Small-Cap Special Equity Strategy Podcast —Royce
article , video 06-25-2024

Small-Cap Special Equity Strategy Podcast

Portfolio Manager Charlie Dreifus and Assistant Portfolio Manager Tim Hipskind join Francis Gannon to discuss their accounting-centric methodology and detail their thesis on three key holdings.


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 Assistant Portfolio Manager 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 period, and the 3-, 5-year, and since inception [5/1/98] periods through the end of May 2024. Charlie, I thought I’d start with you. It's been an interesting year to say the least. But can I get your thoughts, or take us through your thoughts on why Special Equity is attractive in this environment?

“The Strategy has its roots in basic economics and accounting. It’s buying the business at a price where you can finance it back out and have an attractive return—the spread between your earnings and the cost of your capital. The layer on that—which has been a dominant and worthwhile pursuit over all these years—is the overlay of governance and accountability, the quality of earnings and corporate governance.”
—Charlie Dreifus

Charlie Dreifus: Well, it goes to the roots of Special Equity. Special Equity was first launched 44 years ago at Oppenheimer. Same strategy, same discipline. The Strategy has its roots in basic economics and accounting. It’s buying the business at a price where you can finance it back out and have an attractive return—the spread between your earnings and the cost of your capital. The layer on that—which has been a dominant and worthwhile pursuit over all these years—is the overlay of governance and accountability, the quality of earnings and corporate governance.

I had a client once that said, “Special Equity is great, but it's actually like watching grass grow—you never really notice anything.” I think that’s a good thing, and it speaks to the defensive nature of Special Equity during the down periods. On our March 31st Fact Sheet, we showed that, since inception, had you put $10,000 in Special Equity, it would be roughly $85,000 today and the Russell 2000 Value would be $69,000, and in the Russell 2000 there would be $62,000. And the important thing is that the return the investor receives occurs with much less volatility, and so the investor is likely to stay the course, which is important to earn the return.

FG: So I think one of the things that makes the Strategy unique is the team you have working with you, Charlie. Steve McBoyle is an assistant portfolio manager, Tim Hipskind has been working with you now for over three years, but recently he was added as assistant portfolio manager on the Strategy. I was wondering if perhaps you could give us your thoughts on his role on the Fund.

CD: An incredibly important addition. As you mentioned, Steve McBoyle joined the team about 10 years ago and Tim, a little over three years ago. Tim, as you'll hear, not only is a CPA but a trained forensic accountant. Tim was doing a lot of our work on backgrounds—channel checks, competitor checks, etc. The passion and the intensity that Tim brings, you know, reminds me of the best people I’ve seen over my career on Wall Street. These are people who love doing what they do. An example I might add—besides all the work Tim does on individual companies, and obviously all of that led to his elevation to assistant portfolio manager—is his interest in why changes are made in the portfolio. Why are we reducing this position and adding to that position

There’s an art form to managing money, and this is something that Tim is inquisitive about and will only inure and accrue to the benefit of our shareholders.

FG: Tim, let’s bring you into the conversation and get your thoughts on your recent promotion.

Tim Hipskind: Thanks, Frank. I appreciate the kind words, Charlie, and the opportunity and acknowledgement. I really couldn’t have asked for a better team to learn from in Charlie and Steve. My background is in forensic accounting, which initially made Special Equity a great fit. But, as I’ve been on the Strategy for several years now, I’ve really come to value the other unique and intricate elements that have led to the great results it produces.

FG: Tim, take us through an example of a company that aligns with this unique methodology.

TH: Sure. One of the most interesting and fun things about the portfolio is that even within small-caps, there’s very little analyst coverage on Special Equity. Currently about one third of the portfolio has no analyst coverage at all and half have two analysts or less. Also, by design, the companies in the portfolio have very little leverage. Eighteen of the 34 are actually net cash. As a result, they tend to have less business needs for banking relationships and therefore are fewer natural candidates for sell side analyst coverage.

One recent example of an off the beaten track winner was U.S. Lime [United States Lime & Mineral], ticker USLM, which has no coverage. It has some unique elements. It has a controlling shareholder. They don’t hold analyst calls, they don’t participate in conferences, so it could get screened out of certain investors’ universes. They certainly aren’t marketing to investors.

