Podcast: An Accounting-Centric Approach to Small-Cap Investing —Royce
article , video 11-07-2023

Podcast: An Accounting-Centric Approach to Small-Cap Investing

Portfolio Manager Charlie Dreifus and Senior Analyst Tim Hipskind join Co-CIO Francis Gannon to discuss our accounting-centric Small-Cap Special Equity Strategy, a key holding, and Charlie’s outlook.


This transcript has been edited for clarity.

Francis Gannon: Hello and welcome everyone. This is Francis Gannon, Co-Chief Investment Officer here at Royce Investment Partners. Thank you for joining us today. Our conversation is with two members of the Royce Small-Cap Special Equity Strategy, Portfolio Manager Charlie Dreifus and Senior Analyst Tim Hipskind. I should note that the Royce Small-Cap Special Equity Strategy is outperforming its benchmark, the Russell 2000 Value Index, for the year-to-date, and 1-, 3-, 5-, 10-, 15-year, and since inception [5/1/98] periods through the end of October.

“I would be very cautious. It's time to start thinking about positioning for better times, but I think we haven't reached that point yet.”
—Charlie Dreifus

Charlie, the Royce Small-Cap Special Equity Fund was recently highlighted in a Barron's article entitled “small-cap funds are more promising than they have been in years” penned by Lewis Braham. In the piece, Braham claims that, “although small-caps look appealing now, you should probably favor funds that minimize the downside risk,” something that I know you have focused on pretty much throughout your career.

He goes on to focus on the fact that you pay, “scrupulous attention to small-cap company balance sheets,” so there is less potential for individual blowups. Could you spend a moment on why this accounting-centric approach helps minimize risk and perhaps give a recent example?

Charlie Dreifus: Sure. Thanks Frank. Just by dint of personality and educational backgrounds, I'm very risk averse. In graduate school, I learned it was the deconstruction of financials rather than the construction of financials that differentiated companies. I had a wonderful mentor, a guy named Abe Briloff, who wrote frequently in Barrons. The math is very simple: If you lose less during adverse times, the corpus remains intact to do well when the market returns. We do that by focusing on accounting and governance, but we have a strict valuation metric. Importantly, the stocks in the portfolio, and I'm sure Tim will address this, have absolute value. They are inexpensive as businesses. What happens in adverse times, because these companies are not only inexpensive relative to the market, but they’re also inexpensive absolutely.

FG: Tim, let's switch to you for a second here. You've spent with Charlie and Steve McBoyle over 2 ½ years now on the Strategy. How have you found yourself aligning with the philosophy and the strategy?

Tim Hipskind: Thanks Frank. I couldn't be happier with the opportunity to work with both Charlie and Steve. I knew my investment background with the product should be a good fit, but it has been remarkable getting to know both Charlie and Steve and coming to appreciate some of our investment parallels. For example, Charlie, as you mentioned, his enjoyment of deep dives in the financial statements began when he met his mentor, the legendary forensic analyst Abe Briloff, and he had his revelation about accounting and the deconstruction of financials. I actually had the same light bulb moment in my career when I started working at a forensic equity research firm after initially beginning my career as an auditor. Actually, both of our first stock purchases were utility companies in high school, although I believe Charlie had me beat by a few years. I should add for the record that neither of us has much interest in utility stocks now. So, we both enjoy reading the footnotes, both share similar investment philosophies and the same risk-averse nature—which of course, is a hallmark of Special Equity.

FG: One of the things that we often hear from Charlie and Steve is the focus on good governance and seeking to find the types of management teams you would trust with your own checkbook. Having a portfolio with low turnover and having some time to get to know the management teams, have you been handing out your checkbook often yet?

