Chapter 6
small caps, BIG GAINS
Chuck Royce
Remember the kid who from age six knows exactly what he wants to do when he grows up—and then grows up and does it? No adolescent angst about a future identity, no senior year what’s next bull sessions in college, no doubts or detours. The things he wants to do in life, as well as the person he intends to be, are completely obvious to him from virtually the moment he becomes conscious of the wider world, and this certainty lends a kind of self-assured serenity that most of us simply do not have.
Chuck Royce has that serenity, not only, it seems clear, because of his extraordinary success and unquestioned wealth, but because he went about doing exactly what he has always wanted to do, never for a moment wanting to do anything else, and he is still doing it daily and joyfully, with appetite and with vigor. What Royce does, of course, is pick stocks. He has been doing it since the 1950s, and he does it very, very well. What is particularly distinctive about him is that he does it so very well in the segment of the stock market inhabited exclusively by small capitalization stocks—small caps, as they are commonly called for the sake of brevity. The standard cliché about small caps is that they are too risky and too vulnerable to fraudulent practices, that they lack quality, and that they comprise a growth-focused niche that does not really outperform companies with higher market capitalizations. Royce gives the lie to every bit of that cliché. Today, as President and Co-Chief Investment Officer of Royce & Associates, Chuck Royce has achieved an enviable legacy of performance that has consistently shattered the usual assumptions about small caps, an accomplishment that confers legendary status, particularly given the size of his business. The Royce Funds include more than 20 mutual funds with total assets under management of $40 billion, all of it allocated to investments in small-cap value stocks.
In person, Charles M. Royce’s appearance belies his accomplishments in a business known to chew up and spit out those with much more intimidating personas. Shoes off in the office, where he likes to do research, bow tie loosened, he is low-key and welcoming; there is no hint here of the snarl of a world-beater, little outward evidence that this is a guy who threw down the gauntlet against proffered investment wisdom and won. Nor did Royce set out on a path of conquest. His prominent presence in the investment world has a more romantic beginning than that.
It happened when he was a high school student growing up in Maryland. He was in the school library one day, browsing through the reference section, when he happened upon the big green loose-leaf binder containing the weekly Value Line investment surveys, a stock analysis newsletter to which just about every library and brokerage firm subscribed. He “thumbed through” the binder, in his words, and that was it. “I fell in love with the idea of stocks.” Stocks, then and even now, as hedge fund managers vie for attention with rock stars, are an unusual recipient of the amorous yearnings of a teenaged boy, but love often has its roots in serendipity.
Royce himself can find no rhyme or reason why this thunderbolt of passion should have struck him. His father was a civil servant in nearby Washington and his mother a schoolteacher; by no stretch of the imagination did either of them play the market, nor was investing a common topic of conversation around the Royce dinner table. Royce vaguely remembers wondering why his grandfather never worked, and he recalls escaping from Thanksgiving dinner at his grandparents’ house one year, rummaging around where he should not have been rummaging, and coming upon a box of funny-looking papers he would later recognize as stock certificates. But investing in stocks was not something that was in the air or in his background unless one subscribes to Mendel’s theory1 on recessive genes to explain why young Royce’s interest in stocks seems to have been inherited from his grandfather. However, given that there is not yet a DNA test for inherited stock picking ability, the thunderbolt in the library, like every experience of falling in love, remains as inexplicable as it is profound.
It also prompted action. Young Chuck turned “the idea of stocks” into reality by actually buying one—Syntex, one of Value Line’s hot glamour picks, the first manufacturer of the birth control pills that were to transform behavior and revolutionize the culture. It was the first and very possibly the last time Royce put his money on a high flier.
The wherewithal to buy the stock was earned in the usual way—a paper route, summer construction work, odd jobs. “I always felt comfortable financially,” says Royce, so you can cross out covetousness or an inferiority complex, in addition to the urge to conquer, as first causes for his interest in stocks. Rather, “Something in my nature loved thinking about the process,” Royce says, “loved figuring the odds.” Clearly, he understood at an early age what takes most investors years to come to grips with; stock selection is in fact a process, not a whim, not the result of chasing a fad or listening to a tout.
