DREIFUS UPDATE TRANSCRIPT

On this week’s Consuelo Mack WealthTrack: a Great Investor who has made his name investing in small company stocks explains why he now favors large companies. Charlie Dreifus, the portfolio manager of the Royce Special Equity funds discusses where he is finding the greatest values in the market now.

CONSUELO MACK: This week on WealthTrack, they say the best things come in small packages but Great Investor Charlie Dreifus says the time to think big is now. The noted the small company stock manager explains why he has closed his small cap fund to new investors and has opened to large caps in his Royce Special Equity Multi-Cap Fund. A rare interview with Charlie Dreifus is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. They say the best things come in small packages and that has certainly been the case in the stock market in recent years. Looking over the last decade for instance, small company stocks have outperformed large company ones by a significant margin delivering 10.4 % annualized returns versus 7.1% annualized returns for large cap ones. Last year the performance gap was also huge. The Russell 2000 Index, considered the benchmark for small stocks advanced 38.8% whereas the widely followed S&P 500 lagged with a 32.4% return. And not only that, by several measures of value including price/earnings multiples, small stocks look expensive. Five years from the market’s 2009 bottom and clearly in a bull market where are the best stock bargains to be found? That is a question value investors ask themselves every day. However few portfolio managers are interested or able to stray from their area of focus or expertise.

This week’s guest is an exception in both desire and ability. Three years ago he made a decision to expand his long-time concentration in small company stocks to include large ones as well. He is Great Investor Charlie Dreifus who for the last 16 years has made his name managing the Royce Special Equity Fund, which is a value oriented small and micro-cap fund that has beaten its benchmark the Russell 2000 index since inception with less than market volatility. In 2010 Dreifus launched another value oriented fund, but this one was not in small caps and never will be. It is the Royce Special Equity Multi-Cap Fund and it is emphasizing large cap stocks right now. It has also beaten its benchmark, the Russell 1000 since its inception three years ago.

Why did Dreifus want to go big and how did he convince his boss, legendary small cap pioneer and fund manager Chuck Royce to let him do it? Dreifus says although he was managing small he always kept an eye on the big boys.

CHARLIE DREIFUS: Large caps did extremely well from 1982, August of 1982 into March of 2000, and I think the S&P numbers roughly about 18% compounded over that period of time for 18 years, and for 100 years including that time period it’s roughly nine percent, so way over achieved. So it was sort of regression to the mean. Even if the financial crisis hadn’t happened, the likelihood that those stocks were to underperform, and so you had the confluence of an asset class that was overvalued coming into the decade with some concerns, and particularly one of the concerns to this very day in these large stocks is their international exposure and specifically their emerging market exposure. It used to be thought of as a positive. These days it’s thought of as a negative. So the valuations were attractive. I did some of my metrics to just sort of test and see. Is my perception substantiated by the figures? Ultimately everything rests on the numbers. Okay?

CONSUELO MACK: For you.

CHARLIE DREIFUS: For me.

CONSUELO MACK: Yes

CHARLIE DREIFUS: Right, so I went to Chuck and asked him what his thoughts were about us launching a large cap fund.

CONSUELO MACK: I can imagine the reaction you got.

CHARLIE DREIFUS: Yeah, it wasn’t positive, although he didn’t rule it out entirely. He said, “Let’s think about it.” So I thought about it a couple of days, and I went back to him, and I said, “Well, how about this? If you have no problems and I go to Compliance and they have no problem, would it be okay with you if I started buying some of these and did some real research for my own account?” and he said, “Absolutely. Fine. Go do it.” And it turned out I found names and I started making money.

CONSUELO MACK: For your personal account.

CHARLIE DREIFUS: For my personal account.

CONSUELO MACK: Right, in large caps.

CHARLIE DREIFUS: With the blessing of the firm in large cap, and so I went back to Chuck, and I showed him the results, and I said, “You know, the values are still there”, this is 2009 and early 2010. We launched the fund December 31, 2010, ultimately.

CONSUELO MACK: Right. This is the Royce Special Equity Multi-Cap Fund.

CHARLIE DREIFUS: Which just celebrated its third anniversary, therefore.

CONSUELO MACK: And it’s beaten the market. It’s gotten great returns three years. Congratulations.

CHARLIE DREIFUS: Thank you, thank you. So yeah, three years is a short period of time, but we’re encouraged by what we’ve seen. So I kept on working with Chuck, and he kept on saying, correctly so, “Remember, we’re a small cap shop,” largely, and so we finally came up with a name for it which is multi-cap. It’s not all cap. Multi-cap, the distinction there is basically the lowest market cap area generally will be $5 billion, so things below five billion will most often be excluded from the multi-cap portfolio, but it has no upper cap. So it’s a matter of public record, there are names in the portfolio such as Microsoft and Intel with …

CONSUELO MACK: Very large cap.

