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Royce Funds Commentary - An Inside Look at How We Evaluate Stocks

September 09, 2013 | About:
Holly LaFon

Holly LaFon

255 followers
At Royce we employ a business buyer’s approach to investing, a perspective which allows us to look at the long-term value of a business, not just its stock price.

Through this process—combined with our more than 40 years of investing in small-caps—we have had the opportunity to both own businesses that we believe best represent our philosophy and work with companies that share a similar process and goal of compounding wealth over a long-term time horizon.

Our investment approach can be traced back to 1972, when Co-CIO Chuck Royce assumed management of Pennsylvania Mutual, our flagship fund. During this time period Chuck’s investment philosophy began to take shape, eventually laying the groundwork for those funds that would follow.

Rooted in this tradition is a discipline that centers on a business buyer’s approach to investing, which surveys the entire universe of micro-cap, small-cap, and, at times, mid-cap companies for underappreciated and mispriced businesses.

Contrary to a “Wall Street” approach, our absolute value orientation—combined with a long-term investment horizon—attempts to understand and evaluate businesses, not to imitate a benchmark or follow short-term trends. From this perspective, we concentrate our efforts on trying to determine what a company is worth and what a private buyer might pay for the entire enterprise.

Our approach focuses on understanding a company’s structure, the sustainable or competitive advantages that it possesses, its future prospects, and the ability of the management team to guide the business going forward.

Companies that meet our criteria for long-term, multi-year holding are harder to find but do exist throughout the small-cap universe, and when we’re fortunate enough to find one, we hope to hold them for as long as they continue to live up to our investment requirements.

Embodying the spirit of our process is a company whose shares we first bought during the summer of 1998 but that we have held continuously since 2003—Florida-based SEACOR Holdings. SEACOR has since become a long-term position, as of June 30, 2013, in Royce Pennsylvania Mutual, Total Return, 100, Heritage, Premier, Select Fund I, Enterprise Select, andPartners Funds, as well as in Royce Value Trust.

We think that our experience with SEACOR offers a particularly useful example of how our company evaluation process works.

Our Introduction to SEACOR Holdings

While at first only tangentially familiar with its business, we became better acquainted with SEACOR through another company that we owned at the time—Chiles Offshore, then a limited liability company that owned a small fleet of jack-up rigs used in offshore drilling. SEACOR was one of their founding investors.

When we started to look at SEACOR, we noticed that it was an active repurchaser of its own shares and that, at the time, its stock was trading below book value. The company also had plenty of cash on hand to pursue opportunities. We also saw that it had a conservative balance sheet, as well as other characteristics that attracted us.

Understanding the Core Business

SEACOR’s core business is offshore marine, supplying boats that service and transport equipment to offshore oil rigs. Today it owns, operates, invests in, and markets equipment primarily to offshore oil and gas companies.

In the early 2000s SEACOR entered the inland river barge business, which resembles offshore marine. Like a lot of well-run businesses, the company achieved a competitive advantage by expanding into a market with few established competitors.

The inland barge industry at the time was one starved for capital as fleets were growing old and becoming increasingly inefficient in terms of the energy and technology that they were using. Competitors were scrapping boats, and the business had grown outdated. In the early 2000s, SEACOR was able to take market share by building new barges and negotiate attractive pricing with shipyards that were hungry for business.

In fact, throughout its history SEACOR has taken advantage of changing and often depressed markets by using its expertise, capital, and long-term investment horizon to capitalize on an inefficient market, which is precisely what we attempt to do when we select stocks.

Building Core Competency

Through its investments in offshore marine and inland barge, as well as through its relationships with oil companies operating offshore production platforms and exploration drilling rigs, SEACOR turned its attention to another under-managed and under-capitalized business: offshore aviation.

Once again we watched SEACOR enter a business that had aging fleets and that needed capital for new equipment, the latter being crucial to an industry where safety is of paramount importance. By once more expanding its reach to a similar business, the company had the chance to increase its competitive advantage and take market share.

Earlier in its history the company began investing in offshore safety cleanup, environmental remediation, and environmental disaster response companies—mostly mom and pop shops that had limited supplies of helicopters, boats, and booms—at a sizable discount.

April of 2010 saw a disaster of epic proportions: The Deepwater Horizon drilling rig explosion. When the disaster occurred, it revealed the extent of the infrastructure that SEACOR had put together. Because of their positioning and ability to respond, SEACOR became the main contractor for the cleanup, putting to use virtually every boat and helicopter that it had acquired from smaller companies it had previously bought.

We especially like management teams such as SEACOR that put their companies into a position to take advantage of opportunistic opportunities.

We also organize our investment efforts along the same lines by spending considerable time evaluating companies and industries that possess the characteristics that we like but whose near-term pricing is not to our liking. Having a long-term view, like that employed by SEACOR, allows us to deploy capital at more reasonable valuations.

Most of SEACOR’s businesses have not changed that much, but when the industry and markets begin to show signs of trending in a different direction or slowing down, the company has historically been able to adapt accordingly. For example, last year SEACOR acquired lift boats, which are vessels that sprout legs directly into the seabed floor, enabling it to drill a small oil well from the center of the vessel. During the 2009 downturn, SEACOR started buying railroad tank cars at very attractive prices much like how we like to buy businesses—when they are inexpensive.

Valuation Cyclicality = Opportunity

SEACOR’s management is anything but promotional; in fact, we like their modesty. They run the company a little bit like a private company in that they don’t give guidance, and they have very “lumpy” earnings, which is appealing because as long-term investors we seek to exploit inefficiencies created by highly variable quarterly earnings reports, or short-term price volatility, and that’s what SEACOR has.

In addition to the industry’s cyclicality and management’s reluctance to play the guidance game, there’s not a lot of sell-side coverage. There are very few—if any—research analysts covering SEACOR. We think that overall SEACOR is better understood by Wall Street than it used to be, but there are still opportunities to add to and trim our position on an ongoing basis. Our ongoing conversations with SEACOR’s management reveal the following:

  • They are talented allocators of capital
  • They invest in markets that don’t look terribly profitable at the moment and make investments that don’t show a lot of current profitability
  • They will sacrifice short-term profits for long-term profitability, particularly long-term capital gains
In our opinion, the management of SEACOR (CKH) behaves much like contrarian value investors, so it’s easy for us to understand and appreciate what they do. They are counter-cyclical thinkers who seek to extract and build competitive advantages from market dislocations.

At The Royce Funds, we love finding what we think are quality small-cap companies that we can own for years, like SEACOR, which we have owned for more than a decade. We regularly evaluate companies by meeting with management teams and analyzing financial documents.

Royce's portfolio managers and analysts meet with five to eight companies every day and continually share ideas in a search for companies with strong under-levered balance sheets, excess free cash flow generation, and the ability to self-finance.

Important Disclosure Information

The thoughts and opinions expressed in this piece are solely those of the person speaking and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. There can be no assurance that the security mentioned in this piece will be included in any Royce portfolios in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money.

Percentage of Fund Holdings as of 6/30/13 (%)

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future.

Royce Fund Services, Inc. is The Royce Funds' distributor and a member of FINRA and SIPC.


By Chris Flynn

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