At Brown University, he first enrolled in engineering, the standard major for the go-getters in his class, then switched to economics—“it seemed easier.” Royce added parimutuel betting on horses to his thinking about the process often visiting the two local tracks, both now defunct, “After a certain number of races, you could walk in for free,” recalls Royce. He rallied his fraternity brothers, persuading them to pool their money, then calculated the odds and placed the bets. “It was a fine way to kill an afternoon,” Royce says, “and I think we did pretty well.” The betting also provided a very direct education in actuarial systems of risk assessment and management; the lessons—on whether and how well you beat the odds—having been learned in about the time it takes a Thoroughbred horse to run three-quarters of a mile. Not long at all.
Royce’s economics studies certainly supplemented this hands-on learning, but what he loved most about Brown, where he now serves on the Board of Fellows, was the “atmosphere of intellectual discourse” that reigned there. Although today he relishes delving into the minutiae of research, back then, by his own admission, scholarliness was not his strong suit. In addition to the racetrack, there were the usual extracurricular distractions of the college experience. Also, like many young men in the late 1950s, Royce fulfilled his draft obligation through a ROTC program that he began in college—in his case, as a Marine reservist. With one summer spent training at the Quantico Marine Base in Virginia, a couple spent doing construction work, and one devoted to summer school to “true up” his course requirements, graduation soon loomed; it was time to move on and move out.
“Everybody went to business school in those days,” Royce says, and since he wanted to be in New York City, he and a bunch of friends decided they would enroll in Columbia Business School, which was noted for its strong investment reputation and has over the years turned out a number of other legendary investors, Mario Gabelli and Lee Cooperman among them. There, at long last, he threw himself into the study of finance and investment. “It was absolutely what I wanted to do,” he says; it answered the summons he had felt as a kid thumbing through Value Line, and he “just went through it, straight through,” with no stops, no digressions, no summer internships, no uncertainty at all. “It makes a difference to go forward with an idea of what you want to do,” says Royce, and as he grasped the MBA diploma at graduation, he must have had a sense that he was truly on his way.
But when Royce looked for a job after B-School, he found roadblocks instead. It was the early 1960s, and the banks were in ascendance. That was where the best and the brightest wanted to be—specifically, in the highly coveted, hyper-elite credit training programs offered to the most sought-after recruits, and very specifically, in the training program offered by the Chase Manhattan Bank, then the most prominent financial institution in New York, if not the world.
Unfortunately, Royce was not accepted into Chase’s training program, nor into any other bank’s training program, but his admirable determination pushed him forward. As a large firm, Chase had many doors on which to knock for entry-level positions, such as their well-regarded Research Department. Once again, he was rebuffed. This second attempt would not be his last, since persistence is a common and necessary character trait for successful investing. This is particularly true when your playing field is small capitalization stocks, where information is not as readily available as it is for larger, more visible companies that are widely followed by the analysts at brokerage firms. Royce eventually landed a job at Chase as an analyst assigned to track lost dividends. This job, as one might imagine, was indeed forgettable, but at least he had his foot in the door at Chase and eventually qualified for a junior-level analyst position in the bowels of the Research division.
That was when the fun began. Chase, at that time, was “the kingpin of the investment world,” in Royce’s words, and he was in the middle of it, meeting people, exploring the many dimensions of investing, examining and assessing companies and their stock. A lowly junior analyst, Royce was like a kid in a candy shop, giving in to his brain’s desire to wander, figuratively, here and there, exploring whatever research he thought worth probing—at least until his boss, a very senior utility analyst, suggested strongly that he should stick to researching the utility stocks to which he was assigned. Performing research on utility stocks, to be blunt, is often boring, since there is little that can go wrong or, conversely, go right enough to exceed expectations. And because they are supported by high dividend payouts that rarely change, the stocks typically trade in a very narrow price range. The sheer dependability of owning a utility removed the element of excitement from Royce’s research role and did nothing to feed the intellectual curiosity that had originally attracted him to the investment process. Thanks to the stick-to-utilities admonition by his superior, Royce came to the conclusion that he was more a generalist than a utilities guy, and maybe he would be happier in a smaller firm where there would be other dimensions to his position.
