Anyone old enough to remember the 1970s might recall long gas lines, rampant inflation and a brutal stock market. At the time, Charles Dreifus, then a young director of research at a New York brokerage firm, was struggling with so much bad economic news all the time that he remembers turning off his Quotron machine periodically to get a break from the devastation in the stock market.
In another part of the city not far from Dreifus' office, Charles Royce was battling investment demons of his own. In 1973, the year he took over the tiny Pennsylvania Mutual Fund from a colleague, he was weeding out the '60s-era "go-go" stocks that populated the fund and replacing them with what he considered a more resilient breed of small company shares. "I wanted to invest in small companies that paid attention to things like balance sheets and cash flow," he told Financial Advisor in a 2001 interview.
On the surface, Dreifus and Royce have little in common except perhaps for a first name. Dreifus, who was born on an Army base, was a first-generation American and the first in his family to graduate from college. He used his bar mitzvah money to buy stocks. Royce, meanwhile, has a penchant for bow ties that harks back to his days as a student at Brown University, a haven for blue bloods when he attended the school in the late 1950s.
Yet over the next 35 years, the two would share a friendship, as well as a similar investment style marked by attention to clean balance sheets, disdain for hot investment trends and a preference for simple-to-grasp business models. They are also stock market junkies, says Dreifus, who recalls that when he and Royce were at an investment meeting in Australia over 20 years ago they were the only attendees who preferred poring over financial newspapers to playing golf and snorkeling.
By the time Dreifus joined Royce's firm in 1998 to manage Royce Special Equity and handle institutional accounts, he had honed a style in sync with his employer's idea of what a good small company stock is: a piece of an unexciting yet dependable business that could chug along in all kinds of economic environments. To find them, the former accounting major looks at a company as if he were a potential acquirer as well as a stock investor. Price-earnings ratios are not always reliable, he says, since companies can easily fudge or inflate earnings. Instead, he looks at measures such as 12-month-trailing earnings before interest and taxes (EBIT) and return on invested capital, which he says better reflect a company's financial strengths or weaknesses and intrinsic value.
Stocks in the portfolio typically have ample cash on hand either to buy shares back or to distribute as dividends. He believes dividends will take on greater importance as stock market returns diminish, while buying back shares benefits existing shareholders because earnings are spread among fewer shares.
He also likes to see high levels of insider ownership, often by family members. "These companies are the family crown jewels. Their owners tend to pay a lot of attention to risk and have conservative management. And they often have transactional activity-such as a large, one-time cash dividend or the sale of the company-that ultimately benefits shareholders."
The screening process unearths companies with prosaic, simple businesses that the average fifth-grader can understand. National Presto Industries, the fund's largest holding at the end of November, produces appliances and household gadgets such as the PrestoBurger and FryBaby. Another top ten holding, Arden Group, is the parent company of Gelson's Markets, which operates 18 supermarkets in Southern California. Longtime holding Bio-Rad makes laser-scanning microscopes, diagnostic test kits and other products for the life science research and clinical diagnostics market. And Lancaster Colony Corporation, which makes specialty foods, glassware and candles, is one of just 21 U.S. companies to increase dividends each year since 1963.
If there is an Achilles' heel in Special Equity's portfolio, it is the dependence of its holdings on consumer spending. While weakening consumer demand can affect the large number of companies in the Royce portfolio whose sales are tied to industrial or consumer products, Dreifus believes they are strong enough to weather tough economic times. "Many small companies are having trouble finding financing, but the companies we're invested in have a large cash cushion," he says. "Among smaller companies, this is going to be a survivor-take-all environment, and the companies we own are going to be the survivors."
Bear Market Stamina
Pedestrian or not, Dreifus' picks helped the fund emerge from 2008 in better shape than the vast majority of its peers. It ended the year with a one-year total return of -19.6%, 17.4 percentage points better than the S&P 500 index and 12.6 percentage points over its average Morningstar small value fund category peer.
Limiting losses in a dismal year helped Dreifus snag Morningstar's Domestic-Stock Fund Manager of the Year award for 2008. In writing about the honor, Morningstar analyst Russ Kinnel said, "We have a lot of confidence in Dreifus' investing skills. His strategy shields against losses in bad markets even though it also means that Royce Special Equity lags in big market rallies."