A few weeks ago, GufuFocus invited readers to ask Chuck Royce their investing questions. Mr. Royce is the president and co-chief of The Royce Funds, whose Premier Fund (RYPRX, Financial) returned 26.5% last year, and a legendary small-cap investor.
His responses to reader questions are below:
GMO's Jeremy Grantham thinks that small cap stocks are more over valued than large cap stocks, and small cap stocks are going to return less than the large cap peers for the next 7-10 years. What is your view on this?
[Chuck Royce] GMO’s 7-year asset class return forecast has always been an interesting read. I am struck less by the forecast of small vs. large (which are now both negative) than by his idea that US high quality stocks will outperform over the next seven years. It has been our contention for some time that higher quality companies, regardless of market capitalization, would lead as the economy moves from recovery to expansion and our conviction has not wavered. Our view on quality-oriented small-cap companies remains very bullish. I suspect that each asset class will lead at different times.
Do you really think that small investors have an edge with small cap stocks?
[Chuck Royce] The small-cap asset class is highly inefficient and therefore investors of any size have return advantage potential. The sheer size of the universe, both here and abroad, lends itself to significant return potential. The higher level of volatility that characterizes the small-cap universe is also a benefit because it gives investors opportunities on both the buy and the sell side.
For investors who do not have the luxury of having five management teams coming to their offices daily, what would you recommend in terms of research? I am assuming the investor has studied the financial statements and read the annual/quarterly reports.
[Chuck Royce] Perhaps the best way to approach the process is from that of a business buyer – one should seek the answers to questions you would ask if you were buying the entire company. What type of financial and operating leverage does the business possess? How have the returns been in both good and not so good times, etc. It’s not so much a matter of predicting every little nuance of the business, but rather understanding its overall strategy and direction and the opportunities that they have. Many of these questions can be answered with a thorough reading of the annual report. Conversations with management do provide directional insight.
Walter Schloss was a successful investor. He too was quite diversified and invested in up to 100 companies. However, he purely relied on the numbers to find bargains. Since you go beyond the numbers into the qualitative and management side, why don’t you concentrate more to say 25-30 names? Is it because you need more diversification in the small- to mid-cap space?
[Chuck Royce] The question about concentration is always an interesting one, especially with small caps. Typically, investing in smaller companies means you are investing in one business; most of our companies are single-line businesses. This is not necessarily the case with many large-cap companies that actually have multiple businesses. A classic 20-30 stock large-cap portfolio may represent as many as 100 or more businesses. Our most focused portfolios are 70 stocks, which typically mean 70 individual businesses.
One must also remember that small-caps tend to be more fragile entities and therefore subject to “out-of-left field” occurrences that may have detrimental effects on their business. Because of this, we would argue that a higher level of diversification is appropriate.
Can you discuss your qualitative approach to analyzing a business and the industry it participates in?
[Chuck Royce] Our qualitative work centers on understanding business strategy, namely, discerning how returns are earned over various cycles and the levers that management has at their disposal in managing their business. We are less concerned about next quarter’s earnings; for us it’s about getting the direction right and understanding what competitive advantages the business possesses, and how they take shape over the ebb and flow of their respective cycle.
Your firm owns more than 1,400 stocks. What is your investment process like to analyze more than 1,400 stocks? What kind of stocks will pass your screen process?
[Chuck Royce] Yes we do own more than 1,400 companies, but this is across all firm portfolios and includes our domestic and non-US funds. While this may seem like a large number of holdings, our investment universe worldwide, according to FactSet, is more 20,000 companies. Remember, in order for a company to get into one of our portfolios, it has to meet certain criteria at the time of purchase. Interestingly, for every company we purchase, we establish both buy and sell triggers that are built around our estimate of the company’s worth. Frankly, the underlying valuation changes very little quarter to quarter, but the price triggers may be adjusted as we track the company’s progress.
How do you define high quality for small-cap companies?