This was the 1960s, more than 40 years before commission rates would decline to pennies a share and join with greater regulatory scrutiny to pressure profit margins and thin out the ranks of Wall Street firms. The brokerage business was still a growth industry back then, with new firms sprouting up everywhere. In fact, there were hundreds of small firms for Royce to explore for a role more to his liking. He landed at Blair & Co., Granberry Marache, a classic white-shoe brokerage house with a small number of branches and a fairly standard outlook on investing. Hired as an analyst by an investment research professional with considerable experience, Royce was given the opportunity to do “a little bit of everything” and he “really got to see how the brokerage business works.” Royce recalls the invaluable lesson learned at this job: “This is a business where everybody rises or falls with the prosperity of the firm.” Indeed, this knowledge would serve him especially well in his as yet unimagined future, where he would build a significant business enterprise of his own.
In 1968, Royce was lured away by an even smaller firm, Scheinman Hochstin & Trotta, where he was elevated to the position of Director of Research. This, he says now, “made no sense, as I was 29 years old.” That may be too modest of Chuck Royce. After all, Wall Street has always been known as a meritocracy where age does not define an individual’s value nor act as either a barrier or a guarantee to advancement. In fact, the firm supplemented his brief period as an analyst by also making him a broker. This meant that he now had customers to serve along with his research duties, something that today’s regulatory and business practices would never allow. During what was the “Go-Go” decade of the 1960s, however, the regulators and regulations were fewer in number. Back then, the abuses were perhaps less obvious and the needed reform had yet to materialize; elected officials had yet to see the political and practical benefits of villainizing Wall Street. The first assignment for Royce was small caps, although back then, says Royce, “There was no such category. Small caps were just a more aggressive form of investing.” It was also, as it remains today, a populous universe numbering in the thousands of companies, as well as being, in Royce’s word, an “evergreen” universe, rife with new entrants in the form of both Initial Public Offerings—IPOs—and small companies spun off from bigger ones because they either did not fit with the larger corporate vision or were relegated to orphan status for one reason or another. Small caps, both then and now, can feel like the investment world version of a souk; they are as multiform, multifaceted, and multicolored as a bazaar in an exotic locale—and just as volatile. This was the universe in which Chuck Royce grew up as a researcher and stock-picker, and it is where he found a way of looking at the universe that allows him to understand which companies will perform with less volatility.
Royce thought mutual funds were “a fascinating business,” so around the time he began to work at Scheinman, he and a childhood friend bought a mutual fund that had suddenly become “available.” He reasoned that if other people were able to succeed at running a mutual fund, so could he and his buddy.
It was effectively a shell with no real assets and no real going-concern business. It consisted of a registration with the Securities and Exchange Commission, assets under management valued at less than half a million dollars, and a management contract. The fund had been created by twin Englishmen who had run it into the ground, forcing them to shut the doors. During their heyday, however, they had managed to purchase a country house in Pennsylvania, inspiring the name, Pennsylvania Mutual Fund. Royce and his friend decided to keep the moniker, since it “sounded very important” to them. Since Royce himself was directing research at Scheinman at this time, he was only a front man for the fund, taking the title of Chairman of the Board and leaving the day-to-day operations in the hands of his colleague.
The pages of the calendar turned quickly to the late 1960s, the era of the first no-load funds,2 which helped attract more investment money into the industry. Assisted by this surge in capital, the Pennsylvania Mutual Fund did extremely well. In the course of two years, the value of its assets rose from virtually nothing to approximately $100 million—the equivalent of a billion dollars or more in twenty-first-century dollars. Then the landscape changed for the worse and, with recession taking its toll on the economy and on corporate earnings in the early 1970s, the overall market turned down, as did Pennsylvania Mutual Fund’s performance. To make matters worse, disheartened by the market downturn, Royce’s partner had withdrawn more and more from the day-to-day running of the company. At the same time, Scheinman merged with a now-defunct brokerage house, Weis, Voisin & Co.
