Guru Chuck Royce (Trades, Portfolio), famous for the Royce small-cap funds, appeared on a new episode of Consuela Mack last week.
This show is a very interesting source of investment commentary by guru investors. You can watch the show yourself embedded below or, if you are short on time, go with my cliff-notes and commentary. Royce is a specialist in small-cap companies. And I'd say a proponent of a GARP -- growth at a reasonable price -- style. The firm also puts a lot of emphasis on risk management. As the firm is active in the small cap space through mutual funds, it is highly detrimental for them to get hit by mass redemptions at a time liquidity is drying up. They pursue risk management through avoiding biotech and putting a lot of emphasis on picking companies that have quality characteristics: good balance sheet, high returns on capital and solid cash flows.
Royce doesn't think there's anything out of the ordinary about the recent correction. It's not disturbing at all. He believes the worst way to measure performance is by the single calendar year, which is of course what we are all doing in the mutual fund industry. Royce would prefer to be measured over cycles, and his goal is to do well in bull markets and outperform in bear markets.
GuruFocus tracks the performance of the Premier Fund (RYPRX, Financial). The Premier Fund is the most concentrated fund Chuck Royce (Trades, Portfolio) runs. The fund is coming out of a couple of very rough years. According to Morningstar, it strayed a bit from its philosophy by bringing in more energy and basic material names. It has since refocused to focusing on competitive advantages, which the firm has an edge in identifying.
I can easily explain a move into energy, as it has been a great place to find value. However, value has deeply underperformed for quite a few years now. Since inception the fund killed its benchmark with less volatility and much less pronounced drawdowns. This is a major accomplishment:
Royce thinks the burst of the biotech bubble in 2015 helped the fund to catch up. Its benchmark is quite stocked with speculative biotech companies which just isn't their style, and Royce is somewhat skeptical of the sector. He believes in general the zero interest rate environment benefited growth tremendously. While the causality is hard to prove, it makes sense, and we are in one of the very, very rare decades where growth did so well compared to value.
Meanwhile, Royce wants to make money in an absolute sense. They don’t pick stocks in a comparative sense, and they operate with little regard for the benchmark. He describes their investment philosphy as predicated on the well-known value maxims:
- Margin of safety.
- Rule 1: don’t lose money.
- Rule 2: don’t lose money.
Royce does go into detail a bit on what quality means to them, although it doesn't appear to consist of a set of strict rules. Instead there are number of measurable and immeasurable qualitative factors they look for. Three factors are described:
- High return on capital.
- Demonstrated track record of success.
- Competitive advantage.
When talking about quality, Royce provides his first stock pick:
Clarkson PLC (LSE:CKN, Financial)
Clarkson is the global leader in shipping services. The shipping industry has been in a cyclical downturn for a while now. I look into shipping regularly and too many ships were ordered in the past. OPEC cut back on production as did Russia. Finally, metal prices have been low for a while, which means fewer vessels get scrapped. Royce likes Clarkson because it's out of favor currently, but its business model is asset light (thus capable of high returns), it has a brand and it's in the business of selling intellectual property. Its data accumulation makes it a critical player in the marketplace.
Financial services
Royce dives into financial services for a bit as well. He acknowledges liking small banks. There's a lot of M&A going on in the space. Royce points out rates will be rising and spreads on the deposit base widening. That's very good for banks' profitability. He doesn't particularly like banks usually but thinks they are uniquely well-positioned currently.
He is more fond of the alternatives. Which means hedge funds and private equity investment firms. Royce thinks they don’t get the market attention they should. Steven Schwarzman of Blackstone (BX, Financial) complains about the same thing. He's held them for a couple of years now. He continues to have them and think they will do well. Within the Royce Funds KKR (KKR, Financial) is one of the larger alt positions, but they also hold Oaktree Capital (OAK), Carlyle Group (CG) as well as others.
Premier Fund
Talking about the Premier Fund in particular, Royce explains they are looking for companies where they would love to own the whole company and own it forever. That's investing like Berkshire Hathaway's private company portfolio. He names one example, which is Kirby.
Kirby Corp.
Kirby (KEX, Financial) is the leading player in the U.S. inland barging industry. Despite industry headwinds due to overcapacity, its generating a profit. The barging industry enjoys an economic moat due to government-imposed regulation. The Jones Act prevents non-U.S.-based firms from shipping between U.S. ports. That puts a lot of the competition out of business. Currently things look terrible for the industry but according to Royce, great things are ahead.
Royce notes
In the end, Royce defends active management a little bit. This is sort of a thankless job. The firm's track record is good enough, and one of the few that's long enough, that it should speak for itself. But Royce notes we have had a straight up market from 2009. All risk management has been in vain and only cost performance. Active managers do risk management while passive funds don't. Royce is observing active manager are already doing better and volatility is returning. That should help.
To maintain its performance track record, Royce is very careful about how much money it takes in. If there's too much money flowing into funds, it becomes harder to perform. They put satisfactory performance ahead of gathering assets. This does set them apart somewhat although they still have quite high assets under management.
What we all should own some of:
When Consuela Mack asks Royce what we should all own some of, his answer isn't a specific stock, but he proposes to buy international small-caps. According to him they will be as accepted as domestic small-caps in the next five to 10 years. If you read my articles on GuruFocus on a regular basis, you know this is music to my ears.
Enjoy the terrific interview:
Disclosure: Author owns OAK, BX, CG, KKR.