[Chuck Royce] It starts with the balance sheet. We want companies with low leverage and the ability to survive difficult times for their industry or sector. We also want to a history of above-average returns on capital over time – our favorite metric is ROIC (return on invested capital) and we generally seek at least a 15% return on a pre-tax basis over the trailing five years.
How much do macroeconomic views play in your investment process?
[Chuck Royce] We spend very little if any time looking at the world from a macro point of view. It is really an afterthought. From our perspective, taking advantage of opportunities that the market is providing on any given day and building our portfolios from the bottom-up is perhaps more meaningful. That being said, our bottom-up work does lead us to certain investable themes over time.
Why do you invest heavily in industrials?
[Chuck Royce] Industrials have always been an area of interest, especially within the small-cap asset class. I have always been attracted to their free cash flow generation and quality. This is true for both companies inside and outside the United States. Of course, over the past several years an industrial renaissance has been underway in the United States, which should continue as the low wage arbitrage in China and other parts of the world begins to recede.
What kind of companies will work better for investors in an inflationary environment?
[Chuck Royce] Companies that have the ability to pass along cost increases. Typically these are companies with strong market niches or industry leadership positions.
What is your view on gold and silver?
[Chuck Royce] We have no formal thoughts on the price direction of gold and silver. To be sure, however, our focus on the precious metals and mining companies is nothing new. For some time, we have found unique opportunities in these limited resource industries, which have been under-invested for the last 20 years. Materials and industrial products companies are likely to benefit not only from our own efforts here in the US to rebuild infrastructure, but those in China and eventually in Europe as well.
It is important to remember that these are finite resource companies with compelling absolute valuations that do not need a rapidly growing economy to generate significant cash flow. I wish I could tell you that we own them as inflationary hedges, but we do not. We own them because we think they are fundamentally sound businesses with high return on invested capital. Interestingly, many of these companies have not participated to the degree that the underlying commodities have in terms of price appreciation.
What industry segments do you believe are expected to offer investors robust growth during the next five years from now and why?
[Chuck Royce] Over the next five years, we think many sectors and industries are in an interesting position. Some of our favorites are industrials, information technology, energy and asset managers (both domestic and international).
What is the average length of time that you like to hold a stock?
[Chuck Royce] As business buyers, we tend to hold companies for a longer period of time than average. Our investment horizon is three to five years, much more in line with what a business cycle would be.
Do you use any technical indicators to decide when to sell?
[Chuck Royce] Technical indicators are not a critical consideration for us. However, all of our positions have buy and sell triggers based upon our valuation methodology and we do look back historically at valuation patterns.
Thanks for answering questions from us. As a value investor who is bottom-up oriented and looking to pay $0.50 for $1 of value, how do you weight the macro situation and perspective? What is your macro opinion for the next 10 years in terms of inflation and market valuation? What would you recommend as important concepts in an investment strategy for the next 5-10 years?
[Chuck Royce] Our focus remains primarily centered on the company or the industry in which a company resides. We believe that quality will play an important role in determining returns as we move from recovery to expansion.
What did you do right during the market crash of 2008 so that your small-cap fund lost far less than the benchmark? What lessons did you learn? What would you do differently?
[Chuck Royce] Frankly, we did not do as well as I would have liked during the market dislocation of late 2008 and into 2009. Typically our stocks tend to hit bedrock before the rest of the market due to our quality focus. That did not happen as the deleveraging process put extreme pressure on many of our favorite positions. As investors looking for absolute returns, who think of risk as the permanent loss of capital, this was a difficult time. Yet it was also a period full of opportunities. As for lessons learned, we have a process and a philosophy that has stood us in good stead through many market cycles, and once again it kept us focused.
Mr. Royce is optimistic about the prospects for equities. He expects them to have annual returns in the upper single digits, especially for the decade cumulatively. Assuming we are talking about return on equity, I am curious how you select companies that can bring superior return during high inflationary environments? i.e., preference of pricing power?
[Chuck Royce] Part of our bullishness relates to the just-completed decade of zero returns for equities. Reversion to the mean is an important investment concept, and just as equities severely underperformed in the last decade, they are likely to outperform going forward.
