteristics, solid execution and strategy—are critical components of long-term success. Of course, valuation was also debated, as was what price we should pay for these above-average businesses. To many of us, identifying a margin of safety is just as important as finding high-return companies and a key to consistent long-term performance.

It was interesting to see how similar Mr. Dorsey’s perspective is to ours. What was even more striking—and what ties this together for us—is his focus on holding periods which, as he states, “should be measured in years, not months.” In today’s environment of severe volatility, investors have become increasingly focused on the short term, when it seems to us that the importance of a longer-term point of view only grows more paramount at a time like the present. Historically, increased volatility has led to a narrowing of overall equity market leadership as investors become concerned with finding companies capable of generating consistent returns. Focusing on companies with above-average returns on capital, or “economic moats,” and having a longer-term investment horizon should provide continued stability in these volatile days. All of which makes Pat Dorsey’s The Little Book that Builds Wealth a perfect summer read for 2008.

Stay tuned…
FDG