Managing Director and Portfolio Manager George Wyper talks about the changes he’s been making to the portfolio of Royce Focus Value Fund since 2013; the company fundamentals he values most as an investor; and why he typically likes it when a company buys back shares.
What changes have you been making to the portfolio of Royce Focus Value Fund since 2013?
I made changes throughout 2013, which helped to generate higher-than-usual portfolio turnover. A few months ago, I began to do some intensive research in order to reposition the portfolio in a truly differentiated way by emphasizing a few key themes.
My selection criteria are quite similar to the high-quality approach that Royce has traditionally employed. More recently, however, I’ve been emphasizing companies with what I see as particularly skillful capital management in value creation.
As many studies have shown over the last several decades, companies that consistently repurchase their own shares tend to outperform the averages by a considerable margin, irrespective of market capitalization.
My ideal company would generate enough capital to both grow its business and return capital to stockholders through meaningful share buybacks and a modest dividend.
This would allow me to own an ever-increasing share of the business while also leaving more cash to invest. As the largest investor in the Fund, I particularly appreciate that this is a long-term, low-turnover strategy.
What company fundamentals and other attributes do you value most as an investor?
The companies that I like most are those that can successfully grow their business and shrink their float by using internally generated capital. I also look for companies that operate in industries that have strong secular tailwinds, which allow for a long runway of success.
Historically, I’ve found many companies that fit this description in areas such as energy, food, entertainment, and technology. But it’s important to point out that this is not a sector or industry phenomenon; it’s a management-specific attitudinal approach to creating long-term value.
I also take comfort knowing that in weak markets the company is buying back its discounted stock while increasing my ownership stake.
What does it tell you when a company is buying back shares? Why is it important for your investment thesis?
It tells me that management is focused on the metric of increasing value per share and not just building a bigger enterprise.
Don’t get me wrong, I want the manager to build a bigger business if it is creating value in the process, and with the right management it often is.
In fact, if a company’s stock gets way over valued, I support the practice of using it as currency for an acquisition, expecting to buy it back cheaper at a later date.
Buying back stock is not the only arrow in management’s quiver, but understanding the thought process, valuation metrics, and hurdles that are considered illustrates how some managements view the precious resource of their capital.
What are some of the risks involved in buying stocks when the company is repurchasing shares?
There are three principal risks: first, the company may consistently over pay; second, it exhausts the capital it will need later; and third, the business borrows excessively to repurchase stock, and the leverage kills them.
I always want the company to be smart about share buybacks. Ideally, it buys in its stock when it’s cheap.
However, the company may not always have that opportunity, at least not on a consistent basis. Even then, I don’t want to see the company, as Peter Lynch used to say, "Di-worsify" and then harm the rest of the enterprise.
And I really don’t want the company to use all its capital only to be left with none to take advantage of future strategic business opportunities.
Historically, some of the worst offenders in the universe of companies repurchasing their shares have been companies in highly cyclical areas.
Often, when the cycle is strong and they are flush with cash, they’ll repurchase shares at the peak before needing to raise capital during the next downturn—buying high and selling low in effect.
Long-term share repurchase programs have been variously described as going-private-slowly plans or a tontine. This latter term refers to the annuity/savings programs of the Seventeenth Century whereby subscribers contributed to an investment fund on day one and the last living member received all the money.
Similarly, if I find a great company that is consistently buying in its shares, I'd want to own the last share so I could own the entire company.
What do you make of the current market’s behavior so far in 2014?
I’d say the market's activity so far in 2014 reflects the fact that stocks have been strong for five years and that the world is seemingly becoming even more unsettled.
Valuations are not currently as compelling as they were just a couple of years ago, which is not to say there aren’t good values still in the market. There are enormous amounts of cash on many companies’ balance sheets.
Along with more muted global growth, this has led to a sharp rise in M&A activity. In the last two months alone $1.7 trillion worth of deals have been announced. Tellingly, the stocks of both companies involved have risen in many cases.
Growth and shareholder value creation are increasingly the result of M&A, as top-line growth continues to be hard to come by.
Near-zero interest rates have supported the ever-increasing search for yield. The junk bond index currently trades at the old passbook saving rate of 5%.
This is shocking given the questionable balance-sheet quality of many of the companies. But the search for yield remains fierce. Companies that can support a decent and rising dividend are rewarded.
What are the most important things you try to learn from management when you meet with them?
I want to understand their game plan for growing the value of their enterprise and what they think their competitive advantage is.
Management has many levers and options at their collective fingertips, including the introduction of new or enhanced products and services, the use of new technologies, improved marketing strategies, acquisition or divestiture, seeking to benefit from the state of their competitive landscape, better relations with customers and suppliers, a more effective approach to capital management philosophy, and the exploitation of areas where they believe the best opportunities lie.
How has the company valuation process changed over time?
It hasn’t really. The evaluative metrics have stayed the same, although if I meet a management—and often it is a new management—and there is a fundamental shift in how they view the capital management strategy of the business going forward, I might pay up a bit for the stock. But for the most part, the metrics I use haven’t changed.
The key, as always, is to find the right team at the helm that shares the same philosophy as how to create value—then get out of the way and let them execute.
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 companies that currently pay a dividend will continue to do so in the future.
This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Royce Focus Value Fund may invest primarily in micro-cap, small-cap, and mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 35% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.) In addition, as of 3/31/14 the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.)