Steve Lipper: Welcome to this Royce Investment Partners podcast, Three Questions With, and today we're joined by Charlie Dreifus, portfolio manager and managing director at Royce. I'm Steve Lipper your host today, and I'm the Senior Investment Strategist at the firm.

Charlie Dreifus manages the firm’s Special Equity mutual funds and related strategies that attempt to combine classic value analysis, the identification of a good business and accounting cynicism. In 2008, he was named Morningstar’s Domestic-Stock Fund Manager of the Year. Charlie has been at Royce for 22 years and has 52 years of professional experience, though that does not count his years as an active investor when he was a teenager. Charlie holds a bachelor's degree from the City College of New York, Baruch School and a Master of Business Administration from Baruch College. He is a CFA charter holder. Charlie, thanks for joining us today.

Charlie Dreifus: My pleasure Steve, thank you for giving me the opportunity of participating in our very first podcast.

SL: Yes, we are excited, thank you. You had an interesting phrase recently that responded to the zeitgeist today. What you recently said is, "You don't fight the screens," as a response to the phrase of some who say, "Don't fight the Fed." Can you tell us what you mean by that and then link it to your portfolio, walk us through how cash in your portfolio has moved as a result of what's coming through those screens?

CD: Excellent question and something that goes to the heart of what Special Equity is. When I use the term don't fight the screens, which is a play obviously on don't fight the Fed, a term that was coined many years ago by a market strategist and professor of finance, Martin Zweig, whom I knew. What it basically is telling us, we construct portfolios from the bottom up and we are having trouble finding new candidates to add to the portfolio these days. Very different than late March and early April. 

To give you a frame of reference, some of you may be familiar that in Special Equity, in terms of the valuation technique, we use something called the cap rate. That's essentially the return the investor or the buyer of the whole business would earn if he or she bought the entire business. Well, for the Special Equity portfolio, that's come down from March 31st of 10.6% to 7.4% on June 30th. It gives you an inclination as to what occurred. What occurred is valuations went up while earnings went down.

We're still very pleased with our portfolio. The 7.4 meets our test of being enough above the junk bond yield to make it an attractive absolute investment. The issue is that, it's not particularly high number, the 7.4. Now we have names in the portfolio that are obviously much higher than that, but 7.4 is on the low side compared to the junk bond yield, and it's also in an absolute sense low.

That tells us that, it's not a particularly attractive climate for Special Equity to add names, thus we are not trying to put a square peg into a round hole. We're not going to modify our long time tested discipline which has rewarded shareholders overtime. We're sticking with our approach and thus don't fight the screens.

SL: Yeah, thanks for walking us through that and maybe just staying on the Fed a while since it's the biggest actor causing changes in the environment that as equity managers we need to be aware of. They’re not just injecting liquidity as they have in the Great Financial Crisis; they actually in an unprecedented manner are active in credit markets. This intervention is disproportionately supporting companies with weaker balance sheets. That would seem to shrink the advantage that companies with pristine balance sheets, like the ones you prefer, have. How are you thinking about how much of an advantage it is today to have a debt-free balance sheet?

CD: Another great question. It's probably honestly a disadvantage. We're in an environment where the Fed not only provides a free lunch, but as contrast to an otherwise prohibited way of providing lunch during the pandemic, they're providing a smorgasbord. A complete buffet where everyone partakes, and it has huge consequences.

The market is favoring companies that don't have earnings, that don't pay dividends, that have a lot of debt. The riskiest, junkiest of companies that are getting a free pass. That free pass incidentally has consequences much further and deeper. It's allowing zombie companies to continue to exist, which is dampening inflation. It goes actually against the very big objective that's recently talk about the Fed wanting to overshoot on inflation.

The more companies that are boarder line companies that have no pricing discipline, the more likely it is that you're going to have lower inflation. Of course, it also hurts those stronger companies that would survive in any event and their ability to price higher, because you have competitors out there that shouldn't have been allowed to survive that are very carefree about pricing.

SL: Yeah, it's an unusual time. Let's come to more some of the things you've been doing in your portfolio where you have found some opportunities. You've bought several new Financial holdings, I think for the first time in several years. What do you see in this area that attracts you?

