Steven G. McBoyle, CPA, CA, is a portfolio manager for Royce & Associates LLC, investment adviser for The Royce Funds. He manages Royce SMid-Cap Value Fund (with Whitney George) and Royce SMid-Cap Select Fund. Mr. McBoyle joined Royce in 2007. He was previously a Partner (2005-2007), Portfolio Manager (2004-2007) and Senior Research Analyst (2001-2003) at Lord Abbett & Co. Prior to that, he was a vice president, mergers & acquisitions, at Morgan Stanley (2000-2001). Similarly, he was a vice president, mergers & acquisitions, at Salomon Brothers (1997-2000). Prior to that, Mr. McBoyle worked at Deloitte & Touche (1990-1995). Mr. McBoyle holds a bachelor's degree from the University of Waterloo, Canada, and a Master of Business Administration from Columbia University. He is also a chartered accountant, with a degree from the Institute of Chartered Accountants in Ontario, Canada.
Can you give us a little bit about your background?
Steven: I joined Royce in the spring of 2007 with the purpose of building out Royce’s mid cap investing and obviously we did that by way of the launch of Royce SMid-Cap Value and Smid-Cap Select Funds.
A Bad time to start a fund.
Steven: Certainly during that time period it was difficult. On the one hand it feels like yesterday and on the other hand it feels like an investing lifetime. No better period in retrospect to test the defensibility of the smid-cap funds. Prior to Royce, I was a Partner and Portfolio Manager managing small- and mid-cap funds at Lord, Abbett and Company. They’re a large institutional manager. And prior to that, I was (what I like to refer to as) part of the dark side. I was a Vice President in the Mergers and Acquisitions department at Morgan Stanley.
I was about to guess an investment bank when you said the dark side!
Steven: Prior to Morgan Stanley I worked in a similar capacity with the M&A department at Solomon Brothers for a few years. And prior to Solomon Brothers, I worked as a Manager in the Accounting and Auditing department at Deloitte and Touche; both in the U.S. and in Canada where I am originally from. I hold a Bachelor’s degree from the University of Waterloo, which is the only School of Accountancy in Canada. I also hold an MBA from Columbia Business School.
How did you get into value investing?
Steven: Everyone is a product of his or her own environment. I was raised in a money-wise, value-conscious, Scottish home. Obviously that’s an oxymoron; stressing the word Scottish. At a very early age, my father taught me the value of money. Whether it was collecting golf balls on golf courses when we lived in Australia and then cleaning them up and selling them for profit, or collecting glass bottles at construction sites and then reaping the refunds, or my many part time jobs. All of those experiences drove me to appreciate numbers, arbitrage, and the ability to earn returns. Then my father introduced me to two annual reports at a very early age: Coca-Cola Companies and Berkshire Hathaway. The first one I understood pretty quickly given my age. In light of those experiences, there is no real surprise that I first became an accountant.
So besides your father, did anyone else have a large influence on your investment philosophy?
Steven: Honestly, it is impossible to point to any one or two specific individuals. Many have shaped it over the years. Obviously, I was deeply shaped by my father’s sense of value. Then beyond that, I had the good fortune of knowing Michael Burry at Scion Capital, at the very early period.
Before The Big Short: Inside the Doomsday Machine
, and before he became super famous?
Steven: Yes. Back in the mid 90s I knew Michael. Then I was taught by Bruce Greenwald and Joel Greenblatt while at Columbia Business School. And, through my investment career, I have had the good fortune of having some incredible working relationships with some wonderful mentors; Robert Fetch at Lord, Abbett; Whitney George, and Chuck Royce at Royce. And, of course while at Columbia Business School, I read everything there is on Warren Buffett and his business methods. I suspect over time I have drawn on elements of each philosophy.
What metrics do you use then for identifying potential investments (if any)? Price over book? Price over earnings? Free Cash Flow? EBITDA?
Steven: The overarching goal is to find quality at discount prices. The single best measure in my opinion of quality is return on invested capital. That is the bedrock of Royce. Companies that have the ability to sustain high returns on capital, both in the up and down cycles, implicitly are the companies that have distinct competitive advantages, strong barriers to entry, and are quite likely serving favorable industry dynamics. So return on invested capital is very important. Companies that have high cash generative abilities and have limited capital requirements are also ideal candidates. I like to say that the best companies are those that are a royalty on the growth of others, while requiring less capital themselves. We, as risk managers, also dislike leverage. We apply very strict tests in terms of balance sheet strength, which ensures that we are doing our job as risk managers.
Other portfolio managers from Royce stated the emphasis on ROC. So, once you have discovered something that looks very attractive, what is your next step? What is your process?
