Chuck Royce on Small Caps

The Royce Funds is a family of mutual funds that focus primarily on small-cap investing. Charles M. Royce is the President and Co-Chief Investment Officer of the Royce Funds and Royce & Associates.

In May 2012, Chuck Royce was interviewed by Steve Forbes on his show, Intelligent Investing. During the interview, Chuck Royce shares his investment philosophy and explains why he favours small-cap and micro-cap stocks. What follows is the transcript of that interview. Some adjustments have been made to improve the reading experience.


Steve Forbes: Chuck, good to have you back again. When we [last] talked the world looked like it was coming to an end in 2008. I’d like to just quickly hit on your philosophy. You go for micro-cap and small cap. Could you quickly define those and then get to the metrics of what you look for in these things?

Chuck Royce: Sure, we are small-cap investors. Under two and a half billion. Micro under 750. Those are arbitrary numbers but we sort of had that definition for small-cap for some time.

Steve Forbes: Why that part of the universe?

Chuck Royce: It is the most exciting most interesting area of the stock market world. It is broad. It is deep. There are five thousand, seven thousand domestic companies. Twenty, thirty thousand foreign country companies in that cap range. So, there’s always something to do. We cannot look at all the companies and we’re a pretty big player in this universe.

Steve Forbes: So, even though, thanks to technology, you can follow more things than ever before and people have more tools to comb for bargains, you feel there’s just so much out there, that it’s like the California Gold Rush?

Chuck Royce: It is an evergreen universe. There are always companies that are dropping down. Let’s say they get into trouble. They get smaller. There are new IPOs. Even in a bad year, there are a couple hundred IPOs. In a good year, there are five or six hundred. There are spin-offs. So, there is a constant new opportunity set.

Steve Forbes: And in terms of metrics? What do you specifically look for in small companies?

Chuck Royce: We’re looking for that unusual combination of sustainable, high returns on assets. We want to own the company for a long time, ideally forever. You know, a very long time. Certainly three to five years. So, we’re looking for very low turnover. That’s the only way you can do it in this world.

Steve Forbes: You obviously look at things like dividend? Returns on investment?

Chuck Royce: Absolutely. Believe it or not, in the small-cap world, there are lots and lots of dividend-paying companies.

Steve Forbes: So the metrics that are good for big caps are perfectly good for this part of the universe?

Chuck Royce: Absolutely. Most people don’t think they’re there in the small-cap world. Most people associate small caps with very high risk. Or with brand new companies, or losing companies and that’s just not true.

Steve Forbes: You mentioned you like to hold these things. Does that mean the company has to be around for a while or can it be a new one that you think as prospects of longevity?

Chuck Royce: Well, we occasionally look at IPOs. But we would look at IPOs a year later. The history of IPOs is that often they are fully priced and often you get another opportunity later. So, we set up a screening device to monitor IPOs but we think of them about six months or a year or two years later.

Steve Forbes: And in terms of management? What do you look for in management there? You go beyond numbers?

Chuck Royce: We go beyond numbers, of course. We’re looking to understand the strategy. You know the strategy, often these are thin-at-the-top management teams, so we have to believe in the leader. We have to believe in the culture. We want to test our assumptions, though in the marketplace. We want to talk to customers. We want to talk to competitors. You probably get a better pulse by talking to customers than you do talking to the company.

Steve Forbes: In terms of culture, what do you look for? You make a point that you have a certain culture in your company. To find that, what do you look for in companies that you think: this is a little different than just your run-of-the-mill?

Chuck Royce: Well, we’re looking for those abstract things that are very difficult to find; integrity, quality. You know, leadership principles, good governance, good capital allocation. We want to understand their strategy. We don’t want it to be an acquisition strategy, totally. We want a very clear vision and we want the troops to understand that also.

Steve Forbes: So, what have you learned from running a company that you felt you were able to apply, looking at others?