If you have additional questions for Mr. Royce, post them in the comment section below. GuruFocus will be conducting a follow-up interview with him soon.
His responses to reader questions are below:
GMO's Jeremy Grantham thinks that small cap stocks are more over valued than large cap stocks, and small cap stocks are going to return less than the large cap peers for the next 7-10 years. What is your view on this?
[Chuck Royce] GMO’s 7-year asset class return forecast has always been an interesting read. I am struck less by the forecast of small vs. large (which are now both negative) than by his idea that US high quality stocks will outperform over the next seven years. It has been our contention for some time that higher quality companies, regardless of market capitalization, would lead as the economy moves from recovery to expansion and our conviction has not wavered. Our view on quality-oriented small-cap companies remains very bullish. I suspect that each asset class will lead at different times.
Do you really think that small investors have an edge with small cap stocks?
[Chuck Royce] The small-cap asset class is highly inefficient and therefore investors of any size have return advantage potential. The sheer size of the universe, both here and abroad, lends itself to significant return potential. The higher level of volatility that characterizes the small-cap universe is also a benefit because it gives investors opportunities on both the buy and the sell side.
For investors who do not have the luxury of having five management teams coming to their offices daily, what would you recommend in terms of research? I am assuming the investor has studied the financial statements and read the annual/quarterly reports.
[Chuck Royce] Perhaps the best way to approach the process is from that of a business buyer – one should seek the answers to questions you would ask if you were buying the entire company. What type of financial and operating leverage does the business possess? How have the returns been in both good and not so good times, etc. It’s not so much a matter of predicting every little nuance of the business, but rather understanding its overall strategy and direction and the opportunities that they have. Many of these questions can be answered with a thorough reading of the annual report. Conversations with management do provide directional insight.
Walter Schloss was a successful investor. He too was quite diversified and invested in up to 100 companies. However, he purely relied on the numbers to find bargains. Since you go beyond the numbers into the qualitative and management side, why don’t you concentrate more to say 25-30 names? Is it because you need more diversification in the small- to mid-cap space?
[Chuck Royce] The question about concentration is always an interesting one, especially with small caps. Typically, investing in smaller companies means you are investing in one business; most of our companies are single-line businesses. This is not necessarily the case with many large-cap companies that actually have multiple businesses. A classic 20-30 stock large-cap portfolio may represent as many as 100 or more businesses. Our most focused portfolios are 70 stocks, which typically mean 70 individual businesses.
One must also remember that small-caps tend to be more fragile entities and therefore subject to “out-of-left field” occurrences that may have detrimental effects on their business. Because of this, we would argue that a higher level of diversification is appropriate.
Can you discuss your qualitative approach to analyzing a business and the industry it participates in?
[Chuck Royce] Our qualitative work centers on understanding business strategy, namely, discerning how returns are earned over various cycles and the levers that management has at their disposal in managing their business. We are less concerned about next quarter’s earnings; for us it’s about getting the direction right and understanding what competitive advantages the business possesses, and how they take shape over the ebb and flow of their respective cycle.
Your firm owns more than 1,400 stocks. What is your investment process like to analyze more than 1,400 stocks? What kind of stocks will pass your screen process?
[Chuck Royce] Yes we do own more than 1,400 companies, but this is across all firm portfolios and includes our domestic and non-US funds. While this may seem like a large number of holdings, our investment universe worldwide, according to FactSet, is more 20,000 companies. Remember, in order for a company to get into one of our portfolios, it has to meet certain criteria at the time of purchase. Interestingly, for every company we purchase, we establish both buy and sell triggers that are built around our estimate of the company’s worth. Frankly, the underlying valuation changes very little quarter to quarter, but the price triggers may be adjusted as we track the company’s progress.
How do you define high quality for small-cap companies?
[Chuck Royce] It starts with the balance sheet. We want companies with low leverage and the ability to survive difficult times for their industry or sector. We also want to a history of above-average returns on capital over time – our favorite metric is ROIC (return on invested capital) and we generally seek at least a 15% return on a pre-tax basis over the trailing five years.