Steven: The process is all-important. I like to compartmentalize it into what I refer to as the art and the science of investing. Once we satisfy the metrics of a given company, what I call the science part, we spend a lot of time researching quality and asking questions like, “Is the company’s leading market share position sustainable? Does the company have pricing power? Does the company serve a favorable industry structure? (that is to say, is the company exposed to high supplier and customer concentration?) and are the customer prices inelastic? Also, if I were going to kill the business then how would I do that?”
Those are all the questions that we ask ourselves in terms of trying to determine if we are potentially looking at a franchise company. The process obviously involves many conversations with the company itself, the suppliers, vendors, and even sometimes regulators. The process is in-depth and involves the aggregation of much data with, again, the overriding goal of finding quality at temporarily depressed prices. As part of that process, one of the competitive strengths of Royce is that we have the luxury of holding an investment conference every day in our office. The access to management is truly unparalleled. I would say that on any given day we will have four to six companies through our offices. That’s a lot of management teams that you have the ability to interview, test your investment thesis on, inquire about industry dynamics and get the opinions of competition as well.
Can you mention more about the Art and Science of investing?
Steven: The science is simply screening quantitatively for all the metrics that we’ve discussed - return on invested capital, free cash flow, balance sheet strength, underlying capital intensity, and valuation. The hard part is the process of trying to determine whether you are dealing with a sustainable franchise or not. That is part of the art of investing. And, as I have mentioned, we think a lot about, “Is the company changing for the better? … is the industry changing for the better?” Implicitly, I spend a lot of time paying attention to change. Perhaps maybe an example is most helpful. This is obviously where I get excited - talking about stocks.
Take an example such as Lubrizol (LZ, Financial), which is somewhat timely. Lubrizol, (a top holding), is a specialty chemical company that for the last ten years and probably leading up to 2007 had operating margins of sub 10%. Sitting here today, Lubrizol has operating margins of greater than 20%. So it begs the question of what changed? Lubrizol’s business relates to lubricant additives largely; think of chemical polymers that are added to base oil by the big refiners and sold by the remarketers as engine oil. So when you get your oil changed, then you will be using Lubrizol’s products. Structurally during that last 10-year period, the lubricant additive market went through massive consolidation. Some 20 lubricant additive suppliers, like Lubrizol, consolidated to four. Of which today, we only have two that are not captive to the refiners. Likewise, on the remarketing side there was massive consolidation. The Amocos, the Castrols, the Texacos, the Pennzoils, the Quaker States, were all effectively acquired by large refiners. So you had massive consolidation within the industry. Then the refiners entered a massive down cycle in their core business and many of them turned to their lube additive business and started managing them as profit centers. So that was new. Then came $100.00 plus oil; which afforded all the constituencies in the engine oil food chain a very attractive pricing umbrella. All in, the industry became far healthier. Lubrizol, as a market share leader, benefitted from this. What was a three-to-four dollars earning per share company, all of a sudden is projected to earn upwards of $13.00. So the ability to identify this sort of change early is what I like to refer to as the art of investing.
Another example that fascinates me is the railroad industry. For years the railroad industry was a highly cyclical, highly capital intensive, over capacity, low return, highly regulated industry. In fairness, some of that remains true today, but most interestingly, is that for the first time in decades, the industry returned its cost of capital beginning in 2006 and has been showing incremental return on invested capital of some 30% for the last 5 years. So, again, it begs the question of what has changed and how could one have predicted it? It all starts with history.
The rails back in 1930 accounted for some 80% of all the freight ton miles in the U.S. versus some 40% today. In the mid 50’s, we had the construction of the national interstate system. The trucks, by the use of the public right of ways, were able to use this high speed, low density, interstate system. This gave the truckers a huge competitive advantage versus the rails. This dynamic since the 50s served effectively as a catalyst for the trucks to gain some 30 points of share relative to the rails over a 30-year period. Interestingly, during the early 80s to 2005 time period, the U.S. vehicle miles grew by some 100% while the lane miles declined by 6%. So the U.S. needs to add some (I think it is) 13,000 lane miles per year just to maintain today’s congestion level. Yet, as we know, most public highway funding is earmarked for repair and maintenance only. And then on top of that, the big catalyst, we had the passing of the Staggers Act, which deregulated the rail industry; it allowed the rails to competitively price their product and embark on service enhancing technology. So fast forward to today, and the rail industry is composed of seven Class 1 rails that account for some 90%+ of the industry (which is down from 40% in 1980); close to 50% of the nation’s freight movements are captive; rails are able to flex the model, quite effectively; the interstate today is low speed, high density; the rail service is competitive with on time service over 80%; rails have two to four times fuel efficiency advantage over trucks; and, the rails have pricing power. Again, all of that is allowing the rails for the very first time to exhibit underlying operating leverage.
So it’s a long winded answer, but I always get excited when we talk about industry dynamics, and rails are a fascinating example. It’s not necessarily a fantastic business model, but rails today are most certainly a great business model. With the ability to identify change, like Lubrizol or the rails early on, is what I like to refer to as the “art” of the investing.