Chuck Royce: That’s a good question. I’m not sure other companies should follow, exactly. We are in that wonderful business of managing people who are very intelligent, have very distinct ideas of what they want to buy. So, my job is to keep that culture both organizationally active with each other and yet to have the individual talents work well.

Steve Forbes: How has that enabled you, even though businesses are different that you look at, that you can say: I’ve seen this movie before?

Chuck Royce: Well, that’s a good point. We see so many companies, that we really do get a sense of, you know, is this leader just talking nonsense? We can read those two tea leaves. We make mistakes, of course, but we do think we understand business models. And we have seen many business models and there are business models we don’t want to invest in.

Steve Forbes: In terms of your own company, most of it is open-end mutual funds?

Chuck Royce: Yes. We have three closed-end funds – a little bit over a billion dollars – but primarily we are an open-end fund firm.

Steve Forbes: Now before discussing the market today, one of the things you and others observed, is that emotions are investors’ enemies. They get in when giddy and they get out when they think the world is about to implode or explode. And they get whipsawed. So, the market may have nine percent – I’m just picking a number – annual return over time. They get about five because they go in and go out the wrong way.

Chuck Royce: Absolutely true. That is the truth that our investors don’t necessarily get our returns. They may have bought high, sold blow. That phenomenon you just described is a very real one.

Steve Forbes: And how have you done with redemptions since the last few years?

Chuck Royce: We’re having redemptions. It started about a year ago. In the summer, last year we had 20%…

Steve Forbes: A sense of the debt crisis and people just saying that this volatility is too much?

Chuck Royce: I think that is running across the board now. It’s true in all equities, they are being redeemed; bond funds are still being purchased, hard to believe. But people believe that bonds are the answer here. But equities are being redeemed across the board.

Steve Forbes: And I know what you’re going to say but we’ll get it on the record. You’re not buying bonds?

Chuck Royce: No, we’re not buying bonds. But I definitely think we have a better period ahead.

Steve Forbes: Which gets to you being a fan of equities these days. What do you see in equities?

Chuck Royce: Well, if I could be so bold to put up a headline. This was in USA Today. It says “Invest in stocks? Forget about it.” That’s their lead headline. Lead article and it was a wonderful description of what’s going on today in the in the in the retail investor. They’re giving up. They are purging themselves of equities. They are giving up and they’ve had 12 years of almost zero returns. They’ve had five years of zero returns. This is the complete opposite of the 12 years that ended in 2000. From 1988 to 2000. Complete opposite, where returns were high, optimism was high. We have the reverse in effect now and I think this phase is coming to an end also.

Steve Forbes: Describe why. Because if you look at the 60s, you could say the market peaked in 1966, 1968. But it took 14-16 years – the early 80s – before the thing finally, really took off.

Chuck Royce: Well, you’re right, you’re right. It took until the interest rates got to wherever they got. 20%? And Reagan got in. Well, I’m not sure exactly what the tipping point will be. I’m not sure I could point to the exact tipping point in 1981 either. I know it happened in August because I remember it when it happened. But I do think this is a long enough period. 12 years is a long time for essentially zero returns. I very much believe in reversion to the mean as a very powerful fact. You never at the time know what’s going to change things. My guess is that people are going to lose money in bonds. And that that’s going to change the psychology on bond funds. You lose 5%, you could lose 5% like that. Lose 10%, you’re going to really be regretting it. That could happen this year or next year.

Steve Forbes: What do you see in stocks now that you like?

Chuck Royce: Well, in the small-cap world, there are many myths and many opportunities. There’s a big myth that you can’t find high-quality. That small stocks are all filled with, sort of, junky companies. That’s just not true. Many of our funds that focus on the very high-quality end of the small-cap world. There’s plenty to choose from, both here and around the world.

Steve Forbes: And they pay dividends?

Chuck Royce: And they pay dividends. Absolutely. They are dividend paying, small stocks. Significant numbers.

Steve Forbes: What of your funds pay dividends? Just to get investors’ attention.

