Refining Royce's Dividend Value Approach—Royce
article 05-18-2021

Refining Our Dividend Value Approach

As Miles Lewis takes the helm of Royce Total Return Fund, we spoke to him and Chuck Royce about what we look for in dividend-paying small caps and where the current opportunities lie.


Can you talk about the recent change to the portfolio management structure on Royce Total Return Fund?

Charles Royce As of May 1st, Miles and I essentially switched roles on the portfolio. He’s the Fund’s lead portfolio manager while I support him as portfolio manager. Our focus remains on finding high-quality, undervalued, dividend-paying small caps with the goal of lower volatility. We think this approach is best suited for investors with a lower risk tolerance and/or those who may be in the withdrawal stage of their investment lifecycle. The process is still deeply rooted in the same principles that have always driven its success.

Was this move planned when Royce hired Miles in 2020?

CR Yes, we brought Miles on board in May of 2020 with the plan that he would assume the lead role on the portfolio and head up our dividend-oriented strategies. The two of us have worked together very closely over the last year, and I’m very confident in his ability to drive strong investment outcomes in this unique discipline.

Why do you think the small-cap dividend space is such an important investment area?

CR Our research shows that over long-term periods, dividend payers outperform non-dividend payers within the Russell 2000 Value Index, and they do so with better down-market performance and less risk, as measured by standard deviation. We’ve also found that many of the dividend-paying companies tend to have higher quality—and we look primarily at returns on invested capital—and cheaper valuations than non-dividend payers.

Miles Lewis When you couple these attributes with Total Return’s strong bias towards high quality undervalued businesses, small-cap dividend payers look like a logical place to source investment opportunities that can beat the market with less risk. We also think that the valuations for dividend payers currently look compelling versus non-dividend payers—based on EV/EBIT, which is enterprise value over earnings before interest and taxes. More recently, dividend payers have experienced significant underperformance versus non dividend payers. So the current entry point is attractive in terms of both valuation and relative performance. We think that’s a fantastic backdrop for dividend paying small caps.

What factors are among the most important when you look at a company?

ML We see dividends as a potential sign of high quality in a company, as they often signal thoughtful capital allocation habits, management’s confidence in the company’s prospects, and strong free cash flow of the underlying business. However, we also understand that a dividend itself can be a limited proxy for overall quality. In order to gain more insight, we move on to a more thorough nuanced analysis after we’ve identified dividends payers. Our first question is very simple and important: is this a good business? To understand this, we study the economics of the business, its competitive landscape, the sources and duration of its competitive advantage, and the reasons why a customer chooses to purchase the company’s product or service.

“We see dividends as a potential sign of high quality in a company, as they often signal thoughtful capital allocation habits, management’s confidence in the company’s prospects, and strong free cash flow of the underlying business.” — Miles Lewis

Where does the analysis go from there? Are there additional steps?

ML When our analysis suggests that we’ve found a good business, we then examine the financials to see if the numbers support our views—the quality should show up in the financial statements. The specific areas we focus on include returns on invested capital, balance sheet strength, capital intensity, and our ‘North Star’: free cash flow. The final step is arguably our most important—we rigorously analyze the risk factors of each business we evaluate. Our goal is to create a short thesis on each company we evaluate that allows us both to more fully vet key risk factors and identify any we may have missed.

What’s distinctive about how you approach managing your portfolios?

ML I don’t know if these qualities are unique, but I do hold very specific views about investing that influence how I manage portfolios. As I noted earlier, my approach always looks first at risk. I initially learned how to analyze companies in the credit world, where the focus is on what can go wrong as opposed to what can go right. I am a firm believer in capital preservation. Avoiding mistakes is, in my opinion, one of the most effective ways to increase the odds of outperforming. We deliberately size our positions based on the range of outcomes, and our largest holdings are often those where we expect to lose the least—and not necessarily those where we expect to make the most money. We don’t always get that right, of course, but on balance I think it serves us well.

What else do you think sets your approach apart?

ML I’m willing to be contrarian when our research process builds the necessary conviction to go against the grain of consensus. Royce’s long-term investment focus—which I’ve always shared as an investor—is crucial in these instances because being contrarian often means being wrong in the short run. A great example is the Fund’s investment in regional and community banks. We began adding weight in these positions about a year ago, based on the conviction that these banks represented arguably the single best risk/reward in the market last spring—during a time when the market hated banks for myriad reasons. These holdings lagged for a few months as we continued to add exposure to the group. So far in 2021, regional and community banks have been among our most successful investments—and this would not be the case if we hadn’t been willing to invest against the consensus. Equally important, we still like the group.

Can you give us an example of another area you like as a long-term investment?

ML In addition to banks, we’ve also had success recently with companies related to housing, where our high-quality holdings straddle different sectors. They include everything from title insurers to a branded home essentials business. Many investors have very high expectations for housing-related stocks in light of how vibrant demand has been. Based on these high hopes, we wouldn’t be surprised to see some of them cool off a bit in the coming months, especially with the possibility of rising rates over the next year. Our long-term view of housing, however, remains highly constructive, particularly given supply-demand dynamics, growing household formation rates, and the recovering economy. We’d seek to use any short-term volatility for housing stocks to our long-term advantage.




Important Disclosure Information

Average Annual Total Returns as of 3/31/21 (%) 

Total Return 17.12 74.37 10.37 12.31 9.52 7.69 9.48 10.77 12/15/93
Russell 2000 Value 21.17 97.05 11.57 13.56 10.06 7.38 9.53 10.26 N/A
Russell 2000 12.70 94.85 14.76 16.35 11.68 8.83 9.76 9.81 N/A

Annual Operating Expenses: 1.25

1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees, other expenses, and acquired fund fees and expenses. Acquired fund fees and expenses reflect the estimated amount of the fees and expenses incurred indirectly by the Fund through its investments in mutual funds, hedge funds, private equity funds, and other investment companies.

Mr. Lewis’s and Mr. Royce’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. All indexes referenced are unmanaged and capitalization-weighted. The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss. The Fund may invest up to 25% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing Foreign Securities" in the prospectus.)



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