With Charlie Dreifus, Portfolio Manager of Royce Special Equity Fund
Great Investors: Charlie Dreifus Of Royce Funds
In another installment of our Great Investors series, today Steve chats with Charlie Dreifus, Managing Director of Royce Funds and Portfolio Manager of Royce Special Equity Fund and the Royce Special Equity multi-cap fund. Charlie began his investment career 49 years ago and, from the beginning, he has pursued a value-oriented strategy, mostly focused on small-cap stocks, with a special focus on scrutinizing companies’ accounting practices and determining their objective earnings potential.
Small-Cap Stocks: Opportunities For “Discovery” In An Inefficient Market
Steve opens the conversation by asking Charlie why he prefers to work in the small-cap universe. He replies that the small-cap market has been more inefficient than other segments going back to when he first started out and continues to be so today, even though “discovery” (finding overlooked companies) is more difficult today as access to information about these stocks has ballooned. Inefficiency is music to value investors’ ears, as it represents opportunities to find underpriced stocks to buy. For a disciplined, accounting-driven value investor like Dreifus, these opportunities require painstaking due diligence to meet the investment-worthy threshold of discovery. He agrees with Steve’s explanation of why small caps are often neglected, namely that there is only so much equity to own in small-cap stocks and, therefore, only so much money you can put into a small cap investment; it’s impossible to scale up to levels that most fund managers are looking for. Dreifus explains that there is a “capacity constraint” in the small-cap space, a fact which is the main reason why he’s had to close his fund to new investors for a third of its 19-year existence. He notes that there are less scrupulous fund managers out there who will try to grow their “assets-under-management” numbers as if that were a desirable goal in itself, but he believes that doesn’t serve fund shareholders’ best interests.
Small-Cap Value Stocks Are Often Cyclical But Outperform Growth Stocks Over Time
Steve observes that the current investment climate strongly favors growth stocks which have boomed in the past 6 months since the election, in particular, the largest tech companies—Apple, Google, Facebook, Amazon—over value stocks. Given that so much market cap has been created and how much money is being made in large-cap growth stocks, Steve asks Dreifus why he’s stubbornly stuck to small-value cap stocks and what his valuation method entails. Dreifus begins his answer by stating that value-stock companies tend to have a cyclical aspect, i.e., not companies that compound at a steady growth rate or range over time. Demand for their products tends to fluctuate, unlike growth stocks. Over the long haul, they outperform growth stocks, but you have to be careful and disciplined about buying and selling them. As for the markets circa June 2017, Dreifus confirms Steve’s comment, adding that small-cap stocks enjoyed a strong boost immediately after the 2016 election based on expectations that Trump’s administration would pass a variety of laws that would benefit US companies: deregulation, tax reform, infrastructure investment. Now that these expectations have been tamped down and pro-business government intervention is more uncertain, money has rotated out of small caps and back into growth stocks.
A Defensive Portfolio With Cash Reserves
Dreifus dryly comments that the prices people are paying for growth stocks give him nosebleeds and that he’s waiting for a “real” market correction before he starts buying equities again, whether growth or small cap or anything in between. Steve interjects that he must be kidding, but Dreifus insists he’s “one of those eccentric people who actually welcomes [a correction].” He explains that there are two reasons for this: he makes it a first principle to build portfolios that are defensive, meaning they will outperform other portfolios during down or sideways markets —either gaining or losing less value—and secondly, down markets sometimes offer the chance to buy companies instead of having cash on the sidelines. At the moment, he’s only carrying 40 stocks in his fund that typically has 60, a reflection of the lack of attractively priced companies by his criteria.
Buying And Selling Stocks Guided By Analysis And Discipline
He also mentions his commitment to a strategic discipline which triggers him to sell stocks when they have reached “full valuation,” and if he can’t find something to replace it with, he’ll put the residual money into cash reserves. Currently, his cash position is about 12% of the total fund, which is far from being extremely conservative. Steve asks what it would take for Dreifus to decide to put that cash to use by buying new stock in terms of a rate of return or some other metric. Dreifus’s replay is a bit technical, but it comes down to how much the entire earnings of the company would exceed the cost of borrowing the money to buy the whole company. He says that he’s essentially trying to buy $100 dollar bills for $60 dollars. There are a lot of variables in constant flux and every stock is, therefore, a “moving target” subject to these variables: earnings, balance sheets, prices, cost of capital (borrowing costs) and more. He’s not a very active trader; on average his funds hold a stock for 4 or 5 years, which is a lot less turnover than most funds. He attributes this to the possibility that the inefficiencies (underpricing) he’s discovered tend to go unnoticed by other investors. Steve wonders whether Dreifus pays attention to and/or regrets stocks that rise after he’s sold them. Dreifus says he does his best to ignore that information because it could drive you crazy. The discipline is the main thing, one grounded in reliable accounting and economic principles, that leads to long-term success. This approach offers protection from those periods when the market is disconnected from reality: the tech bubble, the “nifty 50” of the early 70s, and perhaps the current market. Episodes like this, when investors lose touch with how to price equities, are usually followed by sharp, costly resets.