Royce was conflicted; he wanted to hold onto his day job at Scheinman for the steady income, but that left him very little time to attend to his other business, which was suffering more and more every day from the effects of the bear market and his partner’s withdrawal. So Royce was left to live with his own Catch-22. The assumption that “if others can succeed at this, so can we” was being sorely tested and found wanting, but Royce could do little because he felt compelled to stay with the job he believed offered him some security. Incredibly, Royce was rescued from this Hellerian dilemma in a twist that Joseph Heller himself would likely have admired, when a business disaster provided an unexpected escape.
The bear market claimed many victims as investors lost both money and confidence in the stock market. Weis, Voisin folded, as so many firms did in the early 1970s, and in 1972, with no more day job, Royce officially took over the Pennsylvania Mutual Fund.
It was, he concedes, a stressful period in his life. The market was doing badly, and so was the fund. Royce was married then, with small children, and “no money coming in.” He began writing a column on investing for Financial World, which was at that time the granddaddy of U.S. business magazines; the work provided the only paycheck he could rely on.
And … it got worse. Now in sole charge of the Pennsylvania Fund, “I promptly lost whatever was left,” says Royce—“40 percent in 1973 and another 40 percent in 1974,” two years that were more or less a perfect storm of disaster for the stock market. Recession, inflation, Nixon—it was all there. So it was perhaps not surprising that at the Board of Directors meeting in September 1974, there was a strong feeling that perhaps it was time to wrap up the Pennsylvania Fund and liquidate the remaining assets. Royce summoned all of his persuasion skills and beseeched the other Directors to reconsider. He prevailed. The fund stayed in business. He had one more chance.
At the end of 1974, the stock market hit bottom. Then, pretty much beginning on New Year’s Day of 1975, it began to take off. Royce’s fund took off with it and beyond; in fact, it was up 125 percent more than the market. The outperformance was truly remarkable, a nice counter to the underperformance of the prior period. In theory and in truth, small cap stocks typically do worse than the overall market in bad times and better in good times—higher risk, higher reward, so the test of a portfolio manager in that discipline is often relative performance. Royce showed his mettle and then some, removing all possibility of debate as to whether it was happenstance or skill. With the usual ups and downs of the investing world, Royce’s funds have been performing well ever since.
The lessons Royce has taken from that experience are crucial. The 1973 to 1974 time period was, as he bluntly expresses it, “just brutal” with the Standard & Poor’s 500 stock index losing nearly half its value. His livelihood, and by extension, his dream of spending his life doing what he passionately loved, were endangered and almost lost. The message was clear: Chuck Royce understood that he “needed corrective therapy about how you mitigate risk.” Of course he had always known in theory that “if you lose 50 percent, you have to make 100 percent”; that is, if you start with 100 dollars and lose half, you now have to double your remaining capital just to get even, a daunting mandate even in a strong investment environment. The events of 1973 to 1974 taught him that, as with so many of life’s lessons where book learning is not a substitute for practical knowledge, “Unless you’ve experienced it, you cannot fully grasp it.” He experienced it, and now he grasped it, and it became the core of what he calls the “vivid centerpiece of my investment style”—don’t lose the money; risk control above all else!
“The small-cap world is so large that you can do virtually anything you want in it,” Chuck Royce asserts. “You can avoid clichés, can subsector the class any way you like to weed out things that don’t fit and reduce volatility. The general perception is that small-caps are all growth all the time, with lots of volume. But the reality is much more varied, more nuanced.”
Analyzing balance sheets, the core of the research process at Royce, requires precision. Paradoxically, there is no precise definition of “small cap.” To Royce’s point, there are many different small cap indices, including value and growth, each as a standalone index as well as value and growth combined into one.3 There are also multiple indices against which a portfolio manager, such as Royce, can choose to be measured,4 including the Standard & Poor’s SmallCap 600 and the Standard & Poor’s SmallCap 600 Growth and Value. Russell Investments, developers of the eponymous Russell family of indices and a competitor to S&P, uses broader metrics for inclusion in its multiple offerings of small cap indices. Equities in the Russell 2000 Small Cap index, for example, have a median market cap of $475 million, with the largest member of the index touching $3.7 billion, the smallest at just over $100 million.5 The S&P 600, on the other hand, has members with market caps as low as $30 million.6 Royce trolls for ideas in an even larger playing field, extending the definition of small cap to $5 billion, with the caveat that the funds may even invest in companies sporting a $15 billion valuation, although this would be unusual.
