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Risks & Rewards

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When you look back over decades of market performance it is clear that market forces have long been connected with other world events. Whether we’re talking about the Arab oil embargo in 1973, high interest rates in the early ’80s, the market “exuberance” of the late ’90s, the tragedy of 9/11, or the Enron and other financial services scandals, the movers of the markets had one thing in common–risk. Some investors think that a portfolio manager’s job is to manage money; others believe it is something else entirely.

“Our primary purpose is managing risk,” says Charles Royce, president and CIO of Royce & Associates, and portfolio manager of the firm’s flagship, no-load, $3.8 billion Pennsylvania Mutual Fund (PENNX) since 1973. “We mitigate [volatility] through all of these risk factors that we are obsessed with, from financial risk, to market risk, to strategy risk, to valuation risk, and that’s where we focus as a firm.”

It’s that long-term focus that helped the fund achieve Standard & Poor’s five-star ranking for the 10-years ended November 30, four stars for its five-year rank, and three stars for the three-year, one-year, and overall rankings. The fund achieved an average annual total return of 14.64% for that 10-year period, versus an average annual 12.58% return for its S&P Small-Cap Value peer group; and 16.16% versus 14.49% for the five-year period. If one had invested $10,000 in this fund on June 30, 1981, and reinvested the distributions, as of September 30, 2006 that holding would hypothetically be worth $320,497.

How did you get to the name Pennsylvania Mutual Fund?

It’s an interesting story. I was a director of research and a stockbroker in the late ’60s. I had a customer–a college friend and a very interesting guy. I talked him into approaching a teeny, almost-bankrupt firm called Pickard & Company, that had this little mutual fund. It was one of the firms that was in back-office trouble back in the late ’60s, as every other firm was in trouble then. He had it for about three years, maybe four years, through ’72; he had a couple of good years and a couple of horrible years. He was a pretty risky investor and probably our inexperience and immaturity had a lot to do with that, and I was in the mix, although I wasn’t the owner of the management company. In that process of this big up and big down [volatility] I took it over in late ’72, right at the turn of the year–and then promptly had a couple of horrible years, ’73 and ’74, as a lot of people did.

I came to the conclusion that there had to be a better way and that managing risk and understanding the downside is as important, or more important, than any other part of the process. You could be in any stock you want but you’d better understand the types of risk, the financial risk, leverage. You’d better understand the volatility. You’d better understand the management setting.

I had a sort of an awakening that put me into what’s now called the value camp, but basically put me into the position to feel very strongly that the most important thing we were doing as a manager involved with highly risky stocks–and just by definition smaller stocks are more risky–that we could do a much, much better job of managing the risk, and by doing that we could do fine. And that’s in fact what’s happened. We’ve stuck with this idea that our primary purpose is managing risk, and that is a central part of what we do through the whole firm, in all the products, but Penn is our flagship, first-born product.

We haven’t changed the name just out of loyalty. We could have changed it to Royce something-or-other, but we decided that the name, the history, it was the first fund, and why bother? So we’ve kept the name and it’s the only fund we have that looks like a different fund–but it really isn’t, it’s the flagship, mother fund.

How much money do you manage overall?

We manage over $20 billion. In this fund it’s probably $3.8 billion, almost $4 billion.

How have you been able to keep a fund that invests in micro caps and small caps open for so long, when so many other small-cap funds close up after a relatively short time?

Because we don’t limit the number of names in the portfolio, and because we can go anywhere. The other funds tend to have very limited charters: Micro-Cap funds are obviously limited to micro cap; our Premier Fund is limited to 60 positions. We don’t have those constraints. But the real answer is we have not had the cash-flow pressure here. When we close a fund it doesn’t really relate to size, although it probably looks that way. It relates to the amount of cash flow coming into the fund. We make a decision based on our ability to manage that inflow. It’s the inflow or rate-of-change that determines our closing policy, by and large.

How else would you say that Pennsylvania Fund is different from other funds in the small-cap world?

I’d say we were very early on the idea that you can manage the risk in this very fragile asset class, and do it in a way that does not change the return–it actually enhances the return. In the classic market efficiency conversation you would have academically you would say the less risk you have, the less returns you’ll have, and that’s just not true in the small-cap world. There’s a real reason to manage risk, to be extremely conservative; you’re going to get the returns–what you’ve done is save yourself from these hiccups that happen once a year. Sticking with that mantra has been a very long-term approach. Certainly other funds do that now, but I would say we were very early on that idea.

Would you tell us about the investment process for the fund?

