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Portfolio > Economy & Markets > Stocks

No Compromises

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Aggressive investors need not apply,” might read a sign hanging over Charlie Dreifus’s office door. Don’t get the wrong idea. Making money is very important to him, but not losing any money is even more important. If you sat across from Dreifus at his desk, you’d see pens, pencils, and paperclips, but more importantly, you’d see erasers. “In security analysis and portfolio management, it is a matter of being right more than being wrong,” says Dreifus, senior portfolio manager for the Royce Special Equity Fund (RYSEX). “As well intentioned and as well disciplined as I am, I, too, make mistakes.”

Though his candor on being fallible is refreshing, his fund’s performance is even more bracing. Since 2000, the small- to micro-cap value fund has posted positive annual returns upwards of 15%, and has earned five stars from Standard & Poor’s. But even that doesn’t affect this modest man’s disciplined approach to investing. “In 1999, I lost people money,” he says rather frankly. But to his credit, it hasn’t happened since.

For the five years ended January 30, 2004, RYSEX had an average annualized total return of 16.0%, versus a total return of -1.0% for the S&P 500 Composite Index, and a total return of 13.3% for all small-cap value funds, according to Standard & Poor’s.

Following a rigorous and disciplined approach, Dreifus is often asked if his research is too strict. His response: “I am certainly very demanding, but the results reflect that process.” Even when small-cap value investing went out of style and investors were racing toward the “next big thing,” he stayed true to his method. We recently spoke with Dreifus about his fund, which has assets of $788 million, his “mentors,” and what he looks for before he invests.

Tell me about your approach to investing. My investment philosophy is grounded in the work of three people: Benjamin Graham, Warren Buffett, and Abraham Briloff.

Graham is best known for margin-of-safety investing. He worked toward the notion of risk averseness, and came up with different methodologies to reduce risk and to put the odds in your favor; in other words, cautious and conservative investing. Though not a direct metric of his, the way I deploy that concept is to buy absolute rather than relative value, and use a merger and acquisition metric when searching for potential investments.

I invest in companies [with capitalizations of] under $1 billion, and occasionally we will wander above $2 billion. I search based on trailing month-to-month data, earnings data, and most recent balance sheets. That is a conservative approach. In the merger and acquisition metric that I use, we measure what the company is selling at, the market cap, plus interest-bearing debt, plus liquidating price, minus cash, divided by earnings before interest and taxes. That’s an even more conservative metric than used in M&A work, where they use earnings before interest, taxes, depreciation, and amortization. It is very much like [the approach that] would be used by someone acquiring the whole company. Obviously that is not my intent, but that is my mentality. That is the first thing: Put the odds in your favor on valuation.

The second element is from Warren Buffett, who said that while valuation is great, you could end up buying inexpensive companies that are bad businesses. Companies are inexpensive for a reason. Buffett developed the notion of franchises. Aside from the issue of valuation, how do you identify a franchise? When you see it, you know it, but how do you go out and search for it? I use a proxy for what I believe will lead me to franchises, which is return on invested capital. If a company enjoys high returns on invested capital, it may have a franchise or a niche, something that allows it to earn these high returns.

The last element is from Abraham Briloff. In the mid-1960s, he laid out all the information available on accounting. He pointed out the conflicts that arise through the consulting practices of accounting firms and their auditing functions, and how there is great latitude in portraying numbers (see sidebar, page 72).

Briloff taught me how to discern between aggressive accounting, which might be inflated earnings, versus conservative accounting, which understates earnings. I’m able to go through financial statements and come to a conclusion.

I screen for candidates based on those metrics. Once I find the candidates, I get their financial statements and evaluate the accounting issues as well as general research on the company.

Our returns are satisfactory. We appeal to people who have a conservative bias and who are interested in preservation and modest enhancement of principal. Our returns have a very low standard deviation and I think that stems from our disciplined, continuous methodology. I am not relenting on it. I reject many more candidates than I end up buying.

I’ve been managing mutual funds since May 1980, and while I certainly have learned and grown, the approach is the same.

Do you have a personal definition of value that you think other value managers might not follow? I tend to be at one end of the spectrum. I am what is often called “deep value.” I really hate to lose money. I want to make money, but frankly it’s more important to me not to lose money. If you don’t lose money, then you always have a chance of making it. Buying absolute value, buying as if I were a businessperson looking to acquire the business, takes a lot of the fluff out [of the universe of value stocks].