Setting Shareholder Expectations By Explaining Strategy
Noting the pressure that many fund managers feel from their shareholders during rising markets to “go big” and match the broader market gains, Steve asks Dreifus whether he ever wonders whether he should succumb to client expectations to match bull markets’ upside. Dreifus says that because it’s such a difficult situation when investor objectives diverge from the fund managers, he goes to great lengths to set his clients’ expectations properly, explaining to them that he will underperform during market upswings and will resist buying fashionable stocks that are a poor fit for his somewhat contrarian but disciplined approach.
Over-Performing During Market Slides More Important Than Beating Returns During Upswings
In Dreifus’s philosophy, it’s more important to outperform the downside that the upside, for the simple fact that recouping the money you’ve lost when stocks sink (reaching the break-even point) requires twice the percentage gain in the stock’s value that you lost. A 50% decline in price requires a subsequent 100% gain to break even. Losing less money in a down market, as Dreifus’ defensive portfolios are designed and have proven to do, allows you to participate more in the next recovery.
Principled Accounting And The Legacy Of Abe Briloff
The final part of their conversation turns to the vital importance of accounting in Dreifus’s value strategy. For starters, Dreifus has been described as a skeptic and even a cynic when it comes to corporate accounting. He talks about the huge influence of the thinking and methodology of famed forensic accountant Abe Briloff. Briloff insisted that the accountant’s job—and their employer’s—is to make sure that financial information is portrayed as it “best describes and resembles economic reality.” Unfortunately, this advocacy put him at odds with accounting practices at countless companies and with the auditors of these companies which seek to paint their finances in the most favorable light they can get away with. Briloff felt that accountants and auditing companies should be even more ashamed than their clients for misrepresenting the books, and he attacked them in print accordingly. As the Ombudsmen of their clients’ finances, auditors should have a strong commitment to protecting the consumers of their clients’ financial statements. Briloff was less interested in adding new theories or practices for the accounting industry, as summed up in his statement: “We don’t need more accounting principles, we need more accountants with principles.”
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: In our continuing series highlighting the Great Investors of our era, I have asked Charles Dreifus, Portfolio Manager of Royce Specialty Equity Fund and the Royce Special Equity multi-cap fund, two mutual funds that combine classic value analysis, which we’re going to get into a little bit, finding out what that is. With the identification of good businesses and also what I think is particularly interesting about Mr. Dreyfus is that he has a healthy amount of skepticism and cynicism, when it comes to the way company’s do their accounting. Charlie Dreifus, welcome to our show.
Charlie Dreifus: Well, thank you, Steve, it’s my pleasure.
Steve Pomeranz: So, I know that you specialize in the small cap universe. The universe of investing is quite large, why did you choose small caps?
Charlie Dreifus: Well, small cap still today, but particularly when I started my career 49 years ago, was inefficient. Meaning that people really didn’t know that these companies even existed. So, there was a discovery factor. Obviously, as we progressed in an internet age, there’s less discovery, but if it exists at all, it would be in the small cap space.
Steve Pomeranz: Because you don’t have a lot of the big investment companies and hedge funds looking at these very small companies, why? Because it’s hard to put a lot of money, a lot of investors’ money into them? They’re not that liquid?
Charlie Dreifus: Yes. In the parlance of Wall Street, it’s not scalable. Meaning you can’t put a lot of money into it, therefore, you cannot build a big business, therefore you cannot necessarily make a lot of money for yourself. So, people are less prone to investing in that; they’d rather take as much assets as they can.
If you are diligent, and if you’re professional and ethical, you realize that there’s a capacity constraint in the small cap space. In fact, I’ve closed, meaning I have not allowed new investors into my fund, in a third of its 19-year history.
Steve Pomeranz: You have to close it in order to stop the cash flow coming in because you can’t really effectively buy companies the way you want to that are so small.
Charlie Dreifus: That’s correct. People do it, and there’s an incentive for the manager in terms of assets under management, but it’s an adverse outcome for the shareholder, the client.