How much do macroeconomic views play in your investment process?
[Chuck Royce] We spend very little if any time looking at the world from a macro point of view. It is really an afterthought. From our perspective, taking advantage of opportunities that the market is providing on any given day and building our portfolios from the bottom-up is perhaps more meaningful. That being said, our bottom-up work does lead us to certain investable themes over time.
Why do you invest heavily in industrials?
[Chuck Royce] Industrials have always been an area of interest, especially within the small-cap asset class. I have always been attracted to their free cash flow generation and quality. This is true for both companies inside and outside the United States. Of course, over the past several years an industrial renaissance has been underway in the United States, which should continue as the low wage arbitrage in China and other parts of the world begins to recede.
What kind of companies will work better for investors in an inflationary environment?
[Chuck Royce] Companies that have the ability to pass along cost increases. Typically these are companies with strong market niches or industry leadership positions.
What is your view on gold and silver?
[Chuck Royce] We have no formal thoughts on the price direction of gold and silver. To be sure, however, our focus on the precious metals and mining companies is nothing new. For some time, we have found unique opportunities in these limited resource industries, which have been under-invested for the last 20 years. Materials and industrial products companies are likely to benefit not only from our own efforts here in the US to rebuild infrastructure, but those in China and eventually in Europe as well.
It is important to remember that these are finite resource companies with compelling absolute valuations that do not need a rapidly growing economy to generate significant cash flow. I wish I could tell you that we own them as inflationary hedges, but we do not. We own them because we think they are fundamentally sound businesses with high return on invested capital. Interestingly, many of these companies have not participated to the degree that the underlying commodities have in terms of price appreciation.
What industry segments do you believe are expected to offer investors robust growth during the next five years from now and why?
[Chuck Royce] Over the next five years, we think many sectors and industries are in an interesting position. Some of our favorites are industrials, information technology, energy and asset managers (both domestic and international).
What is the average length of time that you like to hold a stock?
[Chuck Royce] As business buyers, we tend to hold companies for a longer period of time than average. Our investment horizon is three to five years, much more in line with what a business cycle would be.
Do you use any technical indicators to decide when to sell?
[Chuck Royce] Technical indicators are not a critical consideration for us. However, all of our positions have buy and sell triggers based upon our valuation methodology and we do look back historically at valuation patterns.
Thanks for answering questions from us. As a value investor who is bottom-up oriented and looking to pay $0.50 for $1 of value, how do you weight the macro situation and perspective? What is your macro opinion for the next 10 years in terms of inflation and market valuation? What would you recommend as important concepts in an investment strategy for the next 5-10 years?
[Chuck Royce] Our focus remains primarily centered on the company or the industry in which a company resides. We believe that quality will play an important role in determining returns as we move from recovery to expansion.
What did you do right during the market crash of 2008 so that your small-cap fund lost far less than the benchmark? What lessons did you learn? What would you do differently?
[Chuck Royce] Frankly, we did not do as well as I would have liked during the market dislocation of late 2008 and into 2009. Typically our stocks tend to hit bedrock before the rest of the market due to our quality focus. That did not happen as the deleveraging process put extreme pressure on many of our favorite positions. As investors looking for absolute returns, who think of risk as the permanent loss of capital, this was a difficult time. Yet it was also a period full of opportunities. As for lessons learned, we have a process and a philosophy that has stood us in good stead through many market cycles, and once again it kept us focused.
Mr. Royce is optimistic about the prospects for equities. He expects them to have annual returns in the upper single digits, especially for the decade cumulatively. Assuming we are talking about return on equity, I am curious how you select companies that can bring superior return during high inflationary environments? i.e., preference of pricing power?
[Chuck Royce] Part of our bullishness relates to the just-completed decade of zero returns for equities. Reversion to the mean is an important investment concept, and just as equities severely underperformed in the last decade, they are likely to outperform going forward.
If you have additional questions for Mr. Royce, post them in the comment section below. GuruFocus will be conducting a follow-up interview with him soon.