TH: It has been genuinely fascinating to get to know these management teams and understand the types of companies that Charlie and Steve are looking to partner with. So, if it's OK, I'll just share one brief example. Not too long ago, we visited a portfolio company, one of the largest printed business products suppliers in the United States, based in Midlothian, Texas. They make no bones about the fact that some of their product lines are in secular decline, as you might imagine. However, they've been able to make a number of successful acquisitions as a buyer of choice for companies looking to sell, which is a sustainable advantage. And you wonder, how does that come to be? When we were visiting, we met with one of the top lieutenants of the CEO. In getting to know one another, we learned how he first came to the company as he had previously been working at a competing firm. He shared with us a personal story that unfortunately required a trip to the hospital. But the first person who showed up to check on him was his friendly competitor, the CEO of our portfolio holding. This competitor ended up joining the company, figuring who wouldn't want to work for a person like that? With all the subsequent acquisitions they've done, you can really appreciate why a seller would come to this company first when looking to exit their business.

FG: As we head towards the long-awaited recession—if it comes, when it comes—I’m curious what sort of things you are both looking for in financial statements as you deepen your dive into the footnotes today?

TH: Sure. Certainly, when executives feel pressure to keep the good times rolling is when you often see more aggressive accounting practices. So in this current period, with a flush consumer and rising margins that both may be reversing, we will surely see some of that. As an example, we recently exited a consumer position where we saw too many discretionary accounting accruals moving in a way that gave us concern. When you see things like the warranty accrual declining relative to sales, the allowance for doubtful accounts declining relative to gross accounts receivable, and the reserve for expected returns declining relative to sales—absent a good explanation for all of those—it certainly makes you raise your eyebrows. In this case, in addition to those concerns, we were wary about two large competitors who are increasingly focusing on this market as well as the company's decision to invest heavily in high-priced inventory at a time where we may be headed into a period where luxury products are in less demand.

FG: So when you see these sorts of discretionary accruals decline, how can you tell if there's anything nefarious at play?

TH: The trends we track can of course tell a story. But when possible, we also get in contact with management to allow them to clarify what may be causing the deterioration in the metric. For example, we recently saw that Macy's had a market decline in their liability for customer returns, which is of course assumption based. We're at a current point in the market where you might expect the returns to increase as customers are more selective with what they keep. When we inquired of Macy's, we learned that, along with many of their other operational improvements, they stopped taking returns on final sales and also stopped taking returns beyond 30 days. Both of those practices are quite common in the retail space, so it made sense that the liability for return should naturally decline. It's really situations where you can see these metrics deteriorating without an underlying explanation that really causes us concern.

FG: We've talked about a position you've exited. What interesting positions have you added lately?

TH: I'll talk about a new position called Oil-Dri. The ticker is ODC. Oil-Dri was founded in 1941 on the realization that this mineral called bentonite was great at cleaning up oil spills that were occurring more often on factory floors during and after World War Two. It turns out that bentonite is actually useful in a number of applications, which is why it's now called the mineral of 1,000 uses. In 1947, Oil-Dri sold their first bag of cat litter, and today Oil-Dri’s revenue is actually about 50% cat litter. However, the company continues to innovate around this mineral’s properties and now has a growing fluid purification business which is used in things like edible oils, jet fuel, and renewable diesel, which is itself a fast growing market. They also have a growing product line in animal feed additives. As farms are trying to raise livestock without the use of antibiotics, there are a number of methods being used to replicate those effects. But Oil-Dri’s clays are an effective mycotoxin binder, which is incredibly important in animal gut health. We're excited about the growth in a few lines of business here as well as the market structure, which should allow for continued volume and pricing growth.

FG: Super interesting. Charlie, why don't we conclude with you and your thoughts on the market. It's ongoing—at least an -18.0% correction from the high of July 31st in the Russell 2000. What are your thoughts on the market here?

