Small Cap Manager

Issue #10, July 2002

Accounting for Returns: How Royce Special Equity Fund Gained 34% in Past Year

By Richard Hefter, Editor, Small Cap Manager
For additional information contact:
info@executechfinancialadvisors.com

Charlie Dreifus's investing strategy hasn't changed in the four years he's run the Royce Special Equity Fund, but investors' appetite for small caps sure has. With small-cap value back in vogue, the $220 million fund, which fell 9.6% in its first full calendar year of 1999 when high-tech-growth reigned, has enjoyed returns of 34.1% for the 12 months through June 30, 2002. But other small value funds have gotten smacked in recent months while Dreifus, a 34-year industry veteran who spent much of his career at Lazard Freres and Oppenheimer, managed to make money in the abysmal second quarter, perhaps due to another new appetite by investors: investing in companies with pristine accounting practices. A chartered financial analyst and protigi of Abraham Briloff, the Baruch College professor who emphasizes the importance of "accounting cynicism," Dreifus enjoys poring through SEC documents, scrutinizing financial statements in his quest for winning stocks.

Why has your strategy run so countertrend to this down market?

Obviously for some time now small-cap value has done better than other asset classes, although the Russell 2000 is down [of late]. But we have as perhaps an additional wind to our back a methodology and philosophy that seems to have caught attention.

What is this methodology?

It has three legs: The first is the classic security analysis as taught by Ben Graham -- the notion of striving for a "margin of safety," trying to buy inexpensively so you put the odds in your favor. I try not only to buy the relatively attractive securities but also the absolutely attractive securities. I look at what the return would be to me if I bought the whole company and compare that to what my cost of capital would be. It's a very meticulous, disciplined approach to valuation, not even looking at P/E. It's much more of a mergers-and-acquisitions metric dealing largely with enterprise value and EBIT, not even EBITDA.

Can you explain this valuation metric further?

It's enterprise value, which is essentially the market cap plus interest-bearing debt plus preferred stock and liquidating value, minus the cash the company has. Basically, it's how much it would be at market for you to buy the company. To buy a company you have to buy up all the shares and assume the debt obligation, but you have the company's cash. I divide that total by earnings before interest and taxes (EBIT). I don't include depreciation as others do. It might give me a better result if I did include depreciation, as it would make the stock even cheaper. But my notion is if I were the corporate buyer and I wanted to stay in that business I would have to keep on investing in new parts and equipment to maintain myself, so that's not money I can really look to.

What's the second leg of the stool?

The second leg is incorporating Ben Graham's top student Warren Buffet, who was able to say, "Professor, that's great; however, what you end up doing occasionally when buying inexpensively is you buy unattractive companies." Warren Buffet, as we all know, came up with this notion of trying to buy franchises -- great companies. We all would strive for that, but how do you quantify something like that? What I've done over the years is employ various returns on capital, returns on assets, to use as a proxy for a company that enjoys some kind of niche or franchise -- such that it's able to charge rates for its product or service that are high relative to the assets employed. So I'm looking for inexpensive but good businesses.

What universe are you screening?

I use market caps below $2 billion with a focus below $1 billion. I base my screens on trailing 12-month data, which is another hallmark of what I do. Once I have candidates that appear to be inexpensively priced and have high returns on capital, I go to the accounting review phase, which is perhaps the most critical.

What does this involve?

This involves going through all the SEC filings of a company. This is frankly something I have enjoyed doing throughout my 34 years in the industry, ever since being a student of Abe Briloff, my Baruch graduate school accounting professor and mentor and today still a dear friend. Briloff's been a critic of the accounting profession. The fault he finds with the auditing process is that auditors are unwilling to take on the role of ombudsman and basically say, "Yes, there is this menu of generally acceptable accounting principles, but within that it's your obligation as a company and therefore my obligation as the auditor to the statement to pick the accounting principle that ideally reflects economic reality."

In this regard, I like to believe I add some value in that I'm able to basically grade a company's accounting process. Reviewing the footnotes first and then the actual financial statements, I'm able to develop a mosaic. It's not one single item that tilts "ney" to a company, it's rather the various alternatives the company has used to suggest to me the company is either portraying the numbers aggressively or conservatively.

Having said that, if there's fraud I won't know it, but I do look through these documents to get a sense of how close to reality might this be. And from a scale of A to F, I can array them.