How do you manage risk and how do you define it?
Steven: Risk is simply the permanent loss of capital. It is not an algorithm. It is not a number. It is the loss of capital. By executing our process, that is investing in companies that have high returns on capital, strong free cash flow characteristics, and stellar balance sheets, and buying these companies at depressed prices or at high implied earnings yields, we implicitly reduce risk. It’s as simple as that.
You have been managing small-cap and mid-cap funds for a long time. What’s unique and differentiates smid-cap, and why would an investor consider smid-cap?
Steven: As it applies to Royce, we have increasingly broadened our small cap investment universe over the years to mid-cap stocks. It’s only natural for Royce as a successful small-cap manager for over 35 years, that many of our small-cap companies have become mid-cap companies.
Why smid-caps as an asset class? The benefits are size, knowledge, and latitude. Performance with less volatility is just icing on the cake. The obvious advantage with smids is that it is a larger universe. That is a strong advantage.
The second advantage is the ability to hold onto our small-cap winners, even as they grow out of the small-cap universe. I like to say that there is no reason why an investor should forfeit their institutional knowledge of a successful small-cap stock just because it is no longer small.
The other advantage to mid is latitude. At different times there can be large valuation variations between small and mid. As an investor within small and mid, I have the ability to opportunistically find value up and down the cap spectrum. Today that latitude is less of an advantage, just given the incredible correlation between market cap sizes, and for that matter all asset categories. But that has not always been the case. It was not too long ago that large and growth were trading at 30 times forward earnings, while you could invest in many small industrial companies that were trading at single digit multiples. Being able to take advantages of those variations when they occur is very important and very opportunistic. Smid allows you to do that.
Not to be ignored, it’s important to note that smid-cap stocks have outperformed small-cap stocks over the long term, and have done so with less volatility. Bigger companies, better performance, less volatility, and being able to address this investment universe more opportunistically, those are all reasons why investors should consider smid-caps.
I did not know that smid caps outperformed small-caps historically.
Steven: Indeed. Smid-caps have outperformed small caps over long periods.
That is interesting. It is the first time I have heard that.
Steven: It is surprising to most, and as importantly, and it has done so with less volatility.
I read David Einhorn ’s book "Fooling Some of the People All of the Time," and he said something along the lines of “Even though, there are no analysts covering small- or micro-caps, a lot of people think that with micro-caps and small-caps, it’s easier to find bargains," (which is true overall), but he says that there is always someone on the other side of the trade, and they are always selling for a reason. Do you believe the market is less efficient when it comes to smaller stocks?
Steven: Honestly, I do not think about it a lot. The natural arguments against mid-cap investing are that the category is more efficient, and the liquidity is greater than that of small. The liquidity argument is a relevant argument. More efficient, I am not so certain. Again, the point is that over the long periods of time, smid as a category has outperformed small. That would support the fact that smid is less efficient versus more efficient. The numbers just bear that to be true.
Small-caps have led the rally since March 2009. In general, big caps are less expensive than small-caps. Are you still finding bargains with small-caps, do you think that they will outperform large-caps, or whatever else you have for input on this issue?
Steven: First of all, I generally believe that the correlation amongst asset classes today is remarkably high; as it is across all caps and all asset categories. It is not all surprising that after an explosive small-cap run, particularly amongst the low quality small-caps (again, those are names that we are not involved in—the non-dividend paying, highly levered, low return on invested capital companies), that we believe quality and the larger the cap, are currently the more attractive investments.
The market is now just beginning to discriminate between low quality and high quality. We have seen that in the performance year to date. I would have thought that would have been a far more relevant trend since the crisis began. But, as we sit here today, we’re finding our best ideas amongst quality, mid-cap companies; and those specifically in the U.S.
With international stocks, what do you think about the developing world and the developed versus emerging countries?
Steven: I strongly believe that the relative growth rates and structural differences between developed and developing will quite likely be the most important investment theme of our generation. The U.S. has sneezed, and the rest of the world has not caught a cold. The world is coming to realize that the developing nations are structurally in a better competitive position versus the developed countries. The developing world as we know is growing GDP in excess of 6% and raising rates. While, the developed world is growing less than 2.5% and that is after trillions of monetary inputs and stimulus.
I am not advocating developing country investment; we do not invest that way, we are bottom-up investors. Nonetheless, you have to appreciate the structural differences between developing and developed nations. Take Brazil for example, in 2009 during the crisis, GDP for Brazil hardly contracted. Compare that to contractions around 2.5% for the U.S., 4% for the Eurozone, while Mexico was closer to 7%.
