article , video 03-23-2017

4 Elements of Small-Cap Risk Management

Portfolio Manager Charlie Dreifus outlines the four cultural elements of risk he focuses on in his portfolios.

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One of the things that's distinctive about the way that you manage money, Charlie, is sort of multilayered approaches to risk management. One of the lesser known ways of managing risk is around this idea of cultural risk. How would you describe that, and why would that be important for an investor?

Charlie Dreifus: The entire approach of Special Equity is risk aversion. And there are many ways to mitigate, reduce risk.

The specific questions you asked about the culture, it's all intertwined. What we're trying to assess is this company working, in an honest, transparent fashion for us, the shareholders? And, having read proxy statements for approaching 50 years now, you get a sense of what is right and wrong.

Now things change, clearly. One of the things that my colleague, Steve McBoyle and I have spent a lot of time on was the issue about using, for example, non-GAAP earnings in incentive compensation, which will appear in a proxy statement.

That didn't appear 50 years ago. But it again, gets to the root of the issue, is management too greedy at our expense? Are they, do they want to get themselves in a position where heads they win, tails they win, and we, the shareholders, are the losers?

We don't want to invest in those companies, not only for that reason. We find that those companies are abusive in other ways beyond incentive compensation. They probably have other perks that would bother us. Their accounting probably is too aggressive for our likes. Their audit committee may be too unskilled.

Let's spend a little more time on the specifics, sort of cultural risk and this idea of evaluating integrity.

CD: The first line of defense shareholders have, and particularly with the legislation of Sarbanes-Oxley in the post-Enron crisis, the Audit Committee has a lot more power, but if the constituent members don't have the skill sets, they don't know what to ask, or they're too timid. That doesn't really work to our advantage.

So, what Steve and I look for constantly are the competency of the audit committee, you know, is there a CPA? Is there a CFO? Are there people who have been in the trenches and know where the skeletons can lie and know what the questions are they should be asking?

We love it when an audit committee is also the audit and ethics committee because they're also charge of the ethical playing field.

The other thing that we really would like to see more of and we frankly haven't seen enough of is the integration in terms of the compensation, particularly the incentive compensation. The Compensation Committee, which works separately from the Audit Committee, but the Audit Committee should have a presence or some guidance to the Compensation Committee regarding what is fair in incentive compensation.

What I've seen you say and what I've read previously, there are sort of four elements around this cultural risk or governance that you consistently come back to. There are the strength of the audit committee, the transparency of the accounting, the alignment of the incentive compensation, and the level of insider ownership.

CD: So, the thing that we really haven't discussed is level of insider ownership. What we often see is that the actual shares owned is totally immaterial by management. But they have a couple of percentage points of the company in optionable stock. So that in and of itself, actually raises a flag. First of all, they don't have skin in the game in terms of after-tax dollars.

If most of the stock is option stock, that's less of a positive, and further, it puts us on alert for potential accounting liberties to raise earnings so that the options become much more valuable and then they get cashed in. So, ownership, a stake in the game, skin in the game, is important.

How does this all come together then in the strategy?

CD: Well it gives you the confidence that these people are good partners. And not that they can't make mistakes, but the point is that we believe that their direction, their incentives, their thought processes are much like ours.

And we like that, on a very specific kind of basis, what it does, it allows you, gives you the confidence, when the stock sells off for whatever reason, the market's down, and people perceive something to be wrong in the industry or with the company, it gives you the ability to act opportunistically at a time when others are making the mistake of avoiding the stock.

It also allows for a longer runway. You know, the best kind of investment, frankly, is one that just keeps going up, never really reaches full valuation.

One of the things your strategy has been distinctive about is that down market performance, compared to both the market as well as other small-cap. This fourth element of governance or rooting out cultural risk seems really to be distinctive. Do you think that that's contributed to the down market performance?

CD: Obviously, there are times when it's much more relevant. We had an exceptional year in the small-cap fund in 2002, when Enron and the market was down considerably, and the fund was up considerably.

And that had to do with all the traditional ways we look at companies, but it had also to do with the cultural. The companies we invested in didn't abuse accounting.

And what happened in 2002, which also, I think, happens always although 2002 would be the Nth degree of it, would be this sorting out of good companies, companies where the valuation, absolute value clearly is very, very important in defending. Things that are inexpensive as businesses, unrelated to where the market is selling, I will argue go down less and can even rise when the market declines.

But it's the potpourri of all these other things, and the cultural, ethical accounting mixture is something that, again, people don't have the uncertainty. They don't have to be uncomfortable. Not to say that it will, it's infallible.

As a generalization, these companies will not surprise you in a negative way. The other thing is that oft times these companies are, by the nature of management, these people are also generally cautious and they're not aggressive business people.

There's not that much expectations around them, so there's nothing to disappoint. And if, further, there's credibility to the way they conduct themselves, and the financial statements, I do believe that is a help in those down markets. Yes?

Important Disclosure Information

Average Annual Total Returns as of 12/31/16 (%)

  QTR 1YR 3YR 5YR 10YR 20YR SINCE
INCEPT.
DATE
Special Equity 15.48 32.21 5.42 11.82 8.50 N/A 9.54 05/01/98
Russell 2000 8.83 21.31 6.74 14.46 7.07 8.25 7.08 N/A
Annual Operating Expenses: 1.15%

Important Performance and Expense Information

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund 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 30 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.

The thoughts and opinions expressed in the video are solely those of the persons speaking as of January 5, 2017 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.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell© is a 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.

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