“Whenever one of these wonderful small companies has a hiccup, blows up, gets the flu, something that isn't crippling but definitely interrupts the flow, that sets up opportunities.” –Â Chuck Royce
Among the investors who make it to guru status, Chuck Royce (Trades, Portfolio) is one of the few who does it with small-caps (or at least predominantly small-caps). Another small-cap investor who’s made the GuruFocus Scoreboard is Mariko Gordon (Trades, Portfolio); she worked for Royce before starting Daruma Capital.
As his firm, Royce & Associates, has grown, Royce has expanded his horizons to micro- and mid-cap stocks. He’s also expanded beyond the homefront to set up international funds that use the same formula to find promising small-caps beyond America’s borders.
While Royce considers himself a value investor, he says his top priority is risk management, or the preservation of capital. To find promising candidates that can double in market value over three to five years while managing risk exposure, the guru has an established investing philosophy, strategy and tactics.
Who is Royce?
Charles Morgan Royce, known as Chuck, entered the investment industry after receiving Bachelor of Arts and Masters of Business Administration degrees.
After serving as a security analyst at Blair & Co., and as director of research at Scheinman, Hochstin, Trotta, he purchased Quest Advisory Corp. in 1972. With that, he became the manager of Pennsylvania Mutual Fund, his first solo fund.
The company changed its name to Royce & Associates in 1997, and in 2001 he sold the firm to Legg Mason while retaining independent control.
With his acquisition of the Pennsylvania Fund (later the Royce Pennsylvania Fund), he shifted his attention to small-caps and the downside protection of assets. In the 2000s, and perhaps because of a capital infusion from the sale to Legg Mason, he began to develop global and international small-cap mutual fund portfolios.
In 2014, at age 74, he stepped down from his administrative roles at the firm but did stay on as a fund manager and stock picker.
What is Royce & Associates?
The company, which is also known as The Royce Funds, calls itself a "pioneer" in small-cap investing with more than 40 years in this niche.
Assets under management (AUM) totaled $17.6 billion at the end of calendar 2016, according to its Web site; it also reports that total includes $126 million invested by its officers and employees.
Based in New York City, it is an "affiliate" of the global investment management company Legg Mason, which has an AUM of $728 billion.
The fund family comprises 22 funds in four categories: U.S. Equity, Global/International Equity, Closed-End and Annuity Funds. The first category includes the Pennsylvania Mutual, which got Royce started on his own, and the Premier Fund, which is tracked by GuruFocus.
The Premier Fund is described, in its fact sheet, as being made up of “premier” companies with market caps from $1 billion to $3 billion at the time of investment. These companies are expected to have identifiable competitive advantages, high capital returns and a moatlike franchise.
In addition, they are what Royce considers leading quality companies, firms with low debt, generating excess cash flow and bright prospects. These candidate companies should be available at prices that do not reflect these attributes.
The fact sheet says the Premier Fund has beaten its benchmark, the Russell 2000 Index, in 99% of all monthly rolling 10-year periods for the 20 years ended March 31.
Looking at all U.S. Equity funds, average annual 10-year returns (among funds that have existed at least that long) vary from 2.76% for the Low-Priced Stock Fund to 8.13% for the Special Equity Fund.
The Royce investment strategies
According to the firm’s Web site, all funds share three key criteria:
- They take an active approach, based on bottom-up and risk-conscious fundamental research.
- All are run by experienced small-cap managers.
- Managers all have significant holdings in the funds they run.
Within that overall strategic framework, different funds take different tactical approaches, based on investment styles (focusing on attributes such as valuations, quality of companies, and growth potential). In addition, styles reflect market caps, volatility levels and approaches to risk management.
Three styles encompass all Royce funds:
- Value: attractive valuation is one of the primary criteria, with an emphasis on companies that trade at a deep discount to what Royce managers believe the business is worth. They refer to “statistically inexpensive companies with low price-book (P/B) or price-sales (P/S) ratios.”
- Core: Within this segment, they take two approaches: one focuses on high-quality companies with established, sustainable returns while the second combines value and growth strategies with high quality companies.
- Growth: Companies with high growth potential because of organic revenue growth; these businesses will be part of a growth theme or growth trend and will have sustainable moats.
Turning to market caps, Royce and team target three categories:
- Micro-Cap: Capitalization of less than $1 billion, which provides a universe of more than 3,200 companies.
- Small-Cap: Capitalization of less than $3 billion, which offers a universe of more than 4,000 stocks. The firm notes as well that these companies have more research coverage and more liquidity than micro-caps.