You have about 15% cash in the portfolio. Is it always so high? That is high. In recent years the fund has under gone a real metamorphosis. The fund had $6 million in assets at the end of 2001, and at the end of 2003, it had $750 million. That was a combination of $1 billion coming in, nearly $600 million going out, and performance. Because we did so well in the difficult times like 2001, 2002 was the year we started to attract a lot of money, and we ended up having momentum investors in our mutual fund. As hard as we have tried to accurately portray that this fund is for long-term, conservative investors, not go-go investors, there was still [a large amount of money coming into the fund]. This fund is better suited for people with lower expectations, and nearly half the money that came in left. When they bought, they just were chasing performance.

To handle that and to protect the interest of our long-term investors, I decided to keep more cash on hand.

Having now matured and stabilized, we are still getting money in, but the money is from more conservative investors. After last year’s performance, I am not ashamed of our numbers; they were the kind of numbers you can expect from a fund like this. I think we have largely cycled those people out, and it is my intent to spend down my cash to a more reasonable number.

Your investment approach involves extensive examination of a company’s financial statements. What do you look for? I read financial statements in their entirety. I start with the back and read all the footnotes first. I have always been concerned with stock option dilution, the amount of earnings, the changes in reserve accounts, the changes in discretionaries like research and development or advertising, the tax rate, and the composition of the tax liability. I have always paid attention to what was not on the books, like the unconsolidated entities versus consolidated entities. I always look, too, at the proxy statement. There is information in there about incentives and other disclosures that are helpful.

Did you always believe that you were going to be a conservative investor? As much as I love finance, I have trouble valuing growth stocks. I really don’t know how it is one should value growth stocks. Maybe it is just the lazy man’s approach, but valuing value stocks is easier. My hat’s off to those who can successfully value growth stocks, because I can’t.

Your conservative investment process weeded out the technology sector in this portfolio. Are there one or two sectors you tend to favor? By application of the methodology, there are industries that rarely, if ever, become attractive. Buffett has commented that there are really no great businesses. If you look at return on capital, you don’t find that many technology companies with great consistent returns on capital in the peak of their cycle. They might do okay, but then they go down again. So technology rarely makes it. Within my operating framework, banks tend not to make it; utilities tend not to make it. I end up with manufacturing companies and consumer companies. Many of my holdings have been heartland holdings: the company that manufactures motors in Indiana or sells ham and eggs in Ohio gets into this portfolio.

So you’re a friend of mom-and-pop businesses? Many of the companies I own do have a large family interest and have the mom-and-pop mentality. People approach the management of a company differently if their grandfather started the business and their family wealth is tied up in it. My experience is that companies that have a large family stake tend to have more conservative accounting and tend to be less generous with stock options. With small mom-and-pop businesses like the corner candy store, they want to have more money at the end of the year than what they started with. That is the name of the game.

How do you determine the fund’s distribution? It is bottom-up. When I run my screens for candidates, most often it is individual stocks that may eventually comprise a whole segment within the portfolio. Given my conservative method, I will buy something and when it rises to what I think is full value, I sell it. That doesn’t mean the stock won’t continue to rise. Forgetting about redemption issues, I sell stocks for two reasons. One is high quality–if it has reached its value and is no longer attractive. The second case is when I have made a mistake, and my judgment about consistency or quality or some other part of the company was wrong. That happens also.

What index do you benchmark against? How closely do you manage to the index? I don’t manage against an index, but we have to measure against something. What works reasonably well over a long enough period of time is the Russell 2000. If something is heavily weighted in the Russell, like technology, and it does very well, I won’t do as well. But if it does poorly, then I will do well. I am not weighting myself versus the Russell, so I can have tracking error and I can be very different. The question is, do you have good or bad tracking error? At the end of the year, do you end up underperforming or outperforming the index?

S&P classifies this as a small-cap value fund. Do you agree? Most definitions of small cap these days are holdings between $400 million and $2 billion. Our median market cap at the end of the year was $649 million. We are certainly in small caps, but we also have a reasonable number of holdings under $400 million which would make us microcap.

Where do you see this fund fitting into someone’s portfolio? This is for someone who would be more upset if they lost money. Are you the kind of person that if you don’t do as well as others you won’t sleep at night, or are you the kind of person who would be up if you lost money? I am better suited for the person who would be more upset about losing money.

For a conservative investor, this deserves consideration as a core holding in that sphere, but this is a very narrow slice of what is available to U.S. investors.

Megan L. Fowler writes about business issues from Fairbanks, Alaska. She can be reached at [email protected].


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