Steve Pomeranz: You know, this year growth stocks are in favor. We’ve seen the famous large caps, the FANG stocks, the Facebooks, the Amazons, the Googles of the world doing quite well. Last year not so well, but this year very, very well. So, the idea of buying growth stocks like those versus value stocks, which are a little bit different animal, go in and out of fashion. When you look at small caps today, why do you choose value, and if you could take a second to explain what it means to buy a value stock. Explain why value over growth.
Charlie Dreifus: Great question. Value tends to be companies that have a cyclical element to them. They are not companies that compound at a specific growth rate or at least a band of a growth rate over time. They have products, which may not be as stable in their demand as growth stocks. They historically have actually outperformed growth stocks, but you have to be aware of when to be more aggressive in buying them, and when perhaps not so. Obviously, right now what you explained, Steve, is a recalibration, actually small-cap stocks, and small-cap value stocks did very well immediately post-election because everyone was very hopeful that we would get a lot of government fiscal policies into place that would stimulate the US economy. Small-cap companies are US centric. So, they would be most impacted by positive government intervention in the economy. As it appeared post-inauguration, the likelihood of that started diminishing.
Obviously, as we got further into May, it diminished even more. So, there’s been a recalibration away from the out-performance last year in 2016 of small-cap value into large-cap growth. What people are doing, they’re trying to find in a very uncertain world companies who will exhibit strong either revenue or earnings growth and willing to pay prices that, frankly, give me nose bleeds.
Steve Pomeranz: Right, well, you know getting back to that. So, if small cap value is now out of favor to some degree, are you starting to find companies at compelling prices to buy in the area that you invest or are things at relatively too high levels for you now?
Charlie Dreifus: They still remain at too high levels. I need a real market correction. By that I mean-
Steve Pomeranz: Don’t say that.
Charlie Dreifus: Well, I actually am one of these eccentric people that actually welcomes that. I welcome it for two reasons. I try to build portfolios that are very defensive. They act very well during troubling markets. Flat or down markets. So, I out-performed—many times actually advancing during a declining market. More important, today, is repopulating my portfolio because of the continued march post-March of ’09, higher in terms of prices, it’s become much more difficult to construct a portfolio, which, in my case in the small-cap fund, typically has around 60 names, today has around 40 names. That’s a function of having to…I have a strong discipline, both in buying, and selling…when a stock reaches what I believe to be full evaluation, meaning that there’s no advantage to continue to own it, I will sell it. If I can’t find anything new, the residual goes to cash and cash will build.
Steve Pomeranz: So, you have an excess amount of cash right now if you have sold 20 out of your 60 stocks and you haven’t reinvested them. That money is sitting in cash.
Charlie Dreifus: Correct.
Steve Pomeranz: Yeah.
Charlie Dreifus: It’s roughly in the 12% area. It’s not something astronomical.
Steve Pomeranz: Here’s a question I have for you. You had 12% cash in your portfolios. At what point in time, when you make the decision, what rate of return I guess is your minimum requirement in order for you to decide to … I like this company, but now I like this price?
Charlie Dreifus: Well, it’s a good question. We have a [formulitic approach, which—without causing your listeners to go back to business school—basically, the simple concept is we have to earn…if we bought the whole company, we would have to earn a substantial amount over the cost we would incur in borrowing the monies to buy the business. So, it has to have that differential.
So, we always know it generally is something of going in of a 50%. I often say what we’re trying to do is buy $100 bills at $60. So, 50% above 60 would be 90, there’s a little transaction cost and noise in the system. Again, it’s a moving target, because earnings are changing, balance sheets are changing, prices, of course, are changing, cost of capital, the borrowing cost that we would incur in borrowing to buy this business. So, everything is changing. So, it’s, interestingly enough, on average I tend to hold the stock for four or five years. I have very low turnover compared to the industry because if I truly am finding inefficiencies, by definition it doesn’t mean that it’s going to be discovered the next day.
Steve Pomeranz: Well, if you’re buying companies as they’re declining in price, there’s really a good probability that even after you buy them they’re going to continue to decline. Just because Charlie Dreyfus decides to buy, doesn’t mean a bell rings somewhere-
Charlie Dreifus: Yeah, that’s a shame.
Steve Pomeranz: I know, we all want that. I wanted to ask you about the reverse. So, you have this discipline when you sell a stock because you say it’s fairly priced, but how many of those companies do prices continue up, and up, and up, and you sit there and you go, oh, if I had just waited two weeks. If I had just waited six weeks I could have gotten another 20% on this?
