This conversation is part of our special series, Intelligent Investing 100. Every week for one hundred weeks we bring you an exclusive segment with a recognized thought leader in the field of investing. Stay tuned for a new release every Thursday at 11:30am ET.
We continue this series with a classic interview with legendary small-cap value investor Charles M. Royce, the founder of Royce Investment Partners, based in New York City. Chuck has spent more than five decades at his namesake firm and more than six decades in the investment field.
This interview was led by MOI Global contibutor David Englander in 2019.
The following transcript has been edited for space and clarity.
David Englander: It’s a pleasure to be here with Chuck Royce, chairman of The Royce Funds and the portfolio manager of a number of mutual funds, including Royce Pennsylvania Mutual Fund, which he’s led since 1972. Chuck is known as one of the pioneers in small-cap investing. He’ll tell us about lessons learned over the course of his career. Let’s start with your background and your path to becoming an investor.
Chuck Royce: It was the cliché: I took my newspaper route, bought stocks in my teenage years, and looked at Value Line. I can remember the names of a stock or two I bought. I thought it was great. I can’t tell you what triggered it, but it seemed like a wonderful way to be involved. I like making money.
MOI: What’s your role at Royce today? You stepped down as CEO a couple of years ago.
Royce: I am no longer worried about people’s vacation days or whether we have to have a fire drill. I get to do the fun part. I do portfolio, and I love it.
MOI: You’re well known as a small-cap investor. What was the landscape like in small-cap investing in the 1970s compared to today? To add another question to it, what is the opportunity today in small-cap investing?
Royce: There was no small-cap universe as defined. Although the Russell numbers and data go back to 1978, they didn’t actually reveal those numbers until 1984 or 1985. All this conversation about small stock didn’t start until after Russell began to define the universe. Before that, I simply saw them as interesting companies. Yes, they were smaller, but I never thought of it as an “asset class.” Russell formalized it over time, and so did Morningstar. Those two had the biggest impact on defining it as a class.
MOI: Nowadays, a lot of Wall Street analysts don’t cover small caps. The practice has been in decline for at least 10-15 years. In terms of coverage back then, was it a more inefficient market?
Royce: Absolutely. In those days, information was your key to success. If you wanted to get SEC filings, there was no hit a button and the 10-K arrives on your doorstep 30 seconds later. No, you had to send away for it or go get it. Information was not a commodity, therefore, it was an edge. You could talk to a company. There were no rules specifically about fair disclosure (FD), so it was all over the place. Thus, if you did work and talked to the company, you were likely to have a lot of edge.
MOI: Were there opportunities back then that don’t really exist today, such as net nets?
Royce: That was never really my thing. Yes, I went to Columbia Business School with all these cool people in that world, but it wasn’t terribly of interest to me. I was interested in companies going somewhere, getting to a place, and buying them cheaply, but the net-net world was never our world. To this day, even when they exist, it’s usually a leaky boat. It’s usually not as simple as what you see.
MOI: What are the characteristics of a business you’d like to invest in?
Royce: I like two types of companies. I like microcap, tiny companies, and I’m actively involved with our closed-end microcap product. I also like very high-quality companies, almost two ends of the spectrum. In the quality category, I look for some durable advantage and reinvestment opportunity. In other words, it’s not merely about generating some cash and paying it out. That’s okay, but the important thing is to have a platform which is both durable and re-investable, and, therefore, you can be looking for compounding.
MOI: In the last ten years or so, some moats have become less durable. Once great businesses, like consumer products businesses, might not be great today. What is your view on this?
Royce: You’re getting to the heart of it. A moat is not a snapshot. You could run a screen on everything with return on invested capital of 25%, and you get a whole bunch of companies. That could be a moment in time. It could be luck, some evaporating advantage they had (maybe a cost advantage), or a single cool manager who did things well. You’ve got to deconstruct to the moat, see what it is, determine whether it is sustainable, and if they have more opportunity to grow the enterprise.
MOI: Have you had a lot of success with businesses which start off very small and become bigger?
Royce: I think we’ve had considerable success in the zone of compounding. We started the fund in 1991 with that in mind. Back then, the asset class of small was part of the vocabulary of asset management. I began to think it was two worlds – the upper end of small, where I believe the right approach involves concentration and the idea of some durable advantage compounding, and microcap at the low end, where I try to identify companies with reasonable prospects that are inefficiently priced and could evolve to be great long-term investments. It may not be clear at that moment – they could still be going through a transition between founder and professional management and have one product. It may not be a premier, high conviction thing, but there are interesting aspects. Although there are two different worlds, I try to look at them through the same lens of potential long-term ownership.
MOI: How do you feel about a company if it’s not making profits yet or is not free cash flow-positive?
Royce: That’s the new story. The economy has gravitated from an industrial to a service economy, the latter being less asset-intensive. Therefore, book value and capex in the old-school sense are no longer as relevant. In the old days, you would build a plant, capitalize that asset, and then amortize it over 30 years. It doesn’t mean the plant was a good idea, but you’re not expensing at day one. In the new, asset-light world, you’re making discretionary, largely expensable expenditures, some good and some bad, but you’re no longer capitalizing. In fact, you are penalizing the earnings statement by these discretionary decisions you make in the asset-light world, and that’s even more so in the digital world. In a sense, it’s the same. There will be decisions which turn out well, those discretionary decisions on how to grow your sales force or build a factory for more product. They’re the same thought process of building a business. The factory was not expensed. The extra salespeople are expensed. Oddly, you now have more settings where the loss structure could be okay if they’re appropriate decisions. Boy, does that take work!
