Charles Royce Transcript 4/26/2013 #944

May 6, 2013

CONSUELO MACK: This week on WealthTrack, after 40 years of sailing the world and finding big investment ideas in small out of the way companies, Great Investor Chuck Royce shares the lessons learned and sea changes he’s experienced. Small cap legend Chuck Royce is next on Consuelo Mack WealthTrack.


Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. One of my favorite financial quotations is: “the market can stay irrational longer than you can stay solvent.” It is attributed to British economist John Maynard Keynes who in his mid-30’s almost went bankrupt speculating in currencies on margin. According to his biographers, Keynes was a lifelong speculator who made and lost several fortunes.

The Great Investors we interview on WealthTrack are not speculators. They consider themselves to be disciplined long term investors whose first priority is not to lose money. They would never put themselves or their shareholders in serious financial jeopardy. Their second priority is to take advantage of market inefficiencies. The stock investors among them buy quality companies at substantial discounts to their intrinsic value. Of course Great Investors are also subject to the irrational behavior of the market and their performance can suffer as a result, especially relative to the market or their particular benchmark. The vast majority of our Great Investors guests substantially underperformed the indices during the tech bubble, for instance; if they were not heavily invested in financial stocks they also lagged during the credit bubble. And recently they needed to be in high yield and more risky investments to keep up.


This week’s Great Investor guest is a classic example. He is Charles “Chuck” Royce, a pioneering small cap fund manager, founder and now co-chief investment officer of the Royce Funds, where he runs multiple portfolios. Late last year, Chuck celebrated the 40th anniversary of running his flagship Royce Pennsylvania Mutual Fund. Penn Mutual has outperformed the small cap Russell 2000 for extended periods over the decades, delivering nearly 13% average annualized returns over the last thirty years versus the Russell’s 10% returns. However the fund has underperformed the Russell over the past 3 years. Which sectors has Royce been out of? We’ll find out in a moment. But first I asked him to share the most important lessons learned in his more than four decades of investing.


CHUCK ROYCE: The most important thing for us and the firm is that… the most important thing is not to lose the money. Controlling risk is the single most important job. That’s the hard part. That’s the part that I had to learn through losing other people’s money in ’73 and ’74. And it became a guiding principle for me. The truth is we can’t control everything, but we have a very disciplined approach of the stocks we buy. The balance sheet is probably the single most important thing we’re looking at. We like very conservative balance sheets. We don’t want to take a balance sheet risk. We want to take operating risk. We don’t want to take the risk of the enterprise not having enough fuel to last for the operating cycles. So we sort of limit our risk by focusing, on the upside, the operating possibilities, and on the downside, the balance sheet.


CONSUELO MACK: And yet, you’re saying this in a small cap universe. So, you know, most people would say small company stocks are, by their very nature, risky, and you’re saying… and you have discovered over the last 40 years that not necessarily so.


CHUCK ROYCE: They are risky. They’re more volatile, for sure. But we attempt to mitigate that. And sometimes we’re successful. Not always, maybe two out of three times. In the decline of five years ago, in ’08 and ’09, we did not feel we did a good job at all in preserving capital.


CONSUELO MACK: How could you in that environment have done a better job, aside from going to cash?


CHUCK ROYCE: Yeah, I think going to cash probably would have been the only alternative. Our companies, who were very strong balance sheets, still went down a lot.


CONSUELO MACK: So that’s just the nature of the stock market.


CHUCK ROYCE: That will happen. Yes.


CONSUELO MACK: Right. So another lesson, think long term, full market cycles is how you think when you’re looking at what your expectations are.


CHUCK ROYCE: That’s the hardest part for the individual to think. Market cycle is a better way of measuring performance. Certainly, calendar years are not the right idea. Even three years is not the right idea. So a full market cycle, you could measure it from peak to peak, or trough to trough is…


CONSUELO MACK: In the market?


CHUCK ROYCE: Yeah. In the market is probably the most appropriate way. But you have to suspend your fear in the short term in order to capture the long-term performance.


CONSUELO MACK: And let me ask you about that, because the average diversified stock mutual fund in this country, I think the average holding period is 15 months. That’s not a full market cycle, right?




CONSUELO MACK: Your average holding period, for instance, at the Royce Funds, is three to five years.


CHUCK ROYCE: Closer to five in the case of our real diversified funds.


CONSUELO MACK: Why is it five instead of two, or …


CHUCK ROYCE: Well, there’s nothing magic about five, but our turnover is about 20%, so that would indicate about a five-year holding period. Market cycles could be shorter than five. They could be longer than five. We had a long market cycle in 2000, to the peak in 2007. That was a seven-year market cycle. So they vary, but they’re in the range of three to seven years. Five years is not a bad time frame. But we don’t target, you know, a specific time. We’re trying to double our money in five years, as a rough idea, but, in fact, we would like to hold the stock for a long time, much longer than that, if conditions allow.