CHARLIE DREIFUS: Very large caps, and there are some in the portfolio with five to fifteen billion dollar market caps. The average weighted one is in the 40 to 50 billion dollar which is still by most measures large cap.

CONSUELO MACK: But why? It was a valuation.

CHARLIE DREIFUS: It was a valuation.

CONSUELO MACK: You decided you’re a small cap manager, has been for 15 years, and you’ve decided looking at the valuations that small caps had done well and large caps had lagged, so that was… it was a macro call then, right?

CHARLIE DREIFUS: It was, but I also always… I take my responsibility as everyone at Royce does, and I’d like to believe most in our industry do. I’m a fiduciary to my clients, and whether it hurts my wallet or not, I have a duty to give them my best advice, and if that means suggesting that a different asset class is better, or if that means reducing our fees, or that means shutting the product down, we have to do it. I should also mention we just, on that basis, we now have about $185 million in the multi-cap product, and I went to the board and asked them to reduce the fees. We reduced it from 100 basis-point management fee to 85 basis-points management fee recently.

CONSUELO MACK: Right

CHARLIE DREIFUS: As of January 1st actually.

CONSUELO MACK: Thank you. I mean, I appreciate that as an investor, and I might add along those same lines that the Royce Special Equity Fund which is your small blend fund, you closed it to investors in 2012.

CHARLIE DREIFUS: Two years ago.

CONSUELO MACK: And the reason was?

CHARLIE DREIFUS: The capacity issue. I just couldn’t find… I mean, we could take in more money, but it wouldn’t serve the clients good. It would help Royce and Charlie Dreifus, but in the long run it wouldn’t really help Royce and Charlie Dreifus because we would tarnish our reputation for being good stewards. It’s the second time I actually closed my Special Equity Small Cap Fund, and it’s the confluence of monies coming in, selling securities and the process that I use for multi-cap is the same process that I use for small cap, and part of that is quantitative, and part of it is qualitative. The quantitative, the first and foremost is valuation. Rate of return is a function of entry level, and the math is the math, and the market in general, not only small stocks, large stocks also, it’s elevated. There’s no arguing about that. Okay? The point is, can it go higher, and I believe it can. Perhaps we’ll have time to explore that.

CONSUELO MACK: Well, so let’s talk about that. Let’s talk about your outlook for the market, which you turned really bullish when?

CHARLIE DREIFUS: About a year ago.

CONSUELO MACK: So when? In January of 2013?

CHARLIE DREIFUS: January. Correct.

CONSUELO MACK: And why are you really bullish about the stock market, and large caps in particular?

CHARLIE DREIFUS: Well, I was doing a marketing trip, and I was speaking as I am with you, and as I’m doing the marketing trip, I get more and more bullish, and at the last meeting I sort of yell out, “This is a melt-up. I’ve seen this movie before,” and fortunately, because I’m known traditionally as being ultra conservative. I think I shared with you. Chuck once gave me a portrait of myself wearing belts and suspenders. I’m a cautious individual.

CONSUELO MACK: Prove it. Right.

CHARLIE DREIFUS: So there are several factors at work. Number one, relative to the world, we’re just in a great place.

CONSUELO MACK: The U.S. is?

CHARLIE DREIFUS: The U.S. is. We have natural population growth. We have an abundance of everything, increasingly so. I mean, we all know about the energy renaissance and how we’re going to be exporting petroleum and probably the largest energy producer in the world. The manufacturing renaissance, the fact that we’re re-shoring, companies coming back but, more importantly, case after case of foreign companies coming here. BASF, the old German chemical company, 150 years old, is moving chemical plants to the United States because the cost of natural gas is a third of what it is in Europe, plus the regulations are so much easier. The other thing is we’re a consumer economy, so having said all of this, our exports run 15 percent of our economy. We’re not Germany. We’re not Japan. Yes, it’s good to do exports, but if for some reason we couldn’t, it wouldn’t hurt us, and half of those exports actually are agricultural, so they’re probably not at risk.

CONSUELO MACK: And there’s another aspect of this which you had talked to me about that you have a theory that companies’ profitability as the economy improves, that their profitability can really accelerate. So what is that theory, which is a really long-term trend as far as you’re concerned, could be?

