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Three Core Tenets
Royce Total Return Fund
Interview with: Jay Kaplan

Author: Ticker Magazine
Last Update: Apr 27, 9:52 AM ET
While companies with a track record of dividend payment are known to be better allocators of capital, their stocks tend to be less susceptible to volatility too. However, the truth is that not all dividend payers are worth investing in. Jay Kaplan, portfolio manager of the Royce Total Return Fund, screens the small-cap universe for companies with solid balance sheets and attractive business models that are also trading at a discount due to temporary business or industry setbacks.

“We actually mean total return, which is why we don’t call it high yield, yield, dividend, or any of those terms. We want to emphasize the idea that we are searching for the highest-quality dividend-paying companies we can find—and not the highest yields.”
Q: Would you tell us about the history of the fund?

A: The Fund has been around for almost 25 years. The idea came from institutions in the late 1970s that were wondering if Chuck Royce could do something with dividends that would potentially be as successful as his broader small-cap portfolio, which eventually evolved into this Fund. We were already investing in good, high-quality small cap companies, some of which paid dividends, which nobody really thought about within small cap.

Q: What distinguishes the fund from its peers?

A: We actually mean total return, which is why we don’t call it high yield, yield, dividend, or any of those terms. We want to emphasize the idea that we are searching for the highest-quality dividend-paying companies we can find—and not the highest yields.”

When the rest of the packaged-product investment world talks about equity-like products that generate income, their products tend to skew toward underlying assets that have high dividend yields; their high-income funds skew toward REITs, MLPs, and utilities with high coupons.

We don’t start with the idea of a high dividend. We are looking first for total return, and companies that pay a dividend. If they don’t, we think they should, and when we talk to their C-level executives over time, we try to make that point, and convince them that a dividend is a good idea.

Small-cap equities tend to have more volatility than equities in general, and we know that over time small-cap equities deliver higher returns than other equities. But they tend to do that with higher levels of volatility. So in Total Return, we focus on dividends as a way to potentially limit volatility. If you look at the Russell 2000 Index, you will also find that historically the dividend payers provide a higher long-term return with lower volatility than the index as a whole.
Not every client needs to have exposure in small cap, of course. However, when an advisor wants to offer that in a way that is less likely to scare the client off during times of volatility, a lower volatility strategy is a good way to go.

The tradeoff is that when the Russell 2000 is strong, the dividend payers do less well than the non-dividend payers. Conversely, when the Russell 2000 is not so hot, dividend payers, and our fund, tend to do better than the index as a whole. When you compound that over time, it leads to an attractive risk-adjusted return. That is our claim to fame—we are a good way to get exposure to small cap with less volatility, and to put a little money in your pocket as you go along to help dampen the volatility. When you stack our fund up against the entire universe of small-cap funds, it is near the bottom in volatility

We also believe that capital allocation is important. Within the capital allocation tool kit that management teams have—reinvesting in the business, capital spending, M&A, debt pay down, dividends, buybacks—dividends tend to be a long-term commitment, because they’re very hard to get rid of once you have them. This instills another level of disciple in capital allocations upon C-level executives. It goes along with the type of high-quality companies we like, companies that generate free cash flow, and try to do the right thing for their owners with that free cash flow.

Q: What are the core principles behind your investment philosophy?

A: For a start, we think of investing in a company as if we own the whole business. We understand that the companies in this space tend to be smaller and riskier, so it is important not to have any permanent loss of capital. We know that all businesses go through cycles, and business trends don’t always go straight up. Given the sometimes fragile nature of a company, or its marketplace, we spend a lot of effort making sure that the businesses in which we invest are financially strong. We want rock-solid balance sheets. Consequently, our first core tenet is financial strength.

The second core tenet is to buy good businesses. In an ideal world we want to own businesses forever. We measure how good a company is by looking at return on capital and return on assets, and when their returns look higher than those of other businesses—somewhere, somehow, that points to a better mouse trap. The mouse trap might be the industry, the product, the way the company is run, maybe even how it is structured financially. In any event, when you find a track record of high returns, there is a better mouse trap of some kind involved.

So, we like financial strength, and we like a better mouse trap. And then, because we are value-oriented investors at heart and think the price you pay has an impact on the ultimate return, we also are price-sensitive. As a result, the price paid is our third core tenet, which goes back to the idea of owning the whole business.

We frequently look at cap rate, and compare the operating income against the enterprise value of the business. We ask, if we owned the entire company, how much of the operating profit could we put in our pocket versus what we have to spend to buy the whole business, equity and debt? We would love to buy a business where our operating income return on the capital we would have to employ is about 15%, and then sell that business to someone who is willing to accept a 7