article , video 06-30-2016

Examining an Absolute Value Approach

Portfolio Manager Charlie Dreifus describes his absolute value approach and discusses why earnings play such a critical role. 

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What is an Absolute Value Investment Approach?

I view investing in Special Equity a form of absolute value investing. Now, that is a hard concept to embrace. It's not a term that's often used in terms of investment approach other than the outcome.

People speak of absolute returns but the investment selection process being absolute is a concept that basically says it's devoid of market considerations. The companies that I select I believe are absolutely attractive irrespective of where the market sells because they're not tied to market valuations or, for that matter, obviously peer valuations.

It basically asks the question, which is a question that buyers of anything should be asking, is: what am I getting for what I'm paying, and in finance we actually have terms for that. What we're getting is called the cap rate, the return to the buyer. It's often used in real estate but it applies to equities, also. So I use a definition of what we're getting that is very conservative.

How Do You Pursue Absolute Value?

So what do we do? We have to look at earnings. Most people when they look at earnings, they look at forward earnings. I use the lower of the past 12 months or future 12 months, whichever is lower.

So we're compressing out, removing expectations. Then in the earnings, further definition of earnings, conventionally in business transactions, mergers and acquisitions, private equity deals, the earnings number that's used is earnings before interest, taxes, depreciation and amortization, commonly known as EBITDA. It's a big number. It's a lot of letters, lot of numbers.

I use a smaller acronym called EBIT (earnings before interest and taxes). I don't include depreciation and amortization. I give no credit for depreciation and amortization. Depreciation is clear-cut. Depreciation is an ongoing expense. If you stay in business, you're going to have to buy more capital equipment and so forth. Amortization, arguably, is a little more controversial and many people do add it back. In terms of being ultra-conservative, I don’t.

So, again, using that lower trailing 12 month or future 12 month – EBIT number over enterprise value, enterprise value is what you're going to pay – it's the market price times shares, plus the debt you assume, minus the cash you get – so that establishes the cap rate. That's the return we would earn buying this asset.

Then the next question is: well, what would it cost us to finance that acquisition, and obviously, presumably, you would only do it if there were a spread, if the cap rate were significantly above the cost of financing and that's what we constantly seek to do.

How Do You Seek To Manage Volatility?

We constantly seek to buy things where the return to the buyer is higher than the cost of financing to the buyer, so ergo it has absolute value.

If we are comfortable that the earnings level, that trailing 12 month number, can persist – you have to do your homework and come away with a comfort that that 12 month EBIT number will persist and that's where the mistakes are made.

That's – you know, it doesn't always persist. Something comes about in the world economy – the business model all of a sudden breaks down; there's a destructive competitor out there– but if you can do that, it's the essence of what mergers and acquisitions and private equity's all about and, interestingly enough, because I have invested this way in public mutual funds since May of 1980, so that's 36 years now – we have a lot of data points in terms of daily NAV'’s.

It's remarkable how when the market does poorly, this absolute value kicks in and gives some support. It doesn't mean we can't go down and lose money – we can and do but, historically, one of the reasons the Special Equity Small-Cap Fund, which goes back to '98, has such a low downside capture ratio, I would argue, is because of the absolute valuation in the portfolio.

Important Disclosure Information

Capture Ratios
Fund's First Full Quarter (06/30/98) to 3/31/16

  Upside Downside
From 1st Full Quarter 72 48
10-year 80 64
5-year 74 72

Upsdie Capture Ratio measures a manager's performance in up markets relative to the Fund's benchmark. It is calculated by measuring the Fund's performance in quarters when the benchmark goes up and dividing it by the benchmark's return in those quarters. 

Downside Capture Ratio measures a manager's performance in down markets relative to the Fund's benchmark. It is calculated by measuring the Fund's performance in quarters when the benchmark goes down and dividing it by the benchmark's return in those quarters. 

Important Performance, Expense, and Disclosure Information 

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell© is the trademark of Russell Investment Group. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. 

Royce Special Equity Fund
Average Annual Total Returns as of 3/31/16 (%)

  QTR YTD 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Special Equity 5.63 5.63 -9.60 3.67 5.76 6.57 N/A 8.59 05/01/98
Russell 2000 -1.52 -1.52 -9.76 6.84 7.20 5.26 7.68 6.15 N/A
Annual Operating Expenses: 1.15%

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 180 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.roycefunds.com. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses. 

All performance and risk information presented in this material reflects Investment Class results. Shares of RSE's Service and Consultant Classes bear an annual distribution expense that is not borne by the Investment Class. 

Royce Special Equity Fund invests primarily in small-cap and micro-cap stocks which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) As of 3/31/16, the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree.

The thoughts and opinions expressed in the video are solely those of the persons speaking as of April 12, 2016 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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