CD: Well, Steve as you know we are bottom up investors. Sometimes an entire group shows up because it's not fashionable or just people are rightly or wrongly concerned about the outlook for the industry.

Recently we came across a couple of money managers that looked very attractive, obviously capital light businesses, huge cash conversion. Their earnings are in cash and thus they have incredible balance sheets. Many of these companies, the ones we bought and some others, have very large cash holdings and holdings in their own mutual funds in proportion to the stock price. There's a lot of attraction in this group. What people are fearful of I would think is the high current market valuations and that assets under management AUM is the term, would decline as the market declines eventually. And so, that is probably the reason that people are not that keen on it.

We obviously don't disagree that it would hurt, but if the market went down, we think that these companies obviously have the financial strength to endure that. And that, that situation should it occur, will prompt an even greater degree of industry consolidation that has been occurring. The two names that we bought are candidates to partake to be bought out in that consolidation.

There's a third name, a money exchange company that is part IT and part bank like. What they do is they take dollars from U.S. workers that are sent to family members in places like Mexico or Guatemala, and that too is a very cash rich kind of business with low capital requirements. You're right also Steve, the last time we had any involvement in these kinds of companies was 2014.

SL: Yeah, we can definitely see why that's attractive. That's really terrific insights, thanks for sharing your thoughts around that, around the market and around the areas that you're finding attractive. We'd like to conclude with each of our guests with this non-investment questions, pivoting to that. We're going to do three of those and here we go. What recent book, either fiction or non-fiction that you've read have you liked?

CD: Historically I was not a big reader. I was always as a child, there's a great story which explains my love of the stock market. When my mother offered to read me stories, I said, "No mommy, give me numbers to add or multiply," and so forth. It was only later in life that I started actually reading books. I am sorry to admit, but true nonetheless. My most recent book that has nothing to with business, I do read a lot of business non-fiction, but I read a non-fiction mystery story. The title of the book is “The Life And Death of a Mossad Spy, Sylvia Rafael.” The authors are Ram Oren and Moti Kfir.

It's a story of a woman who comes from no background in this, and in fact she lives in South Africa and decides to move to Israel. This is right before independence in 1948 and gets involved and recruited by the Mossad, and it leads you through her life and ultimately her death while being a Mossad agent. What kinds of things they do and how they go about it, and the toll it takes on their personal lives, it's really quite fascinating. It's the kind of book that is tough to put down. I got it as a gift from someone, and I was mesmerized.

SL: That's fascinating Charlie, thanks for that. That really sounds interesting. Let's continue on a non-financial topic, taking it back to college. What was a non-financial, non-accounting college course which really engaged you?

CD: Actually, far field although there is a connection I suspect, it was sociology. This professor was terrific, and it gave me new insights into so much and particularly into group dynamics. It actually led to my being sent by the Baruch School of City College to a leadership training/group dynamics program that was given by the University of Maine. And I spent the whole summer during my junior year up in Bethel, Maine, learning group dynamics and how the interaction of people and your body language and all those things, and that was all as a result of that sociology course.

SL: Yeah, that's really fascinating. That's a great story, thanks. Finally, what activity outside of business and time with your family do you really enjoy?

CD: Another probably too revealing is that I don't have a lot of outside interests, but it's true and I'm not going to deny that. So, the next down after my family and my work is lending a hand beyond financially to not for profit organizations. It usually has something to do with finance, but it might not or actually serving on the board.

I certainly feel that way about Baruch College and the City University because it was free tuition in the days that I went and had it not been, I wouldn't have been able to go. It's a matter of giving back and paying respect and homage to the school and the professors. I've often said on other discussions my debt to Abe Briloff, my mentor, and all of that came through City College/Baruch College. There are other institutions I feel the same way about and so if I can be of help, I try to do so.

SL: That's great, that's a great example. All of those really, really interesting, great examples, thanks for sharing all of that. Again, thanks for joining us today Charlie.

CD: My pleasure, thank you.

SL: Thanks to all of our podcast listeners for choosing to spend your time with us today. Thanks again and hope you all have a great day.

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