Brazil is resource rich, and energy independent, with some 45% of domestic power being renewable, unemployment is at a record low, real wages have increased since 2000, fiscal deficits are running around 3% of GDP, the banks are healthy, and the Brazilian Real is strong. It is hard not to admire such a strong set of facts. We are sensitive to this important theme, but ultimately we are fundamental bottom-up investors. Again, our investment process dictates where we find the best, absolute investment opportunities, whether they be domestic or international. And, as I have mentioned, we are finding our best ideas on our own soil amongst higher capitalization stocks. But, you have to be very sensitive to the relative structural attractiveness to the developing world.
You have some exposure in the Royce SMid-Cap Value Fund to precious metals, how do you calculate the intrinsic value of metals, and in general how do you view them?
Steven: I generally believe that our monetary policies are ultimately inflationary. But, more specifically, I believe that the U.S. is attempting to orchestrate its first industrial led recovery since World War II. U.S. GDP is 70% consumer based, while China’s GDP is 70% export based. We are both dueling it out to look more like the other. Part of this policy, explicit or otherwise, is a low dollar policy; dollar debasement in other words. The U.S. is not likely to default in any traditional sense, but it would appear to be quite likely that we will ultimately default on our entitlement commitments and/or devalue the currency. And so we are sensitive to those issues. Again, we are bottom-up investors. The process leads us to ultimately have a portfolio with a large concentration of stocks in natural resources and basic materials, and technology.
Now, specific to precious metals and the miners, I am reminded of one of Warren Buffett ’s quotes. “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
Now I could quite as easily say, “Currency is created out of thin air by the Fed and the other central banks around the world. It is circulated in the system. It is saved by the banks, effectively being multiplied. And, it is also vaulted and guarded. And, we are told that it has value from the powers to be. But, again, if you were sitting on Mars and looking down, you would think that we’re nuts!”
In the last century, the U.S. dollar has lost 95% of its purchasing power. Again, we are risk managers and it serves us well to be exposed to the inflatable asset. As long as we are operating in a negative real rate environment, it will be an important investment consideration. As far as it applies to valuation and the underlying intrinsic valuation of any given miners, if you simply look at current spot commodity prices and on any NAV or discounted cash flow basis, you actually have entities for the very first time providing metrics that would satisfy all those that we search for amongst traditional companies, and the world is waking up to that fact.
Can you expand more on your views of the market?
Steven: We touched on the general opportunities a bit. We do not procrastinate on the market, per se. But it really is a tale of two cities. On the one hand, the average U.S. company has probably never looked more attractive. Corporate profitability, in terms of pre-tax margins, for U.S. corporations are at an all-time high and that is at a time when U.S. volumes are running well below peak. Balance sheets have been repaired, financials aside, and one could go even further and say that they have never been better capitalized. Just take a look at the tech sector for example, where we are finding a lot of our opportunities. I think that there is a statistic that the largest top ten tech names have enough cash to buy a quarter of the underlying tech index. Valuations remain very attractive amongst quality higher capitalization stocks. However, one has to be sensitive to the many large artificial forces affecting the macro landscape. I’m personally very sensitive to the fact that during this past crisis, we witnessed a lot of stress, but we did not incur nearly enough distress. We obviously saw a lot of broken balance sheets; however, the capital structures of many companies we would have thought would have seen a lot more distress. But again, there were a lot more forces put to bear. So one of the most fascinating, larger issues being currently debated is that the solvency issue has not been corrected. It has merely been shifted from commercial balance sheets to sovereign balance sheets. The underlying consequences for all these actions have truly not come to bear. However, having said that, the average U.S. corporation looks very attractive.
As I’ve mentioned from an investment perspective, we’re overweight with natural resources and technology. We’re finding great value for the first time in technology in a very, very long period of time because the tech industry has been in a bear market for the last ten years from a valuation and sentiment perspective. Technology once viewed as a market darling, is now viewed as a lower growth, inflation prone sector that is inherently cyclical. Over the past year and a half, what we have seen is one of the more attractively priced sectors that’s showing decent growth during a period of time where capital budgets are constrained. And, most unique to this period, U.S. corporations are increasingly looking for further productivity gains. That is very important for the technology sector. The technology sector is also being viewed as a revenue generating investment for corporations as well; I think this is a new dynamic. There’s a revenue-generating element to it, in addition to a cost driven element. Those are my general views on the market and where we are finding some of the better ideas.
Royce SMid-Cap Value Fund and the Royce SMid-Cap Select Fund are small. Do you think that is an advantage or a disadvantage?
Steven: Well first, the funds are small because they just completed their first three years, during which time they were not marketed. We recently had Morningstar provide the formal review of the funds. The marketing efforts will pick up now that they each have three years of history. You found the funds, so I have hope!
Size, clearly, can be an advantage in the earlier periods in the evolution of a fund. I have born witness to that in my previous capacity running smid funds. And, arguably, scalability over time will also not be an issue in light of the size of the underlying investment universe.