It’s the one we use in the whole firm. We have a large reservoir of companies that we’re familiar with as a firm, because we’ve been in the business for a long time, and we have so many investment principals. We’re always looking at many, many stocks and we’re very, very indifferent as to how the stock got in the firm and how we began looking at it. Once it’s in the firm we are sticklers for trying to understand the long-term characteristics that are going to be the success characteristics: Can this company be a five-year-plus investment? Can it deliver the kinds of returns that we want? We are not interested in trading; we have a relatively low turnover. I’m going to say our turnover is 25%. That’s a very conscious thing. We’re looking for extremely long-term investments that we can hold for a long time and compound at a high number. That is really easy to say, and really hard to find, so we spend a lot of time thinking through the confidence level that we can have in the economics of that company.

Conversely we spend a lot of time thinking through the downside: What can go wrong? Do we believe in the strategy? Is the leverage just too much for us to tolerate? We have very strict leverage rules in the firm–that’s kind of a first line of defense and we’ve found that to just be a very important first-cut at looking at downside.


Is there a ratio that you don’t want to go over [for leverage]?

[Yes], and then: Is what the company looks like–is it really that? Would the customers, consumers, competitors, and employees all say the same thing about this company? That it’s a superb place to work at or buy from? That takes time–that takes many, many months. After we have an initial feeling about the risk-reward, then it’s a question of building true confidence and making this a true long-term investment–so all that takes time.

Do you try to keep the number of holdings (about 450) where it is, or are you flexible with that?

No, basically it relates to the tail of the fund, how many small positions are in the fund, and we don’t have a hard-and-fast rule about the number of positions, but in general we’re going to have about 150 stocks that are going to be close to three-quarters of the portfolio.

Would you talk about some of your holdings? Are there some that have surprised you on the upside?

Well, in the good years, there’s certainly some of that. We definitely did not think this was gong to be a great year for small caps, we thought the shift and gradual rotation to large cap was in play. We were very open to that, not just because it was logical, but that’s what we began to see. We had a gradual shift in the portfolio to somewhat larger-cap size names–not $10 billion companies, but at the upper end of our range. As a firm we start at $5 billion and go down, although this fund’s weighted average cap size is actually $1.2 billion. It’s still pretty small, but we’ve made a gradual shift to using–because I believe that’s going to be the emphasis for the next two or three years, and I think it will be a lower return environment for sure–a higher quality, slightly bigger company.

We have a variety of positions that would meet that criteria. One would be AllianceBernstein (AB), the money manager. They have a wonderful reputation and we’re very pleased with that one–that has worked out [better] than we thought. Other companies that are indicative of this movement [toward] bigger: Lincoln Electric (LECO), our next biggest position, is slightly over our cap-size range right now. It is a global company in the welding business, both with equipment and products that supply that. It’s a very fast growing field because of the activity [building] abroad. Those are two examples of stocks that are somewhat on the large side in capitalization, which has been a trend for the recent year.

Any companies where the thesis just didn’t pan out the way you thought it would?

Oh, we get those every year, and that’s actually a good thing that you get these things. The more difficult companies are the ones that neither work out nor fail. They just languish. We’ll have our fair share of those too, but those are the challenge–to figure out whether they can get going or not. The ones that fail are easy–you just get rid of them. They aren’t really the problems; they sound like problems because they’ve created a loss for you, but they’re not the problems intellectually.

What would it take for you to sell a company?

The sell discipline is not based on price. The sell discipline would be based on a change in assumptions and a failure to confirm what we originally thought about a company, and that definitely can happen. As we get to know the management over time we may say: “You know, these guys are bums.”

Are you out there to see the companies all the time?

More recently, they’ve come to see us. We’re in the epicenter of where people come, and we probably see, in the heavy season, a half-dozen companies a day–and this is the heavy season right now. They’re all over the place, we go to conferences, and when things slow down we go out to see companies.

Where would this fund fit in an individual’s portfolio?

This is our best all-weather fund. I like to think the risk-reward is a really well-balanced one. I’m very proud of our 5-year Sharpe Ratio which would be very much in the upper quartile of all small-cap funds and that’s where we want to keep it.

Do you try for an absolute return each year?

Not each year, no, but I believe truly that we are oriented towards absolute investing. The goal of that is to achieve absolute returns and I would be very disappointed if we didn’t achieve that. So we’re not in the relative return business.

Even though you’re not in the relative return business you use the Russell 2000?

We use the Russell 2000 because that’s what the world uses, and we’re perfectly fine with people looking at all that, but that’s not how we select stocks–we select stocks through absolute return possibilities.

So you’re not looking at an index–any index at all–when you’re looking at your basis?

When we’re selecting stocks, no. At the end of the quarter we look back and see what we did, like anyone else.

Do you own this fund in your own personal portfolio?

Yes. We have about $100 million in all of our funds, and I’m sure I have several million dollars in this fund.


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