As we would expect of one of the pioneers of small cap investing, Royce makes some good points when expounding on his strategy. Arguably, small caps fall victim to a wide array of biases and investment ignorance; they are often lumped together in a group of stocks characterized as high-growth, with strong momentum, and are illiquid in terms of trading volume. But there is no definitive correlation between the market capitalization of a company and the trajectory of its earnings growth. Smaller companies can lumber along much the same as bigger entities. Conversely, one would be hard pressed to find a small cap company experiencing long term hyper growth similar to that of Apple Computer, which as of this writing is the largest company in the world as defined by market capitalization. And lumbering along, of course, does not evoke a vision of stock price momentum. Still, there is some truth to the view that seeking to enter or exit a position in smaller companies may require more patience, depending upon the number of shares or the total dollar amount of stock that trades on an average day. The dollar amount is more important because it is a true reflection of the capital at risk. Royce applied a whetstone to this large and varied world, honing it down to a selected reality of low volatility and high value. “Value” is not a word he particularly likes. In the investment world, he contends, it has become a cliché; overused, it has lost its meaning. In the wider world, it still means the worth or importance that a thing deservedly is held to possess, and in both the wider world and the world of small-cap investing, whether he likes the word or not, Chuck Royce knows value when he sees it.
The potential value of an investment can be favorably skewed by the eye of the beholder. When the Ocean House, the gilded-age hotel on the bluffs of Westerly, Rhode Island (the location of Royce’s summer home) was sold to a developer who wanted to demolish the building and replace it with a row of McMansions, Royce stepped in. In tune with his investing discipline, the Ocean House is a relatively small hotel, the total size of which could possibly be overshadowed by the signage on a typical resort property. But Royce saw a communal, historical, and perhaps even a moral value in saving what could be preserved of a gracious past, and he also saw the social and concretely material value of transforming Ocean House into a new engine of economic activity. So that is what he used his wealth to do.
It is not too far-fetched to relate this instance of preserving and renewing value to Royce’s core investment goal: “I am looking for sustainable, high returns on a company that is misunderstood in the marketplace, that I can buy cheaper than what it should sell for, and where I am buying into a compounding effect that will carry me a long way.” A most critical component of Royce’s thinking is that he is looking to buy companies not stocks; he analyzes each candidate for his portfolio as a business. To do that, Royce follows the discipline he put together out of the “brutality” of 1973 and 1974, and out of all the expertise and all the experience he has gathered in that “aggressive” small-cap universe.
Royce once described his discipline to an interviewer as a “carefully designed way of looking” at a potential investment, a way of looking that “can reduce volatility substantially” so he can “select portfolios that will perform better and with less volatility.”7 And, he might add, so that he may sleep better at night.
One element of the discipline Royce holds to is that “after Syntex, I now pretty much avoid high-flier glamour stocks.” The reason? “The price you pay for stocks has a lot to do with how it’s going to perform.” Paying a premium for the sizzle, by definition, takes a hatchet to the value proposition, since the stock price reflects a possibly fleeting market infatuation with a particular stock. Glamour is an intangible, not found anywhere on the balance sheet and adding nothing to the intrinsic value of a company or its assets. And when the glamour fades, the stock price can start acting as irrationally to the downside as it did to the upside, when it was the darling of the often fickle markets.
With the avoidance of hype as a given, Royce regards the balance sheet as a particularly telling target of focus, with hard assets and cash being truly beautiful. It is a lesson he learned long ago, when he was head of research at Scheinman and he signed off on a favorable report on a company that promptly declared bankruptcy a month later. By his own admission, he simply “paid no attention to the balance sheet,” which even a quick look showed to have accounting conclusions with holes big enough to drive a truck through. This was a lesson learned early in his career and with other people’s money. Since that time, says Royce, “If I have only five minutes to look at a company, the balance sheet is what I check.” But that is just five minutes of a much longer period of analysis, albeit a very important first step. Without a solid balance sheet, the hurdles to a stock making it into the portfolio become close to insurmountable.
