How do you describe your investment approach in the Small-Cap Special Equity Strategy?

Together with the Strategy’s assistant portfolio managers, Steven McBoyle and Tim Hipskind, I try to combine classic value analysis, the identification of good businesses, and accounting cynicism in our approach. These three tenets have their respective roots in the investment and accounting lessons of Ben Graham, Warren Buffett, and Abe Briloff. Abe was particularly important to my development as an investor. He was a mentor to me when I went to graduate school for Accounting. He’s best known, however, for his writings—he wrote several important books, as well as pieces for Barron’s during the 1970s, ‘80s, and ‘90s—that evaluated accounting principles and practices, especially the items that appear on the balance sheet and income statement.

How did Abe Briloff’s teachings help you develop your own distinctive style?

Abe showed me how critical it is to understand the numbers, which had always fascinated me. He showed me why it was important to perform very close analysis of financial statements; to study the footnotes because they so often reveal what the company is doing—or not doing. He taught me to question why companies show revenues and/or treat expenses the way they do. Today, this is known as governance, but at the time—this would be in the late 1960s and early 1970s—Abe thought of it as ‘accountable accounting,’ or, in some cases ‘unaccountable accounting, which is also the title of a book he wrote in 1972 (and coincidentally the same year Royce was founded).

I often say that a deep understanding of accounting principles gives us a chance to uncover the veracity of a company’s finances through our scrutiny of financial reports. Steven, Tim, and I spend a lot of time going over the numbers. Ultimately, we want companies that use conservative accounting procedures with management teams that have demonstrated their commitment to enhancing stockholders’ wealth. This is a discipline that we expect should benefit our investors over the long run because most portfolio managers are not doing similar deep dives into a company’s numbers, specifically not with the accounting background the three of us share.

How did you get your start as an investor?

My parents had a cousin who was a waiter, a very savvy guy who bought stocks for the dividends because they had higher yields than what was available at the bank in the early 1950s. This piqued my interest, especially because I was already interested in numbers of any kind. Later, when I received money for my bar mitzvah, I began buying stocks as a teenager. In fact, when I was in high school in Brooklyn, I would give the guidance counselor stock tips and he’d give me a hall pass in return. This gave me the chance to go and use a public telephone to call my broker. So, I was sort of a 16-year old day trader. Around this same time, I discovered the Moody’s manuals at the library, where I found companies whose stock prices weren’t in the newspaper. Studying those manuals gave me my first experience finding companies that were overlooked or mispriced.

Is finding mispriced companies still central to your approach?

Absolutely. Of course, the process of finding and analyzing companies has changed a great deal since those days. It’s harder to find inefficiencies and anomalies, although it’s relatively easier in small-cap because there are still companies that don’t have analyst coverage. Roughly 15% of the companies in the Russell 2000 Value and more than 13% of those in the Russell 2000 had little or no analyst coverage at the end of September. And in the mutual fund that we manage in the Strategy, Royce Small-Cap Special Equity Fund, almost 47% of the stocks had no more than a single analyst covering them at the end of the third quarter. So, we dig a little deeper than we used to, but we’re patient and are more than willing to do the necessary work to find what we think are attractively undervalued, mispriced small-cap companies.

Can you describe the importance of absolute value as a valuation pillar to your Strategy?

Although we work in a relative world, we operate with an absolute value mindset when selecting stocks. Our goal is an above-average risk-adjusted return with less volatility than our benchmark, the Russell 2000 Value Index. One of the key elements in trying to attain this goal is our focus on absolute value, which we define as a positive economic spread for a company. We search for companies that have a cap rate (conservatively defined as the lower of trailing or forward operating income over enterprise value) reasonably higher than the cost of financing as if we were acquiring the entire company. This spread creates economic value. Our absolute valuation approach creates a powerful, self-governing mechanism in that the spread determines our activities buying and selling stocks, along with the resulting cash position. One example of how this absolute value approach worked in the past was how we built a cash position through the first three quarter of 2018 and then, in the fourth quarter, the mechanism signaled that we should invest heavily. We had a similar dynamic in early 2020, when the pandemic caused absolute value to return to the market.

What is your outlook?

I'm in the minority here at Royce, but I don’t see the current moment as an opportune time to buy stocks, though there undoubtedly will be at some point. In the short run, I suspect that we’re headed towards higher levels of market volatility than we have recently seen. Perhaps then investors will look at both returns and the volatility experienced in achieving them. Should they do so, we believe Special Equity will prove worthy of their consideration. We continue to believe that our investment approach, which I have been steadfastly applying for 44 years, can provide rewarding returns with lower volatility over the long term, despite periods when our performance lags. In the current environment, our self-governing mechanism has led us to a higher cash position, which we look forward to putting to work when opportunities arrive.

Important Disclosure Information