We are thrilled to be celebrating the 40th anniversary of Chuck's management of our flagship portfolio, Royce Pennsylvania Mutual Fund.
Our rich history traces its roots to the late 1960s, when current President and Co-Chief Investment Officer Chuck Royce was working as the Director of Research at Scheinman, Hochstin & Trotta, where one of his responsibilities was acting as a consultant for a mutual fund portfolio then known somewhat more simply as Pennsylvania Mutual Fund.
In November 1972, he bought the Fund's investment adviser, Quest Advisory Corp., and took on sole management of the portfolio. (Quest Advisory was renamed Royce & Associates in 1997.) Please join us as we take a decade-by-decade look at the firm and the markets over the last 40 years.
How the Process Began…
The story of the stock market of the early to mid-70s is likely to sound eerily familiar to a contemporary reader. Its hair-raising volatility, accompanied by a level of economic uncertainty unseen since the Great Depression, conspired to break the spirit, if not the bank account, of many equity investors, including those in small-cap stocks. Between 1969 and 1974, small-caps suffered some of their worst losses since the ‘30s.
Losing substantial amounts of money led some to the idea that safer, more stable investments were preferable. While today's investors have been flocking to bonds and money market funds, the years preceding 1973 saw a marked preference for larger, higher-profile stocks on the idea that they were less risky and more likely to be profitable.
The result was what has come to be known as the "Nifty Fifty" market, in which it was hoped that a small group of large, mostly multinational firms would usher in a Golden Age of "risk-free" high returns. It was not the first or the last time that dreams of investment Utopia seduced some, while cooler heads in the market shook in bemusement. And of course not all investors were ready to abandon small-cap stocks even as a sizable consensus held at the time that the safest and surest route to growth was via blue-chip names.
However, by the end of 1973, the "Nifty Fifty" had gone bust, while the U.S. economy entered a period of stagflation, in which inflation and recession inflicted such a high degree of double unhappiness that a new economic indicator was born—the Misery Index. Investor confidence was rapidly eroding, a process made worse by the Vietnam War, Watergate, and nationwide gas shortages, all of which combined to throw the country into a trying period of self-doubt.
During this confusing and difficult epoch, the cornerstone of Chuck's investment philosophy began to take shape. Two insights were crucial for developing the disciplined approach that we still use today. First was the idea that preserving capital was as critical to successful long-term growth as growing it. An investment approach that lost less during downturns and remained competitive in more bullish periods could provide very strong absolute returns over periods of three years or more, while also being likely to best its benchmark over these same long-term time spans. The second insight was that such an approach could work in the small-cap asset class. Indeed, it could potentially work more effectively there than in other asset classes because of the inefficiency and related lack of institutional attention paid to smaller companies.
As the decade went on, Chuck's goal became clear—to find small-cap stocks that looked greatly undervalued relative to his assessment of their value as a business and then wait patiently—sometimes years—for other investors to recognize the qualities that we saw in a particular business. In this way, he sought to minimize portfolio risk without sacrificing long-term performance.
This discipline grew directly out of Chuck's own experiences with high-growth stocks across asset classes. In those dismal, bearish years of 1973-4, he endured demoralizing declines when the "Nifty Fifty," along with much of the rest of the market, crashed violently to earth. Reasoning that there had to be a better—that is, less risky—way to invest in equities, the aforementioned insights followed.
By mid-1974, Chuck found himself among a small handful of managers who were willing to invest primarily in lesser-known, small- and medium-sized companies (as they were often described then). This was an asset class where few others believed that conservatively capitalized, financially strong companies existed. Bucking the consensus view, Chuck sought out small-caps with attractive balance sheets, high internal rates of return, the ability to generate free cash flow, and long-term earnings records.
Yet Chuck soon developed the conviction that conservatively capitalized, well-managed small companies could be attractive investments. This belief gained strength from the fact that small-caps were (and are) more flexible and possessed better growth potential. He also felt that smaller firms were more likely to have congruent management and shareholder interests. Generally being less well known than larger stocks, small-caps seemed less likely to be properly priced by investors.
While none of this would surprise an investor in small-cap stocks today, in the early- to mid-‘70s, these ideas were seen as radical and possibly foolish. Conventional wisdom held at the time that most small-cap stocks were worth the risk only if they were fast-growing, "baby blue" companies that might swell in cap size to become the next Xerox (NYSE:XRX) or IBM (NYSE:IBM). (The latter's nickname of "Big Blue" inspired the "baby blue" sobriquet for hot small-cap issues.) Few seemed interested in the quietly successful wallflowers that were garnering Royce's attention.
Another significant obstacle that small-caps faced on the road to asset class respectability was their reputation, borne out by history, for higher-than-average levels of volatility. For many investors, the attractive return potential of these stocks has been more than offset by their often higher level of risk. Chuck's insistence on financially strong small companies—those with little debt, ample cash, and high internal rates of return—marked an attempt to reduce some of the volatility inherent in small company investing, as did his refusal to purchase shares of a company at anything less than a sizable discount to his estimate of its worth as a business.
The goal was to effectively reduce risk without sacrificing long-term returns. He also recognized a potential benefit to the high volatility of the small company sector. A volatile market can drive share prices down to considerable lows just as easily as it can float them up to unreasonable highs. He saw each extreme potentially working to the portfolio's advantage, one that would allow him to buy as prices fall and the other to sell as they rise.
