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Chuck Royce Commentary - 'The Lessons of 40 Years'

February 27, 2013 | About:
Holly LaFon

Holly LaFon

258 followers
Forty years after surviving the bear market of 1973-74, Co-CIO Chuck Royce continues to stand by the same disciplined value investment approach he cultivated following its aftermath. As equities continue to rally after a solid 2012, we look back at three major lessons that have brought us to where we are today.November 2012 marked the 40th anniversary of Chuck Royce's management of Royce Pennsylvania Mutual Fund. Forty years is a long time to do anything, of course, so this happy and momentous event has naturally focused our attention on what we have learned from managing portfolios with a small-cap value orientation. More precisely, we thought about what the most significant lessons have been over four full decades in the mutual fund business. Ultimately, three ideas made it to the top of our list.

The first is the importance of managing risk. Chuck's formative years running the Fund coincided with the severe bear market of 1973-74, precipitated by the fall of the "Nifty Fifty," a group of well known large-cap stocks that had previously been thought to be almost impervious to major market corrections (it would not be the last time a group of stocks earned, and lost, that kind of lofty reputation). Chuck's portfolio shed value as dramatically as most others. The bear market recalled to him one of the central lessons of value investing, one that became integral to his own burgeoning approach—capital preservation is as critical to building strong returns as capital appreciation.

As the Fund began to recover from the bear market near the end of 1974, Chuck began to concentrate his efforts on finding what he thought were well-managed companies with the financial strength to withstand adversity. A set of criteria soon emerged that he wanted in each portfolio holding. This list included a strong balance sheet, high returns on capital, and the ability to generate free cash flow. He reasoned that companies with these attributes had what it took to better hold their value during difficult periods for the company, its industry, or the economy as a whole.

The second lesson in some ways grew out of the first. Chuck saw that small-caps, especially in the first two-and-a-half decades of his history with the Fund, were often vulnerable and volatile. Yet within the large and diverse small-cap universe were many conservatively capitalized, effectively managed businesses that performed very well, notably over full market cycle periods. These lengthier spans tended to smooth out some of the inherent volatility to which nearly every company in the asset class was subject to some degree. There was also a benefit to be drawn from seeing how a company performed in both up and down markets, an observation he quickly extended to his own approach. Many styles did well in up markets; others held up in downturns. Chuck wanted an approach that could potentially excel through both up and down phases—through full market cycles, in other words. He decided that an approach that did better in down phases while remaining competitive on the upside would work best in trying to meet that objective. This is how the firm's emphasis on long-term returns became crucial.

From this came the importance of patience and absolute returns. Stressing long-term results has often meant that our Funds were out of sync with their benchmarks over short- and/or intermediate-term periods. It also meant that, even when the Funds outpaced their respective benchmarks over market cycle and other long-term performance periods, we still care most about absolute returns. We thoroughly enjoy outperforming our small-cap benchmarks, but we learned early in our tenure that one cannot eat from the table of relative results. Given the choice, we would much prefer doubling our investors'—and our own—money every five to seven years or so to the occasional victory over a small-cap index.

Anniversaries nearly always lead to a look behind, a gaze through life's rear-view mirror. As we engage in a review of what has mattered over the years, what pleases us most about our long-term record are the lives that our investments have helped to make better. Close behind is the realization that so much of what was important then remains important now—because it still works.

Important Disclosure Information

The thoughts in this essay concerning the stock market are solely those of Royce & Associates, LLC and, of course, there can be no assurance with regard to future market movements.


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