Chuck Royce: Well, one of them is called The Total Return. One of them is called Dividend Value, Royce Dividend Value. They’re both doing fine in this sort of rocky time. But I believe that there’s another myth out there, that small companies aren’t global. About half of the universe of small caps, domestically are global companies. We have many companies with fifty percent or more of their revenues – these are domestic companies – but fifty percent with a global reach. The world is global and small caps are certainly leading that.

Steve Forbes: When you look at sectors today, you obviously focus, as you say, on small caps. Are all sectors in the doghouse now? Why do you think small might be better than big or medium?

Chuck Royce: Well, the small is not, I would say, better but I think it is equal to any market condition. And the way we do small is that we are very risk-averse.

Steve Forbes: There is a seeming contradiction; small and risk-averse?

Chuck Royce: Well, we want to climb up the same mountain without falling down. Risk to me – a value investor – basically is a risk manager. These companies are smaller by definition. They are more volatile. So, you have to sort of apply more risk aversion techniques to the process. We do that through only buying strong balance sheets, being very price conscious about how we buy things. So, we like to think that most of the time we reduce volatility and still achieve the higher returns that are possible.

Steve Forbes: Now when people think of small cap, they think: must be more volatile. But you believe you can pick ones that the volatility is no worse than…

Chuck Royce: I absolutely believe that. And that is, sort of, our record.

Steve Forbes: In terms of the cold hand, you might call it. Everyone went through a hit 2008-2011. And getting back to emotions, isn’t that precisely the time one should start wading in?

Chuck Royce: Sure, if we apply our game correctly, we should add risk when other people are running. We should be adding risk, actually. We did add risk and we went to being fully invested in that 2008-09 period. We had a very pleasant rest of 2009 and a decent 2010 and 2011. Our five-year numbers are, they are okay. They are not earth-shattering but they are above zero.

Steve Forbes: And what case would you make vis-a-vis index funds?

Chuck Royce: Well, I just think we can do better. In the small-cap world, I absolutely, totally believe that active management can achieve positive alpha almost all the time. Certainly in three and five-year batches. That is our record. Our funds have +90% positive returns over the index for all periods going back 15-20 years.

Steve Forbes: Have you been in contact with Burton Malkiel, who sort of invented index funds? He says that’s not possible.

Chuck Royce: Well, in small-cap it´s possible. He could be right in large-caps. I think there´s just inherently a better opportunity set in small cap. I can always find something exciting to do.

Steve Forbes: Now, any sectors particularly excite you these days in the small-cap world?

Chuck Royce: Well, we’re finding there is an industrial resurgence back in this country. We’ve let the dollar go down for a long time. That’s had a beneficial effect. Our companies in the industrial sector tend to be very smart, have proprietary niche products. They are growing.

Steve Forbes: Could you give a couple of quick examples?

Chuck Royce: Sure. Lincoln Electric, they make welding equipment. They’re a global company. They’re located in Erie, Pennsylvania and they’re just booming. There is a wide demand for their product. They’ve expanded overseas but they’re booming domestically.

Steve Forbes: You started a fund in financial services. You, who are fearful of banks.

Chuck Royce: We have very few banks. I’m not a bank believer and, you know, today’s headline is an unfortunate example of why I’m not a bank believer. JP Morgan. That’s a real head-shaker. That financial services fund, which is a very small fund – 20 million of assets – is one of my favourite activities. Because I’m buying many financial services companies that are not banks: money managers, insurance brokers. All interesting providers of information; FactSet, etc. There is tremendous activity in the financial services world outside of banks.

Steve Forbes: So, our banks, in your mind, are sort of like airlines? Companies that service the airlines make money but not the airlines themselves?

Chuck Royce: Well, that’s a good analogy. We have just avoided banks. I’m not going to be able to twist that balance sheet open and we often find the management can’t do it either. It’s not an area that we do. That’s a big part of the Small Cap index, so that creates its own issues. But it doesn’t bother us. We’re trying to gain absolute returns not necessarily beat the index.

Steve Forbes: Now, in your financial services fund, what companies do you like? You mentioned mutual funds?