CHARLIE DREIFUS: Yeah, I’ve noticed of late that many companies, particularly in the industrial sphere and sectors, are showing on flat or down revenues higher operating margins, percentage of earnings. And now there can be the accountant in me is cynical enough to say yes, well, we all know companies have not spent enough on capital expenditures, so deprecation which would be included in those costs are down, so they’re benefiting from that, or because we’re having sort of low inflation which is also a cause for bullishness, incidentally, that low inflation is aiding companies in the sense that they expected raw materials to cost more than they have, and so they’re getting a pricing benefit. They’ve priced for a higher cost, and they’re not having to expend for higher costs, but when I dig deeper and what some people describe as unique to me and probably unique, therefore, in my multi-cap space because I don’t bring much else unique to my multi-cap space, is my deep diver intuitive.

CONSUELO MACK: Right. Your deep dive accounting, your accounting cynicism, but the deep dive into the numbers.

CHARLIE DREIFUS: The numbers, correct, and the deep dive in the numbers, and this goes across asset classes. This occurs in small caps and large caps these days, but on the point we’re talking about, this incremental margins is a sign, if it’s not due to those two factors that I have mentioned, it’s a sign that the cost structure had changed, that the break-evens have been lowered so that once we do start getting higher revenue, and the economy seems to be on traction, people, as we’re speaking now, everyone’s in the process of arising their fourth quarter real GDP. It’s come up from…

CONSUELO MACK: Right. It’s going up.

CHARLIE DREIFUS: It’s going up. It’s come from like two percent to three percent of late. Well, you add one percent or two percent for inflation. You’re starting to get some real nominal GDP. Once GDP goes above five percent nominally …

CONSUELO MACK: Nominal. Right. That’s including inflation.

CHARLIE DREIFUS: Inflation. Then companies will probably have decent revenue growth, and a good portion of that will fall down to earnings per share, profits, and what the market may be saying to us, yes people, the market is elevated on current numbers, but looking out a couple of years, I don’t know. Is it two years? It’s not … I doubt it’s in 2014. Okay? And therefore, frankly, I’m not willing to pay for it. You know, the numbers are the numbers. I buy on reported earnings or lower future earnings. I don’t prepay in either of my funds for future earnings.

CONSUELO MACK: No, I think you said that you want to pay zero for expectations.

CHARLIE DREIFUS: Correct. I want to crunch out expectations from my stocks, because that’s a way I’m trying to make my clients absolute money, and the way to do that is to buy absolute value.

CONSUELO MACK: Give us some examples of where you’re finding absolute value in the large cap space.

CHARLIE DREIFUS: Okay. It often is in areas that are unpopular, and that’s true. I work in the area of anomalies in efficiencies, and the first way to assess if a stock or a whole sector is out of fashion is to run a screen. I use and at Royce we generally use a valuation metric which is a cap rate, the return the buyer would get if they bought the whole company, and I compare that to what I think my cost of capital would be, again, as a private equity or a strategic buyer would. There has to be a spread. There has to be … I have to earn more than it’s costing me. So these days retailing, which there’s a lot of controversy about, and retailing has been controversial now for a couple of years, but I keep on reminding people there is something unique in American DNA. We’re shoppers. Okay? And we’re a consumption economy.

CONSUELO MACK: So a company, for instance, that exemplifies the Royce and the Dreifus approach, a retailer would be what company that you own?

CHARLIE DREIFUS: Well, in the large cap space it would be Nordstrom.

CONSUELO MACK: Nordstrom.

CHARLIE DREIFUS: Nordstrom I think is misunderstood or not fully appreciated. Most people know of them for the service they provide in their stores and fashion. It’s not a full department store. You don’t buy refrigerators at Nordstrom, but they have somewhat of a niche somewhat on the higher end level, of course, but what people have not given them credit for is, first of all, their earnings have been under some pressure because they have developed a very robust, multi-channel approach to retailing. They have this off-price division called The Rack. They have a lot of boutique kind of acquisitions they’ve made which got them into more product but, more importantly, got them expertise in communicating with their customers, and they’ve said publicly that, you know, they’re somewhat concerned 50 years out whether people will be going to malls.

CONSUELO MACK: Right

CHARLIE DREIFUS: And so they’re on the cutting edge of all of this, and that’s costly.

CONSUELO MACK: And cutting edge of online shopping as well that they’re developing.

CHARLIE DREIFUS: Right, right, right, and the fact that you can buy it online, return it at the store, you know, just making it a seamless transaction, taking all of the negatives out of online shopping.

CONSUELO MACK: You’re finding things in a Nordstrom, for instance, that you think your competitors are missing, and so the deep dive accounting shows you what?

