Steve Lipper: Hi, this is Steve Lipper, the Senior Investment Strategist here at Royce Investment Partners. And thank you for listening to us today on Three Questions With. Today, we are joined by Miles Lewis, portfolio manager. Thanks for joining us Miles.

Miles Lewis: Thanks Steve. Great to be here.

SL: Miles joined our firm earlier this year. And prior to that, he was a portfolio manager and investment analyst for the Small-Cap Value Fund and Strategy at American Century Investments. And prior to that, he worked at debt restructurings at MBIA Insurance. Miles holds a bachelor's degree of business administration from the College of William & Mary, and a master's degree in business administration from the Johnson Graduate School of Management at Cornell. And Miles is also a CFA® charter holder.

Miles, let's dive into the strategy, the Dividend Value Strategy, which you lead with Chuck Royce along with Jay Kaplan. Financials is a very large weighting in the Total Return portfolio, recently over 40%. Now I know that you and Chuck view this sector as being much more diverse than many investors appreciate. Can you walk us through how you think about investing in Financials and how you segment it?

ML: Absolutely, Steve. I think first it's important to point out there is a tendency by many in the market to think that Financials equals interest rates and/or really cyclical businesses. But in our opinion, that really isn't the case. And so, when we look at our overweighted Financials, it's also important to note that it's a function of our bottom-up driven process. The Financial space happens to have a lot of attractively valued, high-quality, dividend-paying stocks, and recent weakness in certain parts of Financials has created lots of opportunity for us.

So when we look at the exposure that we have there, we think it's important to peel the onion back a layer or two and look at both how we segment it and then the overall diversity of the business and their correlations to things like interest rates and the economy. So we break the exposure up into three broad buckets: banks, insurance, and capital markets. The bank business models are somewhat homogenous, but the holdings within insurance and capital markets are actually very diverse, and thus they have pretty different business drivers.

So while banks are a big weight at 17.5% of the portfolio, they're actually our smallest overweight within Financials, and our two largest overweights are actually in capital markets and insurance. And each of those two industries is very eclectic and diverse. Capital markets includes things like alternative asset managers such as Ares, the Toronto Stock Exchange, and boutique investment banks that provide advisory services, a company like Moelis. Insurance, on the other hand, is a space where we're very bullish on the P&C insurance cycle, which by the way, has very little correlation to the overall economy. But that group represents, a little less than half of our insurance exposure. We also own a company called First American Financial, which is the second largest title insurance business in the United States, really high-quality company that operates in an oligopoly with high barriers to entry, stable margins, low capital intensity. And while this company lives within insurance, its fundamentals are almost entirely driven by the housing cycle.

And then of course we have our banks, which we believe are one of the best risk rewards in the market right now. And then in terms of interest rates and economic sensitivity, it's our view that the portfolio is very well hedged. Clearly banks are the most rate sensitive and the most sensitive to the economic cycle, but we believe that other parts of the Financials portfolio are going to benefit from lower rates, but perhaps in a less obvious way. So let me highlight two examples. In the P&C insurance space, lower rates are putting pressure on the investment income that they earn in their bond portfolios. And that's forcing them to be more disciplined underwriters, which is helping margins and pricing.

And then one could argue that a company like Moelis, who makes a lot of their money by providing advisory services on M&A deals, is benefiting from lower rates because it's reducing financing costs, making M&A more attractive, and that means more fees for Moelis. So in our opinion, the Financials portion of the portfolio is actually very well hedged both in terms of rates and economic sensitivity, and a lot more diverse than one might assume when simply looking at our sector weightings.

SL: Yeah, that makes a lot of sense. Thanks for walking us through that Miles. So since you've joined us in May, you have been active at reshaping the Total Return portfolio while still remaining true to its mandate of a high-quality, value-oriented approach to investing in dividend paying small-caps. Can you discuss which portfolio areas in and outside of Financials you've been increasing and decreasing your exposure to, along with your rationale?

ML: Yeah sure. I want to just reiterate something you said, Steve, which is that our philosophy hasn't changed at all. And if anything, I think the quality of the portfolio has continued to improve. So, let me highlight a couple of areas that we've been adding to, both which are in Financials.

We've added a lot lately to regional banks. This is a group we think represents one of the best risk/rewards in the market for a few different reasons. The group, we think, is significantly healthier than it was heading into the 2009 recession and we think there's a lot less risk in their loan portfolios today. We also think that they're in the process of beginning to take market share from the big banks, because customers in the pandemic realize the value of a relationship with a local banker and the service that they can provide. And then we just think the valuations here are compelling, despite what we think are fundamentally better business models with less risk and more capital, they're cheaper than they were during the Financial Crisis and we just don't know how much more bad news is left to be priced into the stocks. And so, we think that as the economy recovers, they prove to be less risky than perceived.

And then another group that we've been adding to, but for completely different reasons, is the P&C insurance industry. This is a space that's undergoing what's called a hard market, which just means that prices are improving and because of that, we see margins improving in the next few years, we see better return on equity and we see better book value growth. And unlike the banks, the tailwinds are actually at the back of the P&C insurance industry right now. We just don't think that those are fully appreciated yet in the market.

And then in terms of an area that we've been reducing, I would highlight utilities. These are companies that have nice dividends and they have low vol stocks, but they're not great process fits for us because of the higher leverage and the capital intensity. A lot of utilities actually have to borrow just to pay their dividends. And so that, coupled with the fact that we think there is somewhat of a bubble in defensive stocks and the utilities are poster children for that, and that means that their evaluations have really gotten stretched. And so we've been reducing weight there. But it's important for us to point out that we are being very mindful of the impact that utilities have on the low volatility of Total Return. And so, we're offsetting some of those reductions with additions to really high-quality businesses that have similarly low volatility characteristics, but with business models that we think are a better process fit for us.