Well then, what do you attribute your success as a smid investor to?
Steven: Certainly my past life as an accountant has been very helpful in terms of being able to properly interpret the financial statements of companies As we’ve discussed earlier on, my experiences over time and those individuals and philosophies that I’ve been exposed to have shaped the way that I view value and analyze business models. I suspect over time my knowledge of the language of business and being able to appreciate value has been a strong combination.
Disclosure: I am a shareholder in several Royce mutual funds.
http://www.valuewalk.com/
Also check out: Can you give us a little bit about your background?
Steven: I joined Royce in the spring of 2007 with the purpose of building out Royce’s mid cap investing and obviously we did that by way of the launch of Royce SMid-Cap Value and Smid-Cap Select Funds.
A Bad time to start a fund.
Steven: Certainly during that time period it was difficult. On the one hand it feels like yesterday and on the other hand it feels like an investing lifetime. No better period in retrospect to test the defensibility of the smid-cap funds. Prior to Royce, I was a Partner and Portfolio Manager managing small- and mid-cap funds at Lord, Abbett and Company. They’re a large institutional manager. And prior to that, I was (what I like to refer to as) part of the dark side. I was a Vice President in the Mergers and Acquisitions department at Morgan Stanley.
I was about to guess an investment bank when you said the dark side!
Steven: Prior to Morgan Stanley I worked in a similar capacity with the M&A department at Solomon Brothers for a few years. And prior to Solomon Brothers, I worked as a Manager in the Accounting and Auditing department at Deloitte and Touche; both in the U.S. and in Canada where I am originally from. I hold a Bachelor’s degree from the University of Waterloo, which is the only School of Accountancy in Canada. I also hold an MBA from Columbia Business School.
How did you get into value investing?
Steven: Everyone is a product of his or her own environment. I was raised in a money-wise, value-conscious, Scottish home. Obviously that’s an oxymoron; stressing the word Scottish. At a very early age, my father taught me the value of money. Whether it was collecting golf balls on golf courses when we lived in Australia and then cleaning them up and selling them for profit, or collecting glass bottles at construction sites and then reaping the refunds, or my many part time jobs. All of those experiences drove me to appreciate numbers, arbitrage, and the ability to earn returns. Then my father introduced me to two annual reports at a very early age: Coca-Cola Companies and Berkshire Hathaway. The first one I understood pretty quickly given my age. In light of those experiences, there is no real surprise that I first became an accountant.
So besides your father, did anyone else have a large influence on your investment philosophy?
Steven: Honestly, it is impossible to point to any one or two specific individuals. Many have shaped it over the years. Obviously, I was deeply shaped by my father’s sense of value. Then beyond that, I had the good fortune of knowing Michael Burry at Scion Capital, at the very early period.
Before The Big Short: Inside the Doomsday Machine
, and before he became super famous?Steven: Yes. Back in the mid 90s I knew Michael. Then I was taught by Bruce Greenwald and Joel Greenblatt while at Columbia Business School. And, through my investment career, I have had the good fortune of having some incredible working relationships with some wonderful mentors; Robert Fetch at Lord, Abbett; Whitney George, and Chuck Royce at Royce. And, of course while at Columbia Business School, I read everything there is on Warren Buffett and his business methods. I suspect over time I have drawn on elements of each philosophy.
What metrics do you use then for identifying potential investments (if any)? Price over book? Price over earnings? Free Cash Flow? EBITDA?
Steven: The overarching goal is to find quality at discount prices. The single best measure in my opinion of quality is return on invested capital. That is the bedrock of Royce. Companies that have the ability to sustain high returns on capital, both in the up and down cycles, implicitly are the companies that have distinct competitive advantages, strong barriers to entry, and are quite likely serving favorable industry dynamics. So return on invested capital is very important. Companies that have high cash generative abilities and have limited capital requirements are also ideal candidates. I like to say that the best companies are those that are a royalty on the growth of others, while requiring less capital themselves. We, as risk managers, also dislike leverage. We apply very strict tests in terms of balance sheet strength, which ensures that we are doing our job as risk managers.
Other portfolio managers from Royce stated the emphasis on ROC. So, once you have discovered something that looks very attractive, what is your next step? What is your process?
Steven: The process is all-important. I like to compartmentalize it into what I refer to as the art and the science of investing. Once we satisfy the metrics of a given company, what I call the science part, we spend a lot of time researching quality and asking questions like, “Is the company’s leading market share position sustainable? Does the company have pricing power? Does the company serve a favorable industry structure? (that is to say, is the company exposed to high supplier and customer concentration?) and are the customer prices inelastic? Also, if I were going to kill the business then how would I do that?”
