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Charlie Dreifus: Dividends, Investing Across Market Caps, and Lessons from the Bear - Royce Funds Commentary

May 17, 2013 | About:
Holly LaFon

Holly LaFon

255 followers
As the economy continues to move forward in a near zero interest rate environment and fixed-income instruments—such as bonds—may be losing steam, Portfolio Manager and Principal Charlie Dreifus believes a revival in equities—propelled by dividend increases by companies that currently offer them—may be likely. Charlie also talks about applying his accounting cynicism to small- and large-caps and what he learned from surviving the bear market of 1973-74.

Why Dividends Matter

Among the reasons for a revival in equities are: investors have gotten tired of zero interest rates, investors have seen “smart money” do big deals, and investors see attractive yields, dividend increases, and buybacks.

For the first time in a generation, paying—and, even better, increasing—dividends has become important. While there is no assurance that companies that pay dividends now will continue to do so in the future, dividend payments are growing faster than they have in a very long time.

Investors have learned that management’s preference for acquisitions has all too often diminished value. Higher payouts, on the other hand, mitigate poor capital allocation. The continued movement toward higher payout ratios should help valuations and validate further the case for equities.

What ISI has referred to as a “sea change” in dividends—substantial increases in dividends by notable companies—adds to our dividend growth thesis. Zero interest rates have changed the landscape as to how investors view a firm’s capital structure and capital deployment.

Dividend policy is likely more important now than it ever has been in the entire history of U.S. equities.

As long as rates stay so low and returns on capital are considerably above that of cost of capital, M&A can occur. We still believe that a strategic acquisition (industry consolidation) makes sense as it remains one of the primary drivers of earnings growth. Synergies through such mergers can occur.

Within our portfolios are many candidates to be acquired. They are inexpensive, conservative, and have the balance sheet strength that is useful to the acquirer in executing the transaction.

The total cumulative market cap of U.S. equities is about one-third of the world’s and almost four-and-a-half times the size of the next largest market, Japan. Investors, if they are underinvested in equities, must look to the U.S. Further, we have yet to see the great rotation from fixed income into equities and are still in the infancy of such a movement. Among current market risks are a surge in gasoline prices, a failure to resolve our budget and tax policies, and an intensification of the eurozone crisis.

It appears that most if not all of the world’s central bankers are doing what Federal Reserve Chairman Ben Bernanke has done—when faced with the choice between inflation and deflation they will opt for inflation. If one is a skeptic, one is not only fighting the Fed but nearly everyone else as well. To attain positive real rates of return one must take risk, and the least risky option currently appears to us to be equities.

Small-Caps, Large-Caps, and Surviving a Bear Market

For all of the portfolios I manage, the screening mechanism and the discipline are the same.

One of my guiding principles is to try to find companies where the pricing is attractive (valuation is not extended) and the company has strong financial resources that allow them to maintain, increase, or hopefully consecutively increase dividends due to advantageous value-creating events, such as share repurchases, one-time dividends, etc.

Another key principle is the deep dive into accounting matters. There are far more small-cap companies than there are large-cap companies. Consequently, there are fewer large-cap companies that meet my metrics than small-cap companies.

Of course, most large-cap names are very well covered so it’s unlikely that I’m bringing much, if anything extraordinarily unique, to the table when looking at one of these large-cap companies other than the deep dive into accounting.

In fact, I often find that I see things in these larger businesses that have not been written about by the sell side—whether it’s been otherwise communicated or acknowledged on the buy side, I don’t know.

However, the pricing of the company may suggest to me that it’s underappreciated; that this company is more valuable than the market is giving it credit for because of factors that I’ve discovered when scrutinizing the accounting.

Because large-cap companies tend often to be serial acquirers, they are often serial goodwill and impairment write-off victims—and they’re typically more aggressive in share repurchases—so their equity in relation to total assets is generally lower than it is for small-caps.

Everyone thinks that small-caps are more highly levered than large-caps, but taken as a group, I’ve found that the reverse is actually true.

The past five years have been very challenging. As I look back on 2008, I think I had an advantage by having lived through the bear market of 1973-74 as a petroleum analyst.

What I learned to do in those days was to dollar-cost average and buy on the down days; on days when the market went up, I generally wouldn’t buy because we were probably going to get another down session soon.

Of course, when the market finally makes its bottom, as it did on March 9, 2009, you may not have invested as much as you might have had you somehow known that that was going to be the day.

However, the level of conviction is higher and ultimately among the things that drive performance is the conviction of the portfolio manager in what her or she is doing and the names that her or she owns.

Important Disclosure Information

Charlie Dreifus is a principal and portfolio manager of Royce & Associates, LLC. Mr. Dreifus's thoughts in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. No assurance can be given that the past performance trends as outlined above will continue in the future. There can be no assurance that companies that currently pay a dividend will continue to do so.



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