- Small/Mid-Cap: Capitalization of less than $15 billion and a universe of more than 4,800 stocks. This group includes many established businesses with profitable histories.
Why small caps? They explain at the firm’s Web site that Royce had two key insights in the early 1970s, as he went into the investing business for himself:
The first was that preserving capital was critical; strong absolute returns were possible over periods of three years or more if the strategy lost less during downturns while staying competitive during uptrends.
The second insight was that this type of approach would work with small-caps, and possibly work even more effectively in small-caps. Royce is quoted as saying,
“The theory is that this is a historically inefficient area, that there’s less broker research, there’s less institutional interest, that people tend to sort of come and go, and it sets up tremendous opportunities from time to time, and that over the long term, possibly, you can get a higher return, maybe 100 basis points or more.” –Â Quoteswise.com
Turning to the question of value, Royce has these trenchant words: “It's a much-abused word. Nobody would claim to be a nonvalue investor. It is certainly not the opposite of growth. From our standpoint we are looking at the intrinsic value of the company as an ongoing enterprise.” (Quoteswise.com)
At ValueWalk’s Charles Royce Resource page, it is noted that while Royce may call himself a value investor, he does not consider the word appropriate. He prefers to think of himself as a risk manager, a manager who targets outperformance with lower-than-average risk levels. It also notes that Royce and his managers aim to bring in 100% returns over a three- to five-year period.
Royce’s name is nearly synonymous with small-caps, and that’s generally true. As the firm has grown, his field of vision has expanded to include micro- and mid-cap stocks. Whatever the size of candidate companies, though, they are all subjected to the same broad, bottom-up, fundamental research. Out of that research comes companies that are expected to generate outsized returns with less-than-average risk.
Current holdings
From a sectoral perspective, Royce’s biggest holdings are Industrials, Technology and Consumer Cyclicals:
This list, from GuruFocus, shows the top 10 holdings in the Premier Fund:
- Cognex Corp. (CGNX, Financial) 0.87%.
- MKS Instruments Inc. (MKSI, Financial) 0.84%.
- Children's Place Inc. (PLCE, Financial) 0.84%.
- AVX Corp. (AVX, Financial) 0.84%.
- Gentex Corp. (GNTX, Financial) 0.82%.
- Valmont Industries Inc. (VMI, Financial) 0.78%.
- Lincoln Electric Holdings Inc. (LECO, Financial) 0.78%.
- Landstar System Inc. (LSTR, Financial) 0.76%.
- Copart Inc. (CPRT, Financial) 0.75%.
- Cooper Tire & Rubber Co. (CTB, Financial) 0.75%.
With no individual stock in the top 10 representing more than 1% of the total portfolio, it’s clear that Royce does not run on concentrated picks. We note as well that, all else being equal, a small-cap fund is more likely to hold many names than a larger-cap fund.
Performance
This table shows that while Royce underperformed the Standard & Poor's 500 on three- and five-year cumulative returns, he did outperform on the 10-year:
GuruFocus information shows him beating the S&P 500 on longer cumulative periods (in brackets):
- 15 years: 10.1% per year (3.4%).
- 20 years: 10.7% per year (3.0%).
- 25 years: 11.5% per year (2.4%).
While all GuruFocus gurus are benchmarked against the S&P 500, Royce & Associates benchmarks the Premier Fund against the Russell 2000 and, as noted, says it has outperformed that metric in “99% of all monthly rolling 10-year periods for the 20 years ended March 31.”
Royce has proven that small-cap funds, including actively managed small-caps, can beat the S&P 500, too. Of course, investors who have taken up Royce’s Premier Fund have had to endure some drama to achieve those returns, with occasional losses over the years.
Conclusion
Royce has found success in a niche ignored by most mutual and hedge fund managers: small-cap stocks.
He makes the argument that staying with smaller companies offers several advantages, including the potential to deliver up to 100 basis points (1%) of additional return.
Royce’s strategy, though, resembles that of gurus who focus on larger companies, including the giants that dominate the S&P 500. That strategy is to do bottom-up, fundamental research that identifies good companies or companies with above-average potential, available at discount prices.
His results show he has mastered this combination of strategy and capitalization with long-term results that have enriched his investors.
This article is one in a series on the investing gurus: David Tepper, Prem Watsa, Bill Ackman, Seth Klarman (by Rupert Hargreaves), Chuck Akre, Vanguard Health Care Fund, Yacktman Focused Fund, Jerome Dodson, Frank Sands, the Eaton Vance Worldwide Health Sciences Fund, PRIMECAP Management, Daniel Loeb, Bill Nygren, Mariko Gordon, David Rolfe, Mairs & Power and John Paulson.
Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.