Those are all the questions that we ask ourselves in terms of trying to determine if we are potentially looking at a franchise company. The process obviously involves many conversations with the company itself, the suppliers, vendors, and even sometimes regulators. The process is in-depth and involves the aggregation of much data with, again, the overriding goal of finding quality at temporarily depressed prices. As part of that process, one of the competitive strengths of Royce is that we have the luxury of holding an investment conference every day in our office. The access to management is truly unparalleled. I would say that on any given day we will have four to six companies through our offices. That’s a lot of management teams that you have the ability to interview, test your investment thesis on, inquire about industry dynamics and get the opinions of competition as well.
Can you mention more about the Art and Science of investing?
Steven: The science is simply screening quantitatively for all the metrics that we’ve discussed - return on invested capital, free cash flow, balance sheet strength, underlying capital intensity, and valuation. The hard part is the process of trying to determine whether you are dealing with a sustainable franchise or not. That is part of the art of investing. And, as I have mentioned, we think a lot about, “Is the company changing for the better? … is the industry changing for the better?” Implicitly, I spend a lot of time paying attention to change. Perhaps maybe an example is most helpful. This is obviously where I get excited - talking about stocks.
Take an example such as Lubrizol (LZ, Financial), which is somewhat timely. Lubrizol, (a top holding), is a specialty chemical company that for the last ten years and probably leading up to 2007 had operating margins of sub 10%. Sitting here today, Lubrizol has operating margins of greater than 20%. So it begs the question of what changed? Lubrizol’s business relates to lubricant additives largely; think of chemical polymers that are added to base oil by the big refiners and sold by the remarketers as engine oil. So when you get your oil changed, then you will be using Lubrizol’s products. Structurally during that last 10-year period, the lubricant additive market went through massive consolidation. Some 20 lubricant additive suppliers, like Lubrizol, consolidated to four. Of which today, we only have two that are not captive to the refiners. Likewise, on the remarketing side there was massive consolidation. The Amocos, the Castrols, the Texacos, the Pennzoils, the Quaker States, were all effectively acquired by large refiners. So you had massive consolidation within the industry. Then the refiners entered a massive down cycle in their core business and many of them turned to their lube additive business and started managing them as profit centers. So that was new. Then came $100.00 plus oil; which afforded all the constituencies in the engine oil food chain a very attractive pricing umbrella. All in, the industry became far healthier. Lubrizol, as a market share leader, benefitted from this. What was a three-to-four dollars earning per share company, all of a sudden is projected to earn upwards of $13.00. So the ability to identify this sort of change early is what I like to refer to as the art of investing.
Another example that fascinates me is the railroad industry. For years the railroad industry was a highly cyclical, highly capital intensive, over capacity, low return, highly regulated industry. In fairness, some of that remains true today, but most interestingly, is that for the first time in decades, the industry returned its cost of capital beginning in 2006 and has been showing incremental return on invested capital of some 30% for the last 5 years. So, again, it begs the question of what has changed and how could one have predicted it? It all starts with history.
The rails back in 1930 accounted for some 80% of all the freight ton miles in the U.S. versus some 40% today. In the mid 50’s, we had the construction of the national interstate system. The trucks, by the use of the public right of ways, were able to use this high speed, low density, interstate system. This gave the truckers a huge competitive advantage versus the rails. This dynamic since the 50s served effectively as a catalyst for the trucks to gain some 30 points of share relative to the rails over a 30-year period. Interestingly, during the early 80s to 2005 time period, the U.S. vehicle miles grew by some 100% while the lane miles declined by 6%. So the U.S. needs to add some (I think it is) 13,000 lane miles per year just to maintain today’s congestion level. Yet, as we know, most public highway funding is earmarked for repair and maintenance only. And then on top of that, the big catalyst, we had the passing of the Staggers Act, which deregulated the rail industry; it allowed the rails to competitively price their product and embark on service enhancing technology. So fast forward to today, and the rail industry is composed of seven Class 1 rails that account for some 90%+ of the industry (which is down from 40% in 1980); close to 50% of the nation’s freight movements are captive; rails are able to flex the model, quite effectively; the interstate today is low speed, high density; the rail service is competitive with on time service over 80%; rails have two to four times fuel efficiency advantage over trucks; and, the rails have pricing power. Again, all of that is allowing the rails for the very first time to exhibit underlying operating leverage.
So it’s a long winded answer, but I always get excited when we talk about industry dynamics, and rails are a fascinating example. It’s not necessarily a fantastic business model, but rails today are most certainly a great business model. With the ability to identify change, like Lubrizol or the rails early on, is what I like to refer to as the “art” of the investing.
How do you manage risk and how do you define it?
Steven: Risk is simply the permanent loss of capital. It is not an algorithm. It is not a number. It is the loss of capital. By executing our process, that is investing in companies that have high returns on capital, strong free cash flow characteristics, and stellar balance sheets, and buying these companies at depressed prices or at high implied earnings yields, we implicitly reduce risk. It’s as simple as that.