SL: Maybe let's look now into the consumer sector, and more specifically retailers. So many investors are seeing the traditional retail companies as value traps, cheap but deteriorating fundamentals. Now, you've recently bought a few contrarian positions in retail. Can you tell us about them and how you got comfortable with their businesses in this environment?

ML: Yeah, Steve, I agree. I think a lot of these traditional retailers have been challenged for some time and probably do represent value traps. And so we think if you're going to invest in the space you really want to own a company with franchise value, and that's the safest, lowest risk way to do it. And franchise value for us really means brand value in an iconic brand, but those are hard to find in the small-cap space. But the pandemic has provided us with an opportunity to invest in a couple of iconic brands, and those are Ralph Lauren and Levi's. These are obviously valuable global brands, the companies have strong balance sheets, and we think they're really well positioned to navigate the current pandemic environment and actually emerge much stronger. And there's a few reasons that we really like these companies.

ML: Both of these companies were increasing prices heading into the pandemic, and they've actually continued that during the pandemic. And we think that's a really good testament to their brand value.

I'll also share a little anecdote about Levi's that I think highlights their brand value. Before Target began carrying Levi's a year or so ago, Levi's was the most searched for brand on Target's website that people could not buy at Target. And that's for all product categories, not just apparel. So I think that's a testament to their brand value. And these are companies that had good momentum going into the pandemic, and we think those trends are going to continue as we come out of it, and likely accelerate, because the reality is, many of their competitors are filing for bankruptcy and that's creating opportunities for well capitalized companies like Ralph Lauren and Levi's.

And then the last thing that we think the pandemic has done for these companies that's good for their business models is help them to accelerate the adoption of e-commerce. Now, clearly some of that was driven by stores being shut down, but a lot of it's going to stick, and we think that's going to create tailwinds for these companies in terms of their margins going forward, because e-comm is a more profitable space once it scales within these business models. Now, the next couple quarters, they're going to be ugly, but that's okay. We have a long-term view on these companies and we think their long-term prospects are very bright. And we think the valuations are very compelling. In 2019 the brands were valued by an independent consultant between $4.5 and $5 billion. And Ralph Lauren and Levi's both have market caps of right around $5 billion. And so we think that that brand value provides a really good margin of safety on the investments, and that helps to limit our downside in the long run. And we can't say that about a lot of the small-cap consumer stocks that we look at.

SL: Sounds like an attractive opportunity. Miles, let's transition here on our questions. We like to pair three investment questions and then balance them with three non-investment questions. Let's talk about books that you've read recently. So what is a recent book, either fiction or nonfiction, which you have liked?

ML: I read a book recently called Thinking in Bets by Annie Duke. And Annie Duke was a professional poker player. But what makes her really interesting as an author is that she also has an Ivy League education and a graduate degree in cognitive psychology from University of Pennsylvania. And so our listeners are probably wondering why a long-term oriented investor like myself is talking about reading books about gambling, but the book is really just about making good decisions. And people often think of bets in the context of gambling, but the book points out that a bet is simply a decision made about the future when you don't have all the information that you need in the present. And so the book does a really good job of helping you to improve your decision making by doing things like helping you recognize the biases that are hardwired into the human brain, or differentiating between outcomes and decisions.

So for example, just because you made a decision that you thought was a good one but the outcome wasn't what you expected, that doesn't make the decision process wrong if you had good logic and you thought there was a high probability of being right. And so I think the concept is really fascinating, and it clearly has relevance to investing, but also relevant to life in general and any decision that our listeners might be making, from leaving a job to buying a new house to taking a trip. So I think it's a wonderful book and I'd highly recommend it.

SL: That's great. So let's take you back to college and ask what non-financial college course really engaged you.

ML: When I went to college, Steve, I wanted to be a doctor. And specifically, I was either interested in being a pediatrician or a psychiatrist. And because of the latter, I took a psychology course, my freshman year at William & Mary. And to this day, I'd say that's probably my favorite class. I thought it was fascinating to learn about the human brain and how incentives and needs and reflexes all played such a profound role in the things that we do as human beings and the decisions we make every day. And interestingly enough, that's kind of come full circle because I think a lot of investing from a fundamental perspective is behavioral in nature.

And so I get to think about those concepts today. And that was definitely one of my favorite classes as an undergrad.

SL: Yeah. I can understand why that really engaged you. So our last question is about activities outside of work. So what activity outside of business and time with your family do you truly enjoy?

ML: So I'm a water person. I love being in and around water. My favorite activity is surfing. I just love it, and I would surf every day if I could. I will say that I'm very much a beginner, and I think it would probably be an insult to real surfers if I called myself a surfer, but it's a sport that I love. It's fun because you're connected to the water when you're out in the ocean. But to me it's really interesting, because it can be both relaxing and exciting at the same time. When you're sitting on your board studying the waves, trying to figure out which one you want to take, you're nice and calm. You're not thinking about work or bills that you have to pay. Your mind is just very clear. And then when you see the wave you want, the adrenaline kicks in, you start paddling, you get up on the board, and you ride a wave, and it's just really, really exhilarating and it's an adrenaline rush. And so it's a sport I love. And fortunately, I don't have to make the trade-off between that activity and family.

My eight-year-old son has really taken to surfing, and he's a phenomenal surfer, far better than I'll ever be, but it allows us to get out to the beach and get out on the water and surf together.

SL: That's a wonderful picture. That sounds really, really terrific. Well, Miles, thank you so much for walking us through your thoughts about the investment portfolio, as well as sharing with us some broader perspectives about things that you like and enjoy. Thanks for joining us.

ML: My pleasure, Steve. Thank you.

SL: And thank you all for listening.

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