He examines to what extent a company may be leveraged, since he looks for a company with sufficient return on assets to grow while minimizing debt. He looks at return on capital and at the interplay between income statement and balance sheet as tools of valuation of a company. When he thinks about what he wants to pay for a stock, he is an absolutist rather than a relativist. That is, he finds it less useful to see what others are paying for “equivalents” than to assess the company’s standalone worth. The question he asks about the company is, “If I could own it, without any leverage, what kind of earnings could I take out of it?” The danger in being a relativist who compares two equivalent stocks, says Royce, is that “one stock is always cheaper, but what if both are overpriced?” As an absolute investor, he also expects to make money in absolute dollars, not simply “relative” to an index, although Royce does tend to beat the Russell—the aforementioned Russell 2000 stock market index that is the actual standard benchmark for small caps. Without the ability to make negative bets on stocks—that is, the ability to short—absolute performance is an unusual practical benchmark for a long-only manager, but it is the proper mindset since there is no solace in losing money for your investors.8 But while no manager likes to lose money, asset allocators—the consultants who parcel money out to equity fund managers on behalf of pension plans and endowments—often judge a fund’s success by how well it performs against their particular benchmark. So if the index they are measured against is down 35 percent on the year, as the S&P 500 was in 2008, and the fund only lost 25 percent of its capital, then the portfolio manager would no doubt see his fund size increase from the inflows chasing its relatively less poor performance. Essentially, outperforming mediocrity by the slimmest of margins is the benchmark for most funds, but not so in the case of Royce Funds. They strive for absolute performance, meaning they want to make money in all markets and take no comfort in losing less than others. It is an admirable goal, for sure, but one that has not always been achieved. I know many managers who take victory laps in being the best house in a pretty ugly neighborhood.
Because liquidity is sometimes an issue with small caps—these are not stocks that can typically be sold quickly or in volume—Royce must envision a higher return relative to the risk of not being able to sell out of a position when he wants to, which is the particularly onerous penalty an investor suffers when the investment case turns sour without much warning. Illiquid small cap stocks are the portfolio manager’s version of the Roach Motel: You can check in but you can’t check out. This is why it is critical to size the position appropriately and ensure that the stock price is supported by strong asset values.
It is on this “designed way of looking” at small caps that Royce has built both his formidable investing success and a distinctive and distinguished investment business. Naturally, there have been slow patches and down years. In the late 1990s, when everyone was climbing on the tech bandwagon, Royce did not; to do so would have violated his value discipline. Numerous investors strayed far from their discipline, lured away by the siren song of tech stocks that would double, often triple, even quadruple in price in very compressed periods of time. To those willing to forsake their discipline, the price action and return justified the strategy drift, a slippery slope indeed. “We avoided the tech ascendancy,” he says, and although “we compounded nicely in the low teens, the market was compounding in the twenties. It looked bad relatively speaking, but we performed okay.” Assets grew, but so did the number of redemptions, as mutual fund investors chased the performance of others. When the bubble burst, however, “we were proven right.” Essentially, says Royce, “We changed nothing, but we no longer looked like a dunce.” The market went into a steep decline in 2000 and 2001, “but we did very well during that period, as did anyone with a lower valuation approach.” In other words, ignoring inflated price-to-earnings multiples and disregarding the risk of money-losing business models was no longer a winning strategy.
Today, The Royce Funds is a firm of about 100 people with offices in New York and Greenwich, Connecticut, and with some $40 billion in assets under management. The firm is “a big player in the small cap space,” as Royce says, “but then, the small cap space is so big.” It is a business built on making scale, collegiality, and an open atmosphere work. There are no “junior” people. “We don’t do training here,” says Royce. There is a particular environment—a particular culture—and the firm can move at a leisurely pace selecting people who might fit well in that environment. The interview-to-hire ratio is exceedingly high, the rigor and length of the process outlasting the time frame of many candidates. “You have to be comfortable working out of a cubicle in an open atmosphere,” says Royce—there are no closed-door offices in the place—and it is a “very transparent process” in which “everybody is invited to every meeting” and nobody does his own thing. In fact, only two people have traditional offices, Royce and his long-time number two, Whitney George. But unlike conventional corporate hierarchies, there is no correlation between where an employee sits and compensation, since the portfolio managers can potentially earn millions of dollars a year because their bonuses are tied to their individual performance and that of the funds.