Our sights have always been trained on inefficiently priced companies, those that, for any number of reasons, were undiscovered by, or out of favor with, the market as a whole. To this day, we attempt to understand and value a company's "private worth"—what we think a business would sell for in a private transaction between rational, well- informed parties. If a given stock has the financial characteristics our discipline requires, and is selling at a discount of 30% or more to our estimate, it becomes a potential purchase candidate.
Recognition Begins—The 1980s
Chuck continued to refine and evolve the firm's signature disciplined investment approach. By the dawn of the decade, he was not alone. In 1978, Tom Ebright joined the firm and began to assist Chuck in managing the Fund's assets. Perhaps equally important was his role in spreading the news about our approach and its success. Tom proved to be as effective an advocate for the validity of our take on small-cap value investing as he was adept at stock selection. The result was a gradually growing awareness about the work in which the firm was engaged.
Big Changes for Small-Cap—The 1990s
During the ‘90s the small-cap sector grew more popular while the parameters of what constitutes small-cap expanded by the middle of the decade to include companies with market capitalizations up to $1 billion. Early in the decade, we began to observe that the small-cap market was bifurcating into two distinct sectors based on capitalization. What we learned from these observations had a profound and lasting effect on the way that we structured our portfolios going forward. The contours of this shift remain in place, even as the market cap ceilings have risen over the last 20 years.
We call the upper tier of this investment universe small-cap; today it encompasses companies with market caps between $750 million and $2.5 billion. This area possesses all the attributes of a professional asset class: a higher level of institutional attention, strong price efficiency, and substantial competition among investors. In the early- to mid-‘90s, we developed the conviction—still in place today—that a more concentrated approach, which amounts to taking more specific stock risk, is most appropriate in this range of the small-cap market.
The lower tier we refer to as micro-cap. It includes companies with market caps up to $750 million. Today's micro-cap asset class more closely resembles yesterday's small-cap asset class: a thinly researched, inefficiently priced, somewhat volatile sub-sector whose numerous issues generally go unnoticed by institutional investors, but one that offers substantial opportunities for long-term investors. There are greater trading difficulties and liquidity constraints with micro-cap companies (just as there were historically with small-caps overall); therefore, we believe that broad diversification remains the appropriate strategy in the micro-cap space.
Bubbles and Troubles—2000-2009
Arguably our most challenging decade, these years were distinguished by the extraordinary Internet bubble, the horrific events of 9/11, a real estate crash, and the worst global financial crisis since the Great Depression. In something of a paradox, they were also the period of the greatest asset growth for the firm, as we moved from total assets under management of $3 billion on December 31, 1999 to $35 billion on December 31, 2009. Other changes were equally significant.
The emergence of distinctive performance patterns for small-cap and micro-cap stocks first began to play a major role in the way that we structured portfolios and thought about the small-cap world as a whole in the 1990s. In the ensuing decade, there were two major developments. First was the acceptance of small-cap investing as a professional asset class, especially on the part of institutions.
The second major development was internal. As a firm, we began to devote more time and resources to non-U.S. companies. The number of opportunities in micro-cap and small-cap companies across the globe is increasingly vast, with more companies to choose from and greater total market capitalization than exist in the U.S. We believe that these factors present substantial opportunities to find quality businesses that are mispriced. In addition, the global marketplace generally offers higher dividend yields—an important component of total return.
Opportunities and Challenges—2010-2012
Unfortunately, the recovery proved weaker than desired. Large numbers of investors have been choosing to get out of equities, and stay out, resulting in a large-scale capitulation that has rivaled anything we have seen during other bearish periods, when results were far worse.
In such an unprecedented time, patience is especially critical. Indeed, the ability to be patient is probably the single most important quality that an investor who seeks strong long-term returns can possess. It is easy to talk about the importance of patience and discipline when markets are solid and portfolios are doing well. Yet at some point, these things will change, and both will be tested, as they have been in this market. It has been a very difficult time, but we believe it will pass. When it does, our disciplined approach will remain and, we believe, be effective.
As we celebrate 40 years of small-cap value investing, we look back at what we have seen. Through all manner of markets—many of which were thought to establish a "New Normal"—we have never wavered in our convictions. We still believe that equities remain the best way—maybe the only way—to beat inflation and build wealth over the long term. We are confident that we can create portfolios that can grow commendably; especially in the more historically typical market climate that we believe we are beginning to see in the second half of 2012.
The Royce Funds Today
Back in the 1970s the time was right for a manager to implement a new strategy; Chuck merely took the lessons he had learned over the years and applied them in an area where few others had thought to try. Today, small-cap is an established asset class and value investing within the sector is one of the more popular investment styles, thanks in part to accidental pioneers such as Chuck Royce.
Royce & Associates offers today's investor 40 years of experience coupled with an ongoing commitment to an investment style founded on consistency and discipline, one that emphasizes building long-term returns while reducing risk. In our early days, Chuck single-handedly managed one portfolio worth approximately $1 million. Today our firm includes more than 20 investment professionals who manage more than $30 billion. As it has been since the beginning, our goal is to provide the very best in value-oriented small-cap investments, both here in the U.S. and abroad.