Chuck Royce: Sure, we have several money managers; AMG, Invesco, Ashmore, which is a London-based emerging markets fund. We like some of the public investment managers. We like insurance brokers. We have many of those. A wonderful way to play the very cyclical insurance industry.

Steve Forbes: What brokers do you like?

Chuck Royce: Brown & Brown, Gallagher. So, we like these service/non-asset-type financial services companies.

Steve Forbes: You’ve been doing something outside of the fund. That is real estate. What’s happening there?

Steve Forbes: Is this the time to go into real estate when everyone else is…

Chuck Royce: I live in a summer community in Watch Hill, Rhode Island. There was a wonderful little hotel there that a developer was going to tear down and that just broke my heart. So, I bought the site and rebuilt the hotel. Now I know what developers live through. I’m not likely to do it again but I’m pleased and it’s come out very, very well.

Steve Forbes: Something on being optimistic today when everyone else is pessimistic. Have you ever seen a time when company balance sheets – I’m talking about big companies, small companies – are, in aggregate, as strong as they are today?

Chuck Royce: It is extraordinary. Our portfolios have rock-solid balance sheets. They get better and better. They’re not necessarily hiring the way we would all like. But their balance sheets are in great shape. And their profit margins are at all-time highs. They are fearful but they understand what they have to do. They are ensuring their future and I’m thrilled with that.

Steve Forbes: And you think in terms of hiring, is that a result of the sheer uncertainty out there? So you fortify your balance sheet and just wait and see what unfolds?

Chuck Royce: There is that. I think there’s regulation. There is fear about many things. I think companies are beginning to do more M&A. That’s picking up. Although it’s been slow. I think that will continue. Smaller companies buy competitors. Large companies buy small companies. That’s definitely going on. Sometimes it’s cheaper to buy your neighbour than it is to build a plant.

Steve Forbes: The environment for small companies, is it still semi hospitable in this country or do you fear that in a few years it’s not going to be quite… the soil is not going to be quite as benefistic?

Chuck Royce: Well, we’re all thinking about tax rates. What’s going to happen? We’re all waiting for a sort of grand reform. I think it is a missing element – that is dramatically needed in this society – is a true fiscal reform. Certainly, taxes are a critical part of that.

Steve Forbes: Flat tax?

Chuck Royce: Flat tax? Wonderful idea!

Steve Forbes: Inflation. Are you worried about inflation when you look at what the Fed has done? Or do you think; it may happen but that is already market into the price?

Chuck Royce: Well, it’s a sort of yes/no thing. In the short term… You have to break inflation into so many component parts. There is inflation going on. It’s modest. I think the Fed is doing the right thing more or less. But the consequences, we’re all going to have to deal with. That’s why fiscal reform is so critical.

Steve Forbes: And having lived through 2008, which none of us had seen. You have to go back to the 30s or 1907 to see something like that. Any lessons to take from it or is this just this black swan on steroids and not likely to happen again?

Chuck Royce: Well, that’s a very good question. I think that the lessons there is: things can happen. I was very proud of how this country recovered quickly. Our financial system, our banking system is in much better shape than the European system. I think that’s going to hold us in good stead in the next half dozen years.

Steve Forbes: And you have a lot of funds. How in the world – when you think of small caps – you’ve sliced and diced it in many different ways. Can you quickly explain how that’s come about?

Chuck Royce: We did that over time. And we have sliced and diced it. Small cap is big. It is over a couple of trillion dollars in the small-cap world. So it’s a very large universe. It’s five to eight thousand companies. We have divided it into micro and small and mid. Yes, we’ve done that. We’ve divided it into some concentrated products and some dividend paying products. All to make our job easier and I think it benefits the clients also.

Steve Forbes: You put that headline in front of us. That person who is fearful, what’s the one fund you would say: put your toe in this one?

Chuck Royce: I think our Dividend Value Fund would be just right for almost anybody.

Steve Forbes: Chuck thanks you very much.

Chuck Royce: You’re welcome Steve. Great talking with you.