The firm also takes its time researching stocks and building a full position. While “taking a position can take an hour,” says Royce, “taking a big position can take years.” The equity may be so thinly traded that trying to put on a full position in a short period of time could drive up the price significantly. Then there is all that core research, and of course there is the chance to sit down and meet in depth with a company’s management. Royce, however, is wary of the latter. As interested as he is in what he calls “the dialogue” of how a company got to where it is and about its strategy for the future, he is aware that you sometimes “can’t help being snowed by ‘wow’ people.” And CEOs got to be CEOs for a reason; they usually have powerful and persuasive personalities that can sway one away from objectivity. So Royce is content to take a meeting with management as “a piece of the puzzle” while believing that “results are results” and that they are available in the company filings required by the Securities and Exchange Commission. Once the stock has been purchased for the portfolio, of course, the firm is glad to be in regular communication with management.
That is the way it worked with Ritchie Bros. Auctioneers, the Canada-based industrial equipment auctioneer whose stock has been a big win for Royce Funds. It is an investment that epitomizes the Royce strategy.
The Ritchie brothers owned a furniture store in Kelowna, British Columbia, in the heart of that province’s wilderness area, and in 1958 they found themselves in debt to the bank. They gathered some surplus sofas and chairs from the store and put them up for unreserved auction. When the auction had cleared their debt, they envisioned a business opportunity and went about scheduling more auctions. In 1963 they moved beyond furniture into unreserved auctions for used industrial equipment—tractors, loaders, backhoes, excavators, the stuff needed for construction, agriculture, mining, transportation, manufacturing, and forestry, and they sold $600,000 worth of goods. They expanded the business to the United States in 1970, and then further internationally toward the end of the 1980s. In 1998, the Ritchie Bros. gross exceeded $1 billion and management was ready to take the company public and engage the IPO process.
Royce analysts had been looking at the company for some time. It was a different kind of business, and, says Royce, “We are always alert to the offbeat and to quirky companies like this, and we were very intrigued from the start.” They saw it as a niche business in a highly specialized field—a business that acts, in Royce’s phrase, like “a toll business, collecting a fee each time you pass through.” In such a business, more buyers mean more consignments of equipment to auction, and more consignments mean more buyers. Buyer and seller traffic feeds on itself, expanding the business, an enterprise that depends upon others to expend capital for the products offered—the goods they are seeking to sell. The auctioneers then collect a fee for overseeing the selling process. As the business builds, says Royce, “it creates a very wide moat for other businesses” to cross in order to compete.
When he speaks of a wide moat, Royce is referring to the first-mover advantage that in certain businesses establishes a significant barrier to entry for potential competitors to surmount. Ritchie Bros. had essentially invented a new enterprise, a market that had not existed before. No matter that they sort of stumbled upon it—a positive consequence of their financial misfortune. It was not quite the epiphany experienced by Sir Isaac Newton as he watched an apple fall to earth, but they knew what they had and took advantage of it. “Once it’s established,” as Royce puts it, “it’s yours to screw up.”