How many companies do you typically screen out through this process?

Out of every 10 I look at, my guess is I only end up buying one of them. We're fairly concentrated, with currently about 70 positions. By this selection process I end up very often with companies that have large insider holdings, typically a family that's been involved with the business since its inception that owns 20-30-40% of the company. Their mindset in a non-pejorative way is very much of a private company.

How is this "private-company" mindset beneficial to you as an investor?

They tend to be less aggressive on their own. They're not going to go out and buy something at a crazy valuation. They're not going to issue a lot of stock options and dilute their stakes. They're going to try to minimize taxes and expense everything as quickly as they can. They tend often to have an older member of the family who is even more conservative, and therefore they tend to have quite pristine balance sheets with little if any debt. In fact, if I have indeed identified these niche businesses, they do nothing but throw off cash at you. So these are companies often in an enviable position of having virtually no debt, a ton of equity, high operating earnings and a ton of cash.

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Royce Special Equity Fund's Top 10 Equity Fund Holdings
(as of June 30, 2002, see www.roycefunds.com )

K-Swiss Cl. A 3.8%
Universal 3.6%
Deb Shops 3.5%
National Presto Industries 3.4%
Dress Barn (The) 3.2%
Banta Corporation 3.2%
Russ Berrie and Company 2.8%
Standex International 2.5%
Bob Evans Farms 2.5%
Maxwell Shoe Company Cl. A 2.4%

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Are there any particular industries that tend to come up more in your screens?

At times the screening process will highlight an entire or major portion of an industry that is so discredited for no legitimate reason, but at the moment there's no one particular industry. But in general I'm buying prosaic companies. I'm buying companies that make teddy bears or roast coffee or sell shoes. It's also the Warren Buffet notion of understanding what you buy. I'm not straying into exotic things I have no sense for. These are also, again by dint of market cap size, conservatively run companies which tend to have pretty transparent -- and if not transparent at least much less complex -- financials, which is obviously something that also is favored today. In those cases where there's a family, usually there's some family members who want current income, so usually there's a dividend. The extreme cynic these days would say that not knowing what earnings are, perhaps companies that pay dividends who don't borrow to pay the dividends may actually be earning that money.

What is your exit strategy?

I exit for two reasons, one being that I made a mistake. I know I do make mistakes. The company does less well than I expected, the persistency wasn't there, and I determine the company doesn't merely have a cold, it's got pneumonia or cancer and I'll sell it no matter where it is. Fortunately, that doesn't happen all that often.

The second reason for selling is that the price has gone up, which can happen for several reasons. One is that the shares are propelled higher by some sort of corporate event. Sometimes I feel that inherent in my portfolio are a whole bunch of events waiting to happen. These are companies that have various options they can explore in terms of doing a Dutch Tender, buying their own stock back, or making an acquisition. At times they become the subject of someone either doing an LBO or acquisition because obviously many of these companies can be financed with the strength of their own balance sheet, either by virtue of them not having any leverage or not having any leverage and a lot of cash, and selling at low valuations.

I will also exit when a stock has trickled higher and I don't believe there's a cushion between what the value of the business is any longer and the market price. I will then recycle the money into something that has more of a gap between the two. As it very often happens, my notion of what the full value to a buyer is ends up being less than what an ebullient market will give, so I very often sell too early.

What can you expect of small caps going forward relative to the market?

Classically, as you know, small caps do well out of a recession. However, what may mute small caps' success this time around, at least relative to the market, is the weakness of the dollar. Most small caps, certainly in the value arena but in many cases in the growth, too, have little foreign exposure. They are domestic companies. So the earnings zeros which are now more valuable translating back into dollars will be of little consequence to small-cap companies, where as to the large caps -- particularly growth companies and classic drug companies and consumable companies -- their earnings gains should accelerate.

So in theory you should see greater earnings growth from companies with more international exposure. Offsetting that on the other hand, large companies are probably as a class more susceptible to some of these accounting restatements and tightening of accounting presentations that we're likely to see -i.e., expensing stock options -that should offset some of the earnings gains.

Though small caps, particularly value, have had a pretty good run for some time now, they're still attractively priced, there's still opportunity, and as a stock picker I'm still consistently able to generate new ideas. As long as I can find securities that are not only relatively inexpensive but absolutely inexpensive, it strikes me that it's an asset class that should continue to do well.

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