CONSUELO MACK: See, the third lesson, that major lesson that you’ve learned, is to focus on absolute returns, and, of course, all of us look at the mutual funds that we invest in, and we’re saying, “How did they do versus the market, and how did they do versus their competitors,” and that is how many of us judge. But you’re saying not the way that you judge your performance.


CHUCK ROYCE: We, when we pick a stock, are using absolute standards. We’re trying to, you know, double our money in five years, but, in fact, we’re trying to identify compounding vehicles that can compound, add 15%, plus, over very long periods of time. That’s an absolute standard. We expect to be measured, ultimately, on a relative basis. We know people will do it. We can’t avoid that. The SEC requires us to use a benchmark. However, it isn’t really the standard by which we pick stocks.


CONSUELO MACK: And it’s not the standard by which you judge yourselves.




CONSUELO MACK: Doubling every five years- where did that come from?


CHUCK ROYCE: It’s a pretty arbitrary number, but it’s in the neighborhood of 15%, compounding. We don’t have any funds that actually have compounded at 15%. We fall shy of that. But it’s the right standard for us.


CONSUELO MACK: Let’s talk about the current market, and what the investment environment is like. And you have described this market as an anomalous market. So what is so distinctive about the current market environment that we’re operating in?


CHUCK ROYCE: The most distinctive part is the Fed’s role in the economy. The Fed has determined that it will provide unlimited liquidity, that it will keep interest rates extremely low. Lower than we’ve ever experienced in this country. And we don’t know the consequences of that, in fact. Perhaps it was a good idea. Maybe it wasn’t a great idea. But the side effect, the unintended consequence is that it’s encouraged and sponsored the success of inferior companies. So if you had superior companies, you were disadvantaged in this particular environment.


CONSUELO MACK: And one of the things that you’ve been quoted as saying is that it’s probably been the most frustrating market environment that you’ve ever seen in your 40 years in the business.


CHUCK ROYCE: It’s very frustrating, because we have a quality bias. The quality bias runs through either specific funds. We have funds that feature dividends. We have funds that feature high-quality companies, and we have diversified funds. All of our funds have a high, high, high piece of quality type merchandise. So these companies have been disadvantaged. They were prepared for hard times. They had the ability to do very well in hard times. But, in fact, the inferior companies were able to actually get their act together, fix their balance sheet, sell a junk bond for five or six percent, and go on.


CONSUELO MACK: So it’s not a meritocracy in the market right now. It’s kind of anything but.


CHUCK ROYCE: Exactly. Very good point. It is a climate where, in fact, the inferior has prospered.


CONSUELO MACK: So what do you do in a situation like that? Because now the Fed… you know, somebody said it’s like QE, Quantitative Easing infinity is what… someone’s come up with this expression. And it’s not just in the U.S. It’s also Japan has now completely jumped on the…




CONSUELO MACK: …bandwagon. So, you know, knowing there aren’t too many certainties in life, especially in investing, but this seems to be kind of a certainty, at least for another year, another two years that we’re going to have this incredible repression of interest rates. So you don’t want to like adapt and kind of go with the flow and say, “Okay, you know, let’s go with more risk.”


CHUCK ROYCE: We’re not going to do it. We’re betting on quality. We know, as well as you can know, that quality will out… I do not think it’s another year or two. I think we’re running towards the end of this year. No matter what happens in the jobs reports any one day or headline, I do think there’s a gradual and sustained improvement in the economy that will allow interest rates to go higher. I think the ten-year bond will be two-and-a-half by the end of the year, maybe three next year.


CONSUELO MACK: So the kind of certainty that you’re expressing about that you think that the record low interest rates are not going to continue, that they’re probably going to end this year, did you feel this way a year ago? I mean, you know, how confident are you in your predictive abilities, and what does that tell you about how quality companies are going to perform?


CHUCK ROYCE: This has been a confusing and frustrating time. We are patient investors, but we’re learning new lessons in patience. And we have to… we can think long term. That is certainly our advantage. We preach that that’s the right approach. But we know the conditions today are not ideal for these quality companies. But this, too, will change.


CONSUELO MACK: And the reason why the more risky companies have prospered, at least in the start market, in this environment, is why?