You have been managing small-cap and mid-cap funds for a long time. What’s unique and differentiates smid-cap, and why would an investor consider smid-cap?
Steven: As it applies to Royce, we have increasingly broadened our small cap investment universe over the years to mid-cap stocks. It’s only natural for Royce as a successful small-cap manager for over 35 years, that many of our small-cap companies have become mid-cap companies.
Why smid-caps as an asset class? The benefits are size, knowledge, and latitude. Performance with less volatility is just icing on the cake. The obvious advantage with smids is that it is a larger universe. That is a strong advantage.
The second advantage is the ability to hold onto our small-cap winners, even as they grow out of the small-cap universe. I like to say that there is no reason why an investor should forfeit their institutional knowledge of a successful small-cap stock just because it is no longer small.
The other advantage to mid is latitude. At different times there can be large valuation variations between small and mid. As an investor within small and mid, I have the ability to opportunistically find value up and down the cap spectrum. Today that latitude is less of an advantage, just given the incredible correlation between market cap sizes, and for that matter all asset categories. But that has not always been the case. It was not too long ago that large and growth were trading at 30 times forward earnings, while you could invest in many small industrial companies that were trading at single digit multiples. Being able to take advantages of those variations when they occur is very important and very opportunistic. Smid allows you to do that.
Not to be ignored, it’s important to note that smid-cap stocks have outperformed small-cap stocks over the long term, and have done so with less volatility. Bigger companies, better performance, less volatility, and being able to address this investment universe more opportunistically, those are all reasons why investors should consider smid-caps.
I did not know that smid caps outperformed small-caps historically.
Steven: Indeed. Smid-caps have outperformed small caps over long periods.
That is interesting. It is the first time I have heard that.
Steven: It is surprising to most, and as importantly, and it has done so with less volatility.
I read David Einhorn ’s book "Fooling Some of the People All of the Time," and he said something along the lines of “Even though, there are no analysts covering small- or micro-caps, a lot of people think that with micro-caps and small-caps, it’s easier to find bargains," (which is true overall), but he says that there is always someone on the other side of the trade, and they are always selling for a reason. Do you believe the market is less efficient when it comes to smaller stocks?
Steven: Honestly, I do not think about it a lot. The natural arguments against mid-cap investing are that the category is more efficient, and the liquidity is greater than that of small. The liquidity argument is a relevant argument. More efficient, I am not so certain. Again, the point is that over the long periods of time, smid as a category has outperformed small. That would support the fact that smid is less efficient versus more efficient. The numbers just bear that to be true.
Small-caps have led the rally since March 2009. In general, big caps are less expensive than small-caps. Are you still finding bargains with small-caps, do you think that they will outperform large-caps, or whatever else you have for input on this issue?
Steven: First of all, I generally believe that the correlation amongst asset classes today is remarkably high; as it is across all caps and all asset categories. It is not all surprising that after an explosive small-cap run, particularly amongst the low quality small-caps (again, those are names that we are not involved in—the non-dividend paying, highly levered, low return on invested capital companies), that we believe quality and the larger the cap, are currently the more attractive investments.
The market is now just beginning to discriminate between low quality and high quality. We have seen that in the performance year to date. I would have thought that would have been a far more relevant trend since the crisis began. But, as we sit here today, we’re finding our best ideas amongst quality, mid-cap companies; and those specifically in the U.S.
With international stocks, what do you think about the developing world and the developed versus emerging countries?
Steven: I strongly believe that the relative growth rates and structural differences between developed and developing will quite likely be the most important investment theme of our generation. The U.S. has sneezed, and the rest of the world has not caught a cold. The world is coming to realize that the developing nations are structurally in a better competitive position versus the developed countries. The developing world as we know is growing GDP in excess of 6% and raising rates. While, the developed world is growing less than 2.5% and that is after trillions of monetary inputs and stimulus.
I am not advocating developing country investment; we do not invest that way, we are bottom-up investors. Nonetheless, you have to appreciate the structural differences between developing and developed nations. Take Brazil for example, in 2009 during the crisis, GDP for Brazil hardly contracted. Compare that to contractions around 2.5% for the U.S., 4% for the Eurozone, while Mexico was closer to 7%.
Brazil is resource rich, and energy independent, with some 45% of domestic power being renewable, unemployment is at a record low, real wages have increased since 2000, fiscal deficits are running around 3% of GDP, the banks are healthy, and the Brazilian Real is strong. It is hard not to admire such a strong set of facts. We are sensitive to this important theme, but ultimately we are fundamental bottom-up investors. Again, our investment process dictates where we find the best, absolute investment opportunities, whether they be domestic or international. And, as I have mentioned, we are finding our best ideas on our own soil amongst higher capitalization stocks. But, you have to be very sensitive to the relative structural attractiveness to the developing world.