And Ritchie Bros. management, which now includes non-family members, has hardly screwed up. Their insistence on no-reserve auctions is evidence of their seriousness and integrity; they show high return on invested capital. As they have expanded they have exhibited the ability to take advantage of a cyclical downturn to add auction sites. Counterintuitive perhaps, but the used equipment business is recession resistant as financially secure buyers seek to take advantage of the more plentiful supply of product as it becomes available. Ritchie Bros. was looking like precisely the sort of small-cap company investment in which Royce specialized: undiscovered, non-mainstream, industrial, with high returns and high margins, and with a proprietary critical advantage for success. Honing it down until he was sure it was just the way he liked it, and assessing it on the Chuck Royce standard of potential acquisition—the if-we-owned-this-company standard—Royce bought Ritchie Bros. (RBA) on the Initial Public Offering and during the subsequent trading day at an average cost of $4.19. It was actually something of an unusual IPO, a financing mechanism usually used by companies much younger than the almost two-decade-old auction firm. But Royce still had not completely bought into the stock, wanting to see how Ritchie Bros. acted as a public company. And there was still a lot of analysis to be done. That “began the confidence-building process,” as Royce says, and the firm continued to research Ritchie Bros.—its competition, customers, and process. Everything they found served to increase their confidence, and the Royce position in RBA grew in lockstep. As of this writing, Royce still has a position in the company.9
Royce management and RBA management meet “a couple of times a year.” The former continue to be impressed with the latter. Royce analysts note the skill and savvy with which RBA handled the potentially tricky evolution to Internet bidding, which constitutes approximately a quarter of RBA’s business. Return on invested capital remains strong, and Royce continues to believe the opportunity is huge for RBA to consistently grow market share. For Royce, one of RBA’s largest shareholders, the result is “a compounding effect of a quality company that continues to do better” and that is pursuing an opportunity for even more growth. No wonder “we feel vindicated by RBA, by its progress as a company and a stock.”
Finding the value in a small cap stock takes work, and building a bigger, more impactful position in a company you have invested in takes more work. But if it is work you have wanted to do since you were 15, then no matter your age, you are passionate about doing it. It is the kind of passion that keeps a person focused—acutely, intensely, relentlessly. The same guy who found his passion long ago while flipping through a loose-leaf binder, today powers on his iPad first thing in the morning to check the markets, still in love with the idea of stocks and the process of figuring odds. That is a life win, and it is a big one.
Notes
1. Gregor Mendel was a nineteenth-century Austrian scientist and monk credited with being the founder of genetic science. He believed that certain genetic traits could skip a generation.
2. Investors in no-load funds do not incur a commission or sales charge since the funds are distributed directly by the fund manager rather than by a middleman.
3. In addition to companies such as S&P and Russell providing different market cap parameters for inclusion in their branded small cap indices, significant movement in the overall market averages will increase or decrease these levels to ensure that there is an appropriate universe of stocks to include.
4. Commonly called “benchmarks,” active money managers are judged based upon how well they perform versus a particular index that is similar to their investment style.
5. www.russell.com/indexes/tools-resources/reconstitution/us-capitalization-ranges.asp. Figures as of October 2011.
6. www.standardandpoors.com/indices/sp-smallcap-600/en/us/?indexId=spusa-600-usduf–p-us-s–. Figures as of December 2011.
7. Interview with Consuelo Mack on Wealth Track, February 4, 2011.
8. There is no provision allowing for shorting stocks in the by-laws that govern the Royce Mutual Funds as is true for most all mutual funds.
9. Royce Funds may trade around a position, shaving the holding when it appreciates to a certain level that makes the holding less attractive than an allocation to other stocks. They may also sell it in its entirely and buy it back when the valuation again becomes attractive. In terms of Ritchie Bros., they did exceptionally well, realizing a profit of five times their initial investment, higher at some points, lower at others.
10. Capitalization rate, cap rate for short, is a technique for valuing a company in terms of what it returns on the investment. Cap rate is most commonly used in real estate for measuring how much income is generated on rental properties after various expenses, but Royce applies it to companies. Simplistically explained, cap rate as it relates to stocks is a measure of how much cash flow the company generates versus the price paid for its stock.
11. There are two basic types of acquirers of public companies: financial buyers, of which private equity firms dominate the category; and strategic buyers, companies that are looking to merge their operations into the company they are buying. Because there are more synergies and a greater ability to reduce costs in a merger, strategic buyers can typically pay a higher price for an acquisition than a financial acquirer.
12. EBITDA, as with EBIT, is a conventional measure of a company’s cash flow that is perhaps employed more often by financial analysts. A reason for this is that it takes into account the impact of depreciation and amortization of a company’s assets. EBITDA: earnings before interest, taxes, depreciation, and Amortization.