But if you poke around a bit, and we actually visited their headquarters in Dallas, upon investigation lime and limestone is a pretty good business to be in. Five companies account for about 80% of the lime production in the United States, but the industry actually operates in an even more consolidated fashion because shipping costs make competing beyond a certain radius impractical. They also serve a pretty diversified set of end markets, more than you might expect in steel, construction, paper plants, and environmental markets. What we liked was, like a lot of companies that we saw during the pandemic and its aftermath, the lime industry had an opportunity to test price—and indeed, they found more pricing power. So, there’s a little bit of the discovery factor here, and the company’s performance that made this a big winner for us—we bought the bulk of our shares around $100 late in 2020, adding through some declines in 2022, and today it’s trading around $340 a share.

FG: I think it’s always so interesting to hear about some of the unique companies in the portfolio, especially with small-caps looking so appealing, I think, in the overall market today. But perhaps you could take us through another interesting idea and Charlie?

CD: I have found companies that I keep coming back to. The beauty of that is, particularly if management is still essentially the same, you have a good sense about the business and how it’s run and what to expect—and a sense hopefully of when it’s a good time to buy and when it’s a good time to sell. Standard Motor Products, it's a company that I first researched in the late 1960s over a 50-year history. In fact, the fellow then who was sort of no title, a guy named Larry Sills, the nephew of the founding family, the Fife family. Standard Motor Products was then an auto replacement parts company. It’s since become not only an auto replacement parts, but some OEM [original equipment manufacturer] auto parts. Larry over the years from no title became Vice President, President and CEO, Chairman of the Board. He’s now Emeritus.

The stock’s been beaten down, they have had some headwinds. They make, for example, auto replacement part condensers for air conditioning. We’ve had a relatively cool spring, so that part of the business has had some headwinds and slower business than they would have liked. So that, plus some initiatives on the OEM side and a new distribution center, are making for a flattish, uninspiring year. But the cap rate, the return the buyer would get, would be around 10%, and as long as one could finance below 10%, which one could do this is an economic candidate for inclusion in the portfolio. These headwinds—weather is an unknown obviously—but some of the other issues: the startup of the OEM, the distribution center, the fact that they’ve also been hit with high factoring costs. They sell to the auto replacement parts retailers and distributors, as competitors also do. They factor those receivables, and higher interest rates work against them. When interest rates decline, that will benefit them. I might add also the stock currently has a cash dividend yield of 4.2%. Larry’s son Eric is now the CEO and President. Larry and I continue to speak and he’s on every conference call that we I have with them and as I said it’s more than 50-year relationship.

FG: Tim, how about you? Is there another opportunity you’re seeing in the market today?

TH: I like a company called Atkore—the ticker is ATKR. Atkore was bought by private equity from the conglomerate Tyco in 2010 and had its IPO in 2016. Atkore is primarily a steel pipe and conduit company. So you can think of things like fence posts and mechanical piping for solar and steel conduit for electrical products.

They also had a small PVC conduit business that they were thinking about divesting. It’s always interesting to learn the history of these companies. In studying that divestiture, what they realized was that actually they should be expanding in PVC and their electrical business and becoming larger vendors to their electrical distribution customers, which also serve their biggest business at the time, which was steel conduit. That strategy has worked very well. More recently, they’ve embarked on a similar strategy in HDPC, or high density polyethylene conduit, which also largely sells through electrical distributions, is sort of the same playbook there.

It’s a good strategy because competitively, while peers are typically focused on one material, you’ll have a steel producer that makes steel conduit or a PVC company that will make PVC conduit, Atkore has a full product line, which makes life much easier on the distributor. That distributor customer can operate with one order, one invoice, and one delivery. All this comes at a time when electrical products should see secular growth drivers. There’s heavy use of conduit and related products in data centers, in solar, and the undergrounding of power lines. While there likely will continue to be pricing pressure as commodity input costs have declined and their customers aren’t immune to interest rates, we like the undemanding valuation, secular trends, strong capital allocation, and a management team we really like. I think from here the pullback that has occurred in the stock could make for an attractive entry point.

FG: Atkore is also similar, Tim, to another company that parallels a little bit to your largest holding in Special Equity, which is Encore Wire, which has recently announced an agreement to be acquired. Have you noticed a pickup in transactional activity in the portfolio of late?