CHUCK ROYCE: Well, they were able to fix their balance sheet. It’s really that simple. If they had excess leverage, they were able to sell bonds, they were able to get financing, et cetera, in ways that probably wasn’t true before that. And then there’s this other part of this current condition. It has driven investor preferences towards yield completely. Yield has become a mania. Yield is the internet bubble of today. So anything that looks like yield, without regard to safety, people have piled into.


CONSUELO MACK: So, for instance, you know, real estate investment trusts…


CHUCK ROYCE: Absolutely.


CONSUELO MACK: …and national limited partnerships, and utilities, and so you think that those kinds of investments, and you’re right, everybody wants to be in… just give me some income, that those investments are in a bubble?


CHUCK ROYCE: Sure. Because people have so… the interest rate structure is so distorted, four or five percent looks like gold, and is at that sort of nominal level. But what’s happened, those stocks have gone up substantially, and they’re substantially above their sort of long-term value areas. And I believe they’re in a form of a bubble.


CONSUELO MACK: So if I own a REIT, for instance, right now, or a national limited partnership, or utility, you’re saying you might want to take some…


CHUCK ROYCE: I would be cautious.


CONSUELO MACK: You’d be cautious.


CHUCK ROYCE: Yeah. I would be cautious. Yes.


CONSUELO MACK: Right. Talking about the distortions in the market, aside from these yield vehicles and also the poorer quality, inferior quality has prospered, are there any other distortions that you’re seeing that are concerning to you, or that represent an opportunity?


CHUCK ROYCE: Well, that’s a good point. There’s a whole bunch of stocks in the Russell 2000. That’s our index; that don’t make money. They lose money. About 25% of the whole index loses money. Those stocks have been up terrifically. It’s not an area that we shop in. We shop in the other areas of companies that make money. So it is true that the companies that make money have done less well, and, therefore, we continue to shop in that zone.


CONSUELO MACK: Where are you finding companies making money? I mean you’re a value investor. Where are you seeing the greatest value in the small and midcap space right now?


CHUCK ROYCE: Well, it’s in dear old-fashioned industrial companies. It’s somewhat cyclical, but we’re having an industrial renaissance in this country, and I truly believe over the next five or ten years that that’s going to continue.


CONSUELO MACK: So what kind of industrial companies? Give me some examples.


CHUCK ROYCE: Well, an example could be… they’re usually niche products. Lincoln Electric. They’re in welding equipment. The sort of steel distribution centers. All sorts of niche, very specific, usually very good return companies, somewhat cyclical, but these have been by and large ignored. They’re up, from the bottom, but I believe they will go much further.


CONSUELO MACK: So industrials. I know another area that’s very interesting, and you recently started a small cap financial fund.




CONSUELO MACK: But that doesn’t invest in banks. That’s…


CHUCK ROYCE: We have a few banks…


CONSUELO MACK: …right? All right.


CHUCK ROYCE: …but by and large we’re not bank… we don’t see banks as a sweet spot. Banks are recovering. It’s just not an area of expertise. They’re too difficult to analyze. They’re too complicated. Even banks themselves can’t analyze themselves. So we more or less skip that. Our Financial Services Fund focuses on everything else, from asset managers, to insurance companies, to insurance brokers, to data providers, to service providers, and it’s an important sphere in the economy, with lots of ways to do it other than banks.


CONSUELO MACK: When I look at, there’s a vast array of Royce small cap funds, and midcap funds, and microcap funds. So why did you pick that particular sector? I mean what was it…


CHUCK ROYCE: Well, it’s a favorite sector of ours in all of our funds, in the non-bank sense. I’ve always had an interest in these areas, so we wanted to start it. We know it’s not going to be a big fund. It’s a very small fund. It’s a $20 million fund. And it’s been $20 million for a long time. There’s not a real big interest in this kind of thing, but it’s an important part of this economy. It’s important in lots of different ways. I like the sort of non-asset intensive vehicles, like insurance brokers, or asset managers. These are favorites.


CONSUELO MACK: Chuck, the markets have changed a lot in 40 years, and I’d like to talk about some of the major ways in which the markets have changed, and if it has, at all, affected the way that you invest and the way that we should be investing as well as individuals. So talk to me a little bit about the pace and the fact that it’s this global market now.


CHUCK ROYCE: Sure. Well, it is global, and that’s a big change, and that certainly wasn’t true in the seventies or even in the eighties. But even before that, or around the same time, the New York Stock Exchange began to change, and we have gone away from a central market specialist system, where the specialists had a fiduciary obligation to provide capital. We’ve gone into a different kind of market, and that’s a huge change. We now have high-frequency traders. We now have markets all over the world…


CONSUELO MACK: Right. And off-exchange trading.


CHUCK ROYCE: …trading the same stock.