MOI: The other issue in microcaps nowadays is liquidity. I’ve heard it said that nobody has to own one of these microcaps. There is no natural buyer anymore. With a stock that trades 50,000 or 100,000 shares a day, it takes time to build a position, and you can’t sell that stock.
Royce: You should be paid extra for the difficulty and the lack of liquidity. You should make more money. To me, it’s that simple. You need to have more because it’s going to be harder. You can’t change your mind tomorrow. In the microcap world, you should use the lack of liquidity as an advantage. You’ve got to build it into what you want. We’re not looking for a 10% move in the stock and take three weeks to buy it and three weeks to sell it.
MOI: What are some other critical issues in microcap stocks?
Royce: That’s a great question because, as you know, there have been fewer IPOs recently. However, the great thing about small cap is that it is somewhat of an evergreen universe. Stocks fall down from large cap or medium cap – something goes wrong, they could be spin-outs or IPOs. You have lots of potential new things to look at. That’s what makes it fun, interesting, and evergreen. In the microcap world, though, there are fewer underwriters at that level. Even the J.P. Morgans and Goldman Sachs want to underwrite smaller companies, but there’s fewer of them, so the smaller underwriters have been pushed out, and there’s less stuff going on. That’s a somewhat new development, but it’s a big enough universe. There are thousands of companies in this area.
MOI: I don’t know all the history, but I’d imagine a lot of these small-cap companies used to be covered a lot more than they are today. Equity research in this space has dwindled, and sometimes there are only one or two analysts covering, sometimes none.
Royce: One or two would be typical now, especially in the microcap, but there would be plenty with no coverage because the bankers have gone bye-bye, and the companies might not need money. There are reasons for it. That makes it better if we do our job right. As you know, there are a million of these conferences, some of them brokerage-sponsored. There are still conferences where they put 200 companies, and you have a speed-dating version of looking at something. Some of that’s worthwhile to get a glimmer of what management is. They’re okay, but I’m not sure what you get out of it. The FD now requires that the presentation be on the website the same second, so it doesn’t matter. They can’t go off script, or they’ll get slapped pretty quickly for it. After a couple of drinks, who knows what they’re saying, but if you meet that person 10 times over two or three years, you will pick up the nuance of change in tone and direction. You’ll pick up the second derivative parts of that presentation in a way you cannot do the first time.
MOI: With microcaps, management is really important because they’re going to be the driving force. What do you see as characteristics of a management team that build confidence over time? Is it incentives, the things they’ve done, capital allocation?
Royce: There are people who can articulate what you just said, and people who are really good at it and can’t articulate. In the smaller world, you don’t get as much polish of the operator, but you might get just as much good governance, capital allocation, good thoughts, and a long-term view but without the polish. You have to be careful about too much polish. What you want is an authentic person and getting to the truth about their love and care for the business. This probably doesn’t come from that presentation.
MOI: How about incentives in terms of their stock ownership?
Royce: I would say there’s nothing specific. As you go through generation one, two, and three over 20 years, there’ll be different moments in the turnaround world. A company gets in trouble, and there’s a whole new team brought in. You’re issuing different forms of compensation. That’s not good or bad. It’s simply something you’ve got to understand because it’ll be in the calculation. In the tech world, they are crazy about options and free stock. We have this weird thing where those aren’t counted as compensation. I think the key is totally understanding what it is and why it’s best for that case. In the earlier stage, the founder has the stock, so he doesn’t need to get a big salary. With the founder, however, you’re worrying about what happens next. Is his little son any good? Honestly, each of those cases is going to have a different set.
MOI: Sticking with the idea of a small cap growing up to be a big company, Watsco was a small distributor and rolled up.
Royce: Watsco is an example of an excellently executed roll-up. In general, you should be wary of roll-ups because they can be lousy, but that’s a great example.
MOI: How do you get a sense of a company’s culture?
Royce: One thing we know is that we can’t screen for culture. That’s good because if you can get to the bottom of it and add that to your confidence factor, it’s a great thing. You’re not going to get it from the presentation. You’re probably not going to get it at a conference. You’re going to get it through asking a lot of questions. Maybe you get somebody very local or talk to medium-level employees. Do they like working there? Do they get up and want to go to work? Culture is a great idea to get to understand. I couldn’t tell you exactly how you get there, but it would be through observations across the ecosystem, and it would take time.
MOI: Would you say you’ve owned the companies you’ve invested in for a long time or followed them for a long time?
Royce: Absolutely. I followed them for a long time. I would bet we have owned or been involved with the majority of our Premier companies (maybe 80% of them) for 10 years, so it is a long time. We strongly believe that one of the last inefficient frontiers is time arbitrage, understanding what’s possible if you sustain that competitive advantage.
MOI: A lot of people are so short-term focused nowadays.
Royce: The word short-termism describes a lot of management teams. Many managers are hired guns, brought in to do something. They are completely focused on short-term results. Cutting costs is the simple way to success for this kind of people. Very few companies would acknowledge it, but that’s what goes on.
MOI: When you read a conference call transcript, what things turn you off or make you think the management team is short term oriented?
