Can you talk about the recent change to the portfolio management structure on Royce Total Return Fund?
Charles Royce As of May 1st, Miles and I essentially switched roles on the portfolio. He's the Fund's lead portfolio manager while I support him as portfolio manager. Our focus remains on finding high-quality, undervalued, dividend-paying small caps with the goal of lower volatility. We think this approach is best suited for investors with a lower risk tolerance and/or those who may be in the withdrawal stage of their investment lifecycle. The process is still deeply rooted in the same principles that have always driven its success.
Was this move planned when Royce hired Miles in 2020?
CR Yes, we brought Miles on board in May of 2020 with the plan that he would assume the lead role on the portfolio and head up our dividend-oriented strategies. The two of us have worked together very closely over the last year, and I'm very confident in his ability to drive strong investment outcomes in this unique discipline.
Why do you think the small-cap dividend space is such an important investment area?
CR Our research shows that over long-term periods, dividend payers outperform non-dividend payers within the Russell 2000 Value Index, and they do so with better down-market performance and less risk, as measured by standard deviation. We've also found that many of the dividend-paying companies tend to have higher quality—and we look primarily at returns on invested capital—and cheaper valuations than non-dividend payers.
Miles Lewis When you couple these attributes with Total Return's strong bias towards high quality undervalued businesses, small-cap dividend payers look like a logical place to source investment opportunities that can beat the market with less risk. We also think that the valuations for dividend payers currently look compelling versus non-dividend payers—based on EV/EBIT, which is enterprise value over earnings before interest and taxes. More recently, dividend payers have experienced significant underperformance versus non dividend payers. So the current entry point is attractive in terms of both valuation and relative performance. We think that's a fantastic backdrop for dividend paying small caps.
What factors are among the most important when you look at a company?
ML We see dividends as a potential sign of high quality in a company, as they often signal thoughtful capital allocation habits, management's confidence in the company's prospects, and strong free cash flow of the underlying business. However, we also understand that a dividend itself can be a limited proxy for overall quality. In order to gain more insight, we move on to a more thorough nuanced analysis after we've identified dividends payers. Our first question is very simple and important: is this a good business? To understand this, we study the economics of the business, its competitive landscape, the sources and duration of its competitive advantage, and the reasons why a customer chooses to purchase the company's product or service.
Where does the analysis go from there? Are there additional steps?
ML When our analysis suggests that we've found a good business, we then examine the financials to see if the numbers support our views—the quality should show up in the financial statements. The specific areas we focus on include returns on invested capital, balance sheet strength, capital intensity, and our 'North Star': free cash flow. The final step is arguably our most important—we rigorously analyze the risk factors of each business we evaluate. Our goal is to create a short thesis on each company we evaluate that allows us both to more fully vet key risk factors and identify any we may have missed.
What's distinctive about how you approach managing your portfolios?
ML I don't know if these qualities are unique, but I do hold very specific views about investing that influence how I manage portfolios. As I noted earlier, my approach always looks first at risk. I initially learned how to analyze companies in the credit world, where the focus is on what can go wrong as opposed to what can go right. I am a firm believer in capital preservation. Avoiding mistakes is, in my opinion, one of the most effective ways to increase the odds of outperforming. We deliberately size our positions based on the range of outcomes, and our largest holdings are often those where we expect to lose the least—and not necessarily those where we expect to make the most money. We don't always get that right, of course, but on balance I think it serves us well.
What else do you think sets your approach apart?
ML I'm willing to be contrarian when our research process builds the necessary conviction to go against the grain of consensus. Royce's long-term investment focus—which I've always shared as an investor—is crucial in these instances because being contrarian often means being wrong in the short run. A great example is the Fund's investment in regional and community banks. We began adding weight in these positions about a year ago, based on the conviction that these banks represented arguably the single best risk/reward in the market last spring—during a time when the market hated banks for myriad reasons. These holdings lagged for a few months as we continued to add exposure to the group. So far in 2021, regional and community banks have been among our most successful investments—and this would not be the case if we hadn't been willing to invest against the consensus. Equally important, we still like the group.
Can you give us an example of another area you like as a long-term investment?
ML In addition to banks, we've also had success recently with companies related to housing, where our high-quality holdings straddle different sectors. They include everything from title insurers to a branded home essentials business. Many investors have very high expectations for housing-related stocks in light of how vibrant demand has been. Based on these high hopes, we wouldn't be surprised to see some of them cool off a bit in the coming months, especially with the possibility of rising rates over the next year. Our long-term view of housing, however, remains highly constructive, particularly given supply-demand dynamics, growing household formation rates, and the recovering economy. We'd seek to use any short-term volatility for housing stocks to our long-term advantage.
Mr. Lewis's and Mr. Royce's thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
