Modeled after Royce Premier Fund, which is managed by Chuck Royce and one of our oldest (and primarily domestic) Funds, Royce International Premier seeks to own non-U.S. companies that meet a very specific set of investment criteria. Portfolio Manager David Nadel and CEO Chuck Royce talk about the portfolio's investment strategy and the types of businesses we want to hold for the long term.
Chuck Royce (Trades, Portfolio): David, it is a pleasure to talk to you about Royce International Premier Fund. Tell us a little about the history of how this fund got started.
David Nadel: International Premier was inspired by Royce Premier Fund, and the idea that Mark Rayner and I had with this fund was to focus on the classic compounder businesses—the companies that are creating total shareholder value through a combination of growth and the payment of dividends.
We have for some time been attracted to these world-class business models that have a high portion of recurring revenue, so annuity like structures, and/or business models that have a highly differentiated product offer. These types of companies, I felt, are capable of producing a-cyclical growth so that it's not necessary to kind of call the economic cycle, but you can stick with these businesses for years on end.
Chuck: There is a large similarity to what we do in the domestic Premier Fund. We would stick to that same type of company: high recurring income, companies with sort of very special moats, unusual characteristics, market position, etc. I'm thrilled that this is very similar. Give us an example of some of the types of companies that are in your portfolio.
David: There are many examples that I can give, I mean certainly in terms of companies that fit that kind of annuity profile or even a differentiated profile. One I would site is Spirax-Sarco. Spirax-Sarco is the global number-one provider of steam systems. Steam systems have nothing to do with steam engines. They are very current.
Chuck: Sounds old fashioned.
David: It's not old fashioned at all. In fact it has very nice organic growth and it's in very high demand, with about half of revenues coming from the emerging markets. Steam systems are used in things like pharmaceutical production. They are ten times the size of the number two in this market. They have consolidated services in the market. What's remarkable about the Spirax-Sarco (LSE:SPX, Financial) business model is that 75% of their revenue comes from aftermarket support and service—what in England would be called "spares and repairs." And we love businesses that have significant spare and repair components to them. In Spirax-Sarco's case, this is paid through the operating expense, OPEX budgets, of their customers, not even the CAPEX budgets.
I think one other feature you'll find that's in common with a lot of the companies that we hold, and we perhaps have been a little bit more explicit about this than the domestic Premier Fund, is we are really attracted to companies that delight their customers. As long-term investors, that is—we think—going to lead to the best shareholder value creation over time as opposed to shorter-term shareholder-focused decisions like share buybacks, etc.
Chuck: Terrific. There was a piece that the firm offered a few years back called "Quality Recognizes No Borders." Explain what that means.
David: I think it means a few things. There are a lot of very high-quality companies in the U.S., but at the same time you can find many markets outside the U.S. where there are an equal portion of really high-quality companies and, arguably, a few markets where there's maybe even a higher portion of high-quality companies. I would cite Switzerland as an example of that, where I cannot think of a market that has on a per square-mile basis, or per population basis, a higher concentration of world-class businesses.
Chuck: Give us an example of a Swiss company that has fit in the portfolio.
David: I guess there's a couple I would cite. One is VZ Holding (VZN, Financial), which is one of our top positions in the International Premier Fund. VZ Holding is a wealth management business, and they have essentially just simplified the whole set of services that a person would face as they're approaching retirement—everything from will creation to insurance, to succession issues, and of course wealth management—into one neat little package, and they have a very sticky relationship with their customers. We often look for stickiness in our businesses.
I guess another one I would cite is Burckhardt Compression (XSWX:BCHN, Financial). Burckhardt Compression has more than 100 years of history. They make reciprocating compressors that are used in things like the transportation of liquid natural gas. Something like 75% of the reciprocating compressers that Burckhardt Compression has made since its founding over 100 years ago are still in service. These are remarkably complex, very high price point things that take up the size of a small room in many cases. So when you think about the quality of the craftsmanship, those are things that you associate with markets like Switzerland.
Chuck: You have pioneered a quality scoring system. Tell us a little bit, briefly, how that works.
David: Enterprise Quality Scoring is a framework which allows us to assess in a consistent and kind of unemotional way the quality of businesses that we look at. The stock-selection process of the Royce International Premier Fund really is focused on, in the early stages, screening businesses and evaluating businesses for signposts of quality, and then the valuation piece is on the backend.
So Enterprise Quality Scoring is at the center of what we're doing in terms of quality assessment, and it covers five topics: sector dynamics, the competitive positioning of the business, the operational efficiency of the business—in other words its ability to translate revenues into cash flows—its financial track record, and then something we call "extras," and we call it extras because it forms a nice acronym that spells the word SCORE. But extras, really what that's about is things like corporate governance and shareholders' rights, which are particularly important in some markets more than others.
What Enterprise Quality Scoring deliberately excludes, and I think this is important for people to understand, is valuation because what it's meant to do is take the emotion out of assessing the quality of a business and to look at businesses as one asset at a time and to say, "If you could only own one asset, what sort of characteristics would you want in that business?" I bet what you'd want would be things like a-cyclical growth, high levels of cash generation, high barriers to entry, a real moat, a franchise that you can rely on.
A lot of the other things that attract people to stocks, if you will, instead of to companies, are often things like valuation, and we're, again with Enterprise Quality Scoring, trying to get past the pitfall that I think sometimes value investors can fall into where they are attracted to a statistically cheap company but then they have to justify that its quality is better than the market appreciates.
Chuck: How would our fund compare to the index in terms of qualitative metrics?
David: I think the International Premier Fund compares favorably to the index because the returns on invested capital (ROIC) on average for our holdings are in the mid-twenties, and the index is somewhere around 14%. But one thing to keep in mind with the index is that's arguably an inflated number because the holdings within the index include money losing companies, which of course have negative ROIC. Those are excluded from the calculation from ROIC whereas the ROIC average of 26% for our portfolio, I think, includes every holding that we have because I don't believe we have any money losing companies.
So I think those statistics compare quite favorably. People will often assume that ROIC are mean reverting. In other words, they're going to degrade to the cost of capital. I mean, certainly, The Economist magazine always preaches this theory and, you know, any finance professor would preach the same theory if they're in the efficient market theory camp. With the International Premier Fund we definitely do not believe that these extraordinary ROIC are going to mean revert. In fact we are quite confident that they're sustainable because of the unique attributes of these businesses that we're finding.
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 International Premier Fund may invest a significant portion of its assets in foreign companies which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, currency or other developments that are unique to a particular country or region. These risk factors may affect the prices of foreign securities issued by companies headquartered in developing countries more than those headquartered in developed countries. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund's investment in a limited number of stocks may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any 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.) Return on Invested Capital is calculated by dividing a company's past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock). The portfolio calculation is a simple weighted average that excludes cash, all non-equity securities, investment companies, and securities in the Financials sector with the exceptions of the asset management & custody banks and insurance brokers sub-industries. The portfolio calculation also eliminates outliers by applying the inter-quartile method of outlier removal. Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