Charlie Dreifus: It happens all the time. I’d learned early on in my career that you cannot do could of, would of, should of, because you’ll drive yourself crazy.
Steve Pomeranz: Right.
Charlie Dreifus: What you do is you have a discipline, hopefully, based in some economic, accounting, capitalistic, notions, that works over time. That doesn’t mean that the market can’t escape from times of reality, we’ve seen that in the past. We may be seeing that currently. The market has a way at times of neglecting reality. You think of the tech bubble, I go far enough back to the nifty 50 in 1972, 1974.
Steve Pomeranz: Which were 50 of the most popular stocks, Xerox, Polaroid…
Charlie Dreifus: Correct.
Steve Pomeranz: Avon was in there years ago.
Charlie Dreifus: Avon, Sears Roebuck, a lot of companies that have stumbled over the years.
Steve Pomeranz: Right.
Charlie Dreifus: It was a broader version of FANG. So, these episodes happen from time to time, and people lose their bearings as to how they should price businesses in the marketplace, and then they return to reality, often with a sharp damaging effect on them.
Steve Pomeranz: One of the problems that managers have is that clients are looking at them to … If the market’s going up, clients want their portfolios to be rising. They don’t want a situation, even though the piper will or may be paid in the future, they don’t want you to be basically say, hey, well, we’re out of the market because we think that prices are too high, then the market continues up. Say the Dow another 1,000 or 2,000 points, there’s a lot of pressure on managers to stay in the game. I don’t think you’re under that pressure.
Charlie Dreifus: Well, I’m sure I have some clients who have that notion. I have always throughout my career tried to set expectations. The worst thing for a manager, in the long run, is to get a client whose objectives are different than that which are the manager’s objectives. So, what I have tried to frame in terms of expectations is I will underperform on the upside. I will not own that item that is most in fashion as you suggested, Steve. I will own stuff that is unfashionable, that’s been rejected by others. Somewhat contrarian, but with a discipline.
Steve Pomeranz: Right.
Charlie Dreifus: Therefore, I have a long history of underperforming the upside. The simple math is if you outperform the downside—the technical phrase here is upside, downside, capture ratios—if you have a history of doing so much better during adverse times, you keep the corpus, the money, intact, so that you can participate during the up times. It’s the mathematical truism. If you decline 50%, you have to be up 100% just to be even. You don’t want to be in that position.
Steve Pomeranz: Yeah, you don’t want to dig a hole so deep. So, you may see the S&P was up 40, 50%, but then the year before it was down 40%. It doesn’t mean that you’ve broken even as a matter of fact.
Charlie Dreifus: Correct.
Steve Pomeranz: It’s far from it, you need 100%. We don’t have much time left, really one of the parts of your talk when I heard you out in Omaha, a few weeks ago, was you were talking about a mentor of yours Abe Briloff, who was really a maverick in the accounting industry, which I think is kind of an oxymoron. Tell me a little bit about Abe Briloff. Bring us in, because he’s kind of a hero, and yet I don’t think many people have heard of him.
Charlie Dreifus: Yes, Abe Briloff, and I encourage your listeners to Google him. He was the leading forensic accountant in the United States. He passed away a couple of years back at age 96 and a half. For much of his career, the last 25 years, he was legally blind, but yet was very prolific. His advocacy was that it’s the company and accountant’s responsibilities to portray financial information as it best resembles the economic reality.
Shame on companies that portrayed it, obviously, in most instances in a more favorable light than it’s deserved, but even greater shame and scathing articles attacking the auditing profession for allowing it. His belief was, and I concurred, obviously, that the auditors are the Ombudsmen. They should be the protectors for the consumers of the financial statements such that we get economic reality. So, Abe’s addition to the notion of accountancy was not so much the construction of it…I was an accounting major undergrad, I did extremely well, but I hated it…it was only in a graduate program where I had Abe as a professor, and Abe taught us the deconstruction of financial statements. Frankly, without Abe Briloff, there would be no Charlie Dreifus. My entire career I owe to him.
Steve Pomeranz: I want to end with a quote that I heard you say at the conference. That is Abe said, “We don’t need more accounting principles, we need more accountants with principle.” On that note, I’d like to thank-
Charlie Dreifus: Amen.
Steve Pomeranz: Yeah, amen. I’d like to thank Charlie Dreifus, Portfolio Manager of the Royce Special Equity Fund and Royce Special Equity Multi Cap Fund for joining me today. Charlie, it was a great interview. Thank you so much.
Charlie Dreifus: Thank you, Steve. Look forward, bye bye.