CONSUELO MACK: Right. So does it make it… a lot of people feel that it makes it less safe. Do you feel less safe in the markets now?


CHUCK ROYCE: I think safe isn’t really the right issue. I think short-term volatility is, and that, of course, makes people feel anxious, and I guess less safe. Lots and lots of daily volatility, high daily volatility. It’s about the same in the long term, monthly, or quarterly volatility, but daily volatility is higher. We now trade in increments of a penny. And it isn’t clear when you’re buying stock how much you can buy at any one penny. So in some weird way there’s less information, and we think of more modern markets as providing more information, but in the case of trading New York Stock Exchange stocks, you actually are just sort of flying blind often.


CONSUELO MACK: So are there any other major changes really that have affected you as an investor, and what you do as an investor?


CHUCK ROYCE: Well, the biggest change for us is the imposition of indexes. That started in the late seventies, but really took hold in the eighties and nineties.


CONSUELO MACK: Thank you, Jack Bogle, right.


CHUCK ROYCE: Exactly. So we now have to compare ourselves against indexes. And, you know, that’s okay, but it’s not our favorite idea. Indexes are, you know, now a big part of the market, and part of that… and then has come passive investing, and then has come ETFs. ETFs, in the last ten years, have just zoomed off the planet. At the same time, active managers have done less well, perhaps encouraging more passive investing. So we’re in a kind of vicious cycle, that investors think ETFs are the path to glory, and that active management no longer works. I hope that’s not true.


CONSUELO MACK: So small cap companies, which I mean you essentially created small cap companies as an asset class, as a distinct asset class. So remind us again, what does investing in small cap companies do for us as investors? What does it add to our portfolio?


CHUCK ROYCE: Great question. These are small. It’s a huge universe. It’s a universe of trillions of dollars. So the small asset class is not small at all. Lots and lots of stocks- 5,000, 6,000, 7,000 domestic stocks; 30,000, 40,000 internationally. Very large universe. In an ideal way it should provide higher returns and provide it in a non-correlated way. It doesn’t do it all the time, but it does do it most of the time.


CONSUELO MACK: Non-correlated to large cap?


CHUCK ROYCE: Yes. It should have a different performance scheme, and sometimes it does, sometimes it doesn’t, but in an ideal world it’s performing differently.


CONSUELO MACK: And just let me ask you. For instance, we’ve had a highly correlated market during the financial crisis. There’s more dispersion in results now. So are we back to a situation where the small cap stocks are actually not that correlated to the large cap stocks?


CHUCK ROYCE: Not really. They’ve been more correlated recently. However, their performance in that sector, in one, three, five, ten, fifteen, twenty, has been stronger than large cap. That’s a pretty long period of time. I’m not saying it goes on forever. I do think there will be natural rotation, where there will be plenty of times in a three- or five-year period where large caps do better, but small caps have so many advantages that it is not surprising that they’ve had superior performance. Now, on the correlation, we are in a period of higher correlation. This cliché of risk on, risk off has affected everything, small caps included. But I do think over time they will start to separate their performance pattern.


CONSUELO MACK: One Investment for a long-term diversified portfolio, what should we all own some of in a diversified portfolio?


CHUCK ROYCE: Well, I’m going to give a similar answer I did last year. A non-asset manager, Alliance Bernstein.




CHUCK ROYCE: It has a superior diversified portfolio of products. It pays a high yield. And it’s structured as a yield product. And they have excellent management.


CONSUELO MACK: And is that in your new Financial Services Fund?


CHUCK ROYCE: Absolutely.


CONSUELO MACK: Chuck Royce, from Royce Associates, thank you so much for joining us here at the fabulous Ocean House.


CHUCK ROYCE: Thank you.


CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: consider owning some high quality small cap stocks, both U.S. and international, in your portfolio. As Royce explained, there are thousands of small cap stocks traded here and overseas. Many of the higher quality ones dominate their business niche, are conservatively run and pay dividends. Considering that some 25% of the Russell 2000 companies lose money, this is probably one asset class where buying an index fund isn’t the best route and going with a proven active manager is. An incremental approach also makes sense since small cap stocks as a group have far outpaced their large cap brethren in recent months.


Next week we will have another television exclusive, this one with Financial Thought Leader Charles Ellis. Charley will share his fifty years of investment consulting wisdom, highlights from his new book, What It Takes: Seven Secrets of Success from the World’s Greatest Professional Firms. If you have missed any of our past Great Investor or Financial Thought Leader guests, you can find them on our website, You can also see additional and extended interviews in our WealthTrack Extra feature. In the meantime, thank you so much for taking the time to visit with us. Have a great week and make it a profitable and a productive one.

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