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March 01, 2004 at 02:00 AM
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].