TH: Yes, we have. And to Charlie’s point earlier, it really underlies one of the core tenets of the Fund’s philosophy, which is a focus on the yield a buyer of the whole business could earn relative to the cost of financing that acquisition. We have seen a pick up of recent portfolio activity after a bit of a pause relative to the pace of takeouts we’ve seen historically. As you mentioned, Encore Wire was acquired by a strategic acquirer out of Italy. We thought Encore would be an attractive takeout candidate due to market misperception about valuation, the durability of their earnings, and the market underappreciating some of the secular trends they were exposed to similar to Atkore.

We also recently had U.S. Silica announce its intent to be acquired by a private equity firm. Here also we had hoped for some kind of transactional activity or corporate action. They have a very high quality industrial and special products division, but its valuation is overshadowed by investor focus on their frack sand business. And then third, we also have Macy’s currently in the midst of a process from a potential acquirer who has recently been granted further diligence access, with the possibility of providing an increased bid for the company. So, we’ve certainly seen a pick up in activity in the portfolio as of late.

Francis Gannon: Do you anticipate more activity and perhaps you know as a side, it would be interesting to hear what you’re hearing from companies in terms of their own M&A?

TH: In terms of their own companies M&A, we actually just met with the company last week, and it was interesting to hear that the pace of deals coming across their desk from distressed companies they said it never been higher. But despite that distress in the market, the target valuations are still elevated. So there has been some movement in the market, but it’s still taking time for sellers to get beyond the sort of anchoring bias to prior market valuations.

In terms of companies that I think could be good acquisition candidates, many are attractive, we believe, because of the focus on absolute value in that economic spread a buyer could earn, but also because many of their balance sheets would help facilitate that acquisition. One that comes to mind on that front is NVE Corp. The ticker is NVEC. A privately held competitor that looks quite similar to NVEC was recently acquired at twice the revenue multiple of NVEC. This is admittedly a niche of magnetic sensors, but the market is increasingly focused on this niche with some of the inherent benefits of the technology that are applicable in EVs and industrial automation. Given that disparity of valuation and NVEC massively net cash balance sheet, it seems plausible that a company looking to catch up on this increasingly important technology could make a bid.

FG: Special Equity is known for its scrupulous attention to company balance sheets, as well as accounting and governance. Any interesting tales from company footnotes recently?

TH: My favorite as of late was a food packaging company that came across a screen. It looked interesting, it was a growing business, seemingly strong relationships with large and growing customers, and a cheap valuation. But upon doing further research, we learned a couple of interesting things, starting with the fact that the CEO’s brother owned the company’s largest vendor—and this vendor was also a large shareholder of the listed company. We’re no strangers to companies with family involvement as we like the inherent incentive to think for the long term. But it also requires understanding the risks that can arise from these conflicts of interest.

In this case, we learned that this brother/vendor accounted for 10% of the company’s purchases, but 20% of the payables—so, some potential for more favorable than market payment terms for the listed stock and why not, if the brother is a large shareholder of the listed company? What’s more, after the company invested $6 million into a joint venture that had multiple construction and regulatory approval delays—guess who was there to buy them out at their initial investment of $6 million plus interest? Again, the brother. So, we do spend a lot of time to assess governance and the ethical landscape of companies and seek to avoid situations like this where we as the shareholders might be paying the price for some of these family relationships that are a little too close.

FG: Charlie, as you’ve always said, the devil’s in the details.

CD: Yes, and that’s the concept of accountability. The veracity of the statements, the governance, are such an important factor, and it goes back to my mentor, Abe Briloff, whom we’ve discussed in the past.

FG: Charlie and Tim, thank you for a very timely update today on the Royce Small-Cap Special Equity Strategy, and we appreciate all of your time. Thank you.

CD: Thank you and thank our investors.

Important Disclosure Information

Average Annual Total Returns as of 3/31/2024 (%)

NET               GROSS
Small-Cap Special Equity 2.17 11.49 5.32 8.25 6.27 8.62 05/01/98  1.22  1.22
Russell 2000 Value
2.90 18.75 2.22 8.17 6.87 7.73 N/A  N/A  N/A
Russell 2000
5.18 19.71 -0.10 8.10 7.58 7.29 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. 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 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 3/31/24 (%)

  Small-Cap Special Equity

United States Lime & Minerals


Standard Motor Products




Encore Wire


U.S. Silica Holdings




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.

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 3/31/24, 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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