You have some exposure in the Royce SMid-Cap Value Fund to precious metals, how do you calculate the intrinsic value of metals, and in general how do you view them?
Steven: I generally believe that our monetary policies are ultimately inflationary. But, more specifically, I believe that the U.S. is attempting to orchestrate its first industrial led recovery since World War II. U.S. GDP is 70% consumer based, while China’s GDP is 70% export based. We are both dueling it out to look more like the other. Part of this policy, explicit or otherwise, is a low dollar policy; dollar debasement in other words. The U.S. is not likely to default in any traditional sense, but it would appear to be quite likely that we will ultimately default on our entitlement commitments and/or devalue the currency. And so we are sensitive to those issues. Again, we are bottom-up investors. The process leads us to ultimately have a portfolio with a large concentration of stocks in natural resources and basic materials, and technology.
Now, specific to precious metals and the miners, I am reminded of one of Warren Buffett ’s quotes. “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
Now I could quite as easily say, “Currency is created out of thin air by the Fed and the other central banks around the world. It is circulated in the system. It is saved by the banks, effectively being multiplied. And, it is also vaulted and guarded. And, we are told that it has value from the powers to be. But, again, if you were sitting on Mars and looking down, you would think that we’re nuts!”
In the last century, the U.S. dollar has lost 95% of its purchasing power. Again, we are risk managers and it serves us well to be exposed to the inflatable asset. As long as we are operating in a negative real rate environment, it will be an important investment consideration. As far as it applies to valuation and the underlying intrinsic valuation of any given miners, if you simply look at current spot commodity prices and on any NAV or discounted cash flow basis, you actually have entities for the very first time providing metrics that would satisfy all those that we search for amongst traditional companies, and the world is waking up to that fact.
Can you expand more on your views of the market?
Steven: We touched on the general opportunities a bit. We do not procrastinate on the market, per se. But it really is a tale of two cities. On the one hand, the average U.S. company has probably never looked more attractive. Corporate profitability, in terms of pre-tax margins, for U.S. corporations are at an all-time high and that is at a time when U.S. volumes are running well below peak. Balance sheets have been repaired, financials aside, and one could go even further and say that they have never been better capitalized. Just take a look at the tech sector for example, where we are finding a lot of our opportunities. I think that there is a statistic that the largest top ten tech names have enough cash to buy a quarter of the underlying tech index. Valuations remain very attractive amongst quality higher capitalization stocks. However, one has to be sensitive to the many large artificial forces affecting the macro landscape. I’m personally very sensitive to the fact that during this past crisis, we witnessed a lot of stress, but we did not incur nearly enough distress. We obviously saw a lot of broken balance sheets; however, the capital structures of many companies we would have thought would have seen a lot more distress. But again, there were a lot more forces put to bear. So one of the most fascinating, larger issues being currently debated is that the solvency issue has not been corrected. It has merely been shifted from commercial balance sheets to sovereign balance sheets. The underlying consequences for all these actions have truly not come to bear. However, having said that, the average U.S. corporation looks very attractive.
As I’ve mentioned from an investment perspective, we’re overweight with natural resources and technology. We’re finding great value for the first time in technology in a very, very long period of time because the tech industry has been in a bear market for the last ten years from a valuation and sentiment perspective. Technology once viewed as a market darling, is now viewed as a lower growth, inflation prone sector that is inherently cyclical. Over the past year and a half, what we have seen is one of the more attractively priced sectors that’s showing decent growth during a period of time where capital budgets are constrained. And, most unique to this period, U.S. corporations are increasingly looking for further productivity gains. That is very important for the technology sector. The technology sector is also being viewed as a revenue generating investment for corporations as well; I think this is a new dynamic. There’s a revenue-generating element to it, in addition to a cost driven element. Those are my general views on the market and where we are finding some of the better ideas.
Royce SMid-Cap Value Fund and the Royce SMid-Cap Select Fund are small. Do you think that is an advantage or a disadvantage?
Steven: Well first, the funds are small because they just completed their first three years, during which time they were not marketed. We recently had Morningstar provide the formal review of the funds. The marketing efforts will pick up now that they each have three years of history. You found the funds, so I have hope!
Size, clearly, can be an advantage in the earlier periods in the evolution of a fund. I have born witness to that in my previous capacity running smid funds. And, arguably, scalability over time will also not be an issue in light of the size of the underlying investment universe.
Well then, what do you attribute your success as a smid investor to?
Steven: Certainly my past life as an accountant has been very helpful in terms of being able to properly interpret the financial statements of companies As we’ve discussed earlier on, my experiences over time and those individuals and philosophies that I’ve been exposed to have shaped the way that I view value and analyze business models. I suspect over time my knowledge of the language of business and being able to appreciate value has been a strong combination.
Disclosure: I am a shareholder in several Royce mutual funds.
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