CD: It’s a great question. I'll take a stab at it. The market was on a high occasioned by the banking problems that came to the fore in March of this year—Silicon Valley Bank and a couple of others. The Fed provided an enormous amount of liquidity. The whole government basically said—you know, it wasn't only the Fed, it was the FDIC—all deposits were guaranteed. Everyone came to the rescue. That liquidity had an enormous effect on the market—and sort of ran out in July. It was interesting how that all happened and terms of time sequence, the market still opposes issues to me. The market has come down as you suggest, Frank. But the market can rally. We also of course right now have geopolitical stuff going on, so depending on headlines we can get rallies or declines which really don’t speak to the issue. The issue to me remains inflation.

We recently got the monthly PCE—the personal consumption expenditure statistics. Chair Powell and the entire Fed really focused on a very arcane and not often cited part of that index, which is Super Core Services excluding housing. It gets at service inflation: What people are being paid, how much more they're being paid, and so forth. The most recent month, which was September, came in at 4.3%. It’s toward the bottom end of this this year's range. the upper end was close to 5%. But the objective of the Fed is 2% inflation. There's a long way to go to get to that.

It appears now that all three major auto manufacturers have come to agreement with the UAW, where the package is going to way exceed 4.3% annually. I just don't know how, given inflation, given the requirements of funding the deficit, and higher interest rates on our outstanding debt, how interest rates are going to come down anytime soon except for a crisis, which certainly could occasion that and has historically. The other is to get unemployment much higher. You mentioned something earlier about recession. Everyone thinks that we can have sort of immaculate deflation. It doesn't happen that way. Deflation comes about, or lower inflation comes about, with pain. When unemployment rises, there's personal hardship for people, but corporate earnings take a dive. And more so, people don't understand the revenues that most companies are reporting these days are up on price, not volume. When the recession comes, pricing's going to erode, margins are going to erode.

So I would be very cautious. It's time to start thinking about positioning for better times, but I think we haven't reached that. The icing on the cake is that we run screens weekly, and the screens don't show it: When the market screams value—think in terms of the height of the pandemic, March of 2020, April of 2020—we added in that period of time, I want to say, 10 names. We're not seeing that. We have a discipline that I alluded to earlier that, without our personal assessments, strictly adheres to the methodology, that gets you out of the market often a bit too early as the market rises and things get expensive, but then drives you back in—and we're not there yet.

The other thing—the Fed is also very afraid of people having inflationary expectations. And there was another statistic that was released recently that concerns me. The University of Michigan's monthly inflation expectations report showed that consumers’ inflation expectations rose. That flies in the face of declining gasoline prices. The consumer usually responds—virtually their entire response is predicated on gasoline prices. The other sort of anomaly that's occurring—during the heightened war, the Middle East crisis that we're all facing these days—the flight to safety has been to gold. It hasn't been to Treasuries, which is the usual one. It appears to me at least that people are fearful of inflation not declining anytime soon, or perhaps even rising.

FG: So perhaps we should end where we began—with a quote from the article in Barrons, which basically said that “Although small-caps look appealing now, you should probably favor funds that minimize the downside risk.”

Important Disclosure Information

Average Annual Total Returns as of 9/30/2023 (%)

NET               GROSS
Small-Cap Special Equity -3.96 15.47 11.43 5.34 5.70 8.34 05/01/98  1.21  1.21
Russell 2000 Value
-2.96 7.84 13.32 2.59 6.19 7.17 N/A  N/A  N/A
Russell 2000
-5.13 8.93 7.16 2.40 6.65 6.67 N/A  N/A  N/A
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 www.royceinvest.com. 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 and other expenses.

Mr. Dreifus’s, Mr. Hipskind’s, and Mr. Gannon’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.

Percentage of Fund Holdings As of 9/30/23 (%)

  Small-Cap Special Equity



Oil-Dri Corporation of America


Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

Downside Capture Ratio measures a manager's performance in down markets relative to the Fund's benchmark. It is calculated by measuring the Fund's performance in quarters when the benchmark goes down and dividing it by the benchmark's return in those quarters.

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. The Russell 2000 Value and Growth indices consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. 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.) As of 09/30/23, the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than more broadly diversified portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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