CHARLIE DREIFUS: What I found, among other things, in Nordstrom was the fact that unique these days wasn’t in the past, but unique these days is that Nordstrom with total assets of eight, nine billion dollars, has over $2 billion of credit card receivables that they own. In other words, if you have a charge account at Nordstrom, Nordstrom is carrying that and has to finance that, but it’s a matter again of loyalty, closeness to the customer. You could go out if you wanted to and sell that portfolio. Obviously, you would get above par. You would get above the stated value, because this is a very high- quality portfolio that people would want, and they would get a serving fee. They would get a residual, so to speak, off of those credit card receivables even if they didn’t own them, if they sold them to a third party.

CONSUELO MACK: That’s something that you’ve seen.

CHARLIE DREIFUS: That’s something that I have never seen people really mention. The other thing that people don’t mention is that Nordstrom, which some retailers do also … they’re not totally unique on this … they own 22%, 22% of their stores are on company-owned land and stores.

CONSUELO MACK: So you’ve got the real estate value as well.

CHARLIE DREIFUS: Real estate. Well now, there’s another significant portion where they own the store but not the land. They may have options to buy the land, but 22% of the portfolio is all theirs. There’s a value. There’s a comfort level. There’s a financial anchor as I describe it that I don’t think people really look at, and my experience is when you buy companies that have this absence of expectations … no one’s hyping it. Quite the contrary; no one cares. Okay? That’s where the opportunity strikes, not always and not in every case, but in a portfolio it seems to work out.

CONSUELO MACK: Charlie, one of the things that we haven’t talked about, and that is how important dividends are in your process.

CHARLIE DREIFUS: Well, dividends are important. They’ve always been important. I actually did an academic paper many years ago, because if any asset that throws off more income, everything else being equal, is more valuable, and so what I have focused on in recent years are companies that have a tendency and ability … that’s the most important thing, the cash flow, the cash conversion cycle is such that they can raise their dividends with no fear of having to reduce them subsequently, and the companies that do this over long periods of time are called dividend aristocrats. That’s generally a term that’s used for companies that do it more than 25 years or so, and what I believe, and it’s interesting, these don’t provide high yield. Most times it’s an adequate yield, but it’s not a high yield.

CONSUELO MACK: So it’s a growing dividend stream is what you’re looking for.

CHARLIE DREIFUS: it’s a growing dividend stream

CONSUELO MACK: Right. And that’s going to lead me to the next question which is the One Investment for long-term diversified portfolio. So what is it that we should all own some of in our portfolios?

CHARLIE DREIFUS: Well, and I’m going to mention a concept and then two names, and I do personally own both of these two names, although I’m looking for more venues, more product that offers this kind of yield that I’m going to talk about. The two, these are dividend growth ETFs, and the two that I would like to highlight but I encourage your viewers to do their own research and find some more … there are a lot of them … are the SPDR S&P …

CONSUELO MACK: Dividend ETF. Right.

CHARLIE DREIFUS: Dividend ETF. The symbol is SDY, and the other is the Vanguard Dividend Appreciation.

CONSUELO MACK: Dividend Appreciation.

CHARLIE DREIFUS: VIG, and both of them, you know, have decent yields. They’re constructed around that index so there’s little, if any, active management, but they have a history of owning the companies. There are, as of today, 18 companies in the United States that have raised their dividends for 50 years or greater consecutively. You can own them all if you don’t do the deep dive into the accounting and if you’re not cognizant of valuation.

CONSUELO MACK: Right

CHARLIE DREIFUS: So interestingly, with all of those caveats and metrics that I use, nonetheless seven of those are in my multi-cap fund, and one is in my small cap fund.

CONSUELO MACK: Charlie, thank you so much for joining us on WealthTrack. Thanks Charlie.

CHARLIE DREIFUS: My pleasure, I’d love to come back.

CONSUELO MACK: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point picks up on Charlie Dreifus’ theme of investing in companies that have a history of growing their dividends. It is: invest in growing dividend streams. Historically dividends have contributed at least 40 percent of stock returns. And as Dreifus said, all other things considered, income makes an investment more valuable.

There are many products available to participate in growing dividend stories. Dreifus just recommended two ETFs: The SPDR S&P dividend ETF that holds all stocks in the S&P 1500 that have raised their dividends every year for the past 20 years. There are about 80 of them. And the Vanguard Dividend Appreciation Index ETF which focuses on U.S. firms that have raised annual dividends for at least 10 years. Among the mutual funds specializing in dividend growers are two that come highly recommended by both Morningstar and Barron’s. They are the Vanguard Dividend Growth Fund and the T. Rowe Price Dividend Growth Fund. It is worthwhile putting the power of increasing dividends to work in at least a portion of your portfolio.

In the meantime to see past shows and additional interviews done exclusively for our website’s Extra feature please go to wealthtrack.com. And for those of you on Facebook and Twitter we look forward to connecting with you. Have a great weekend and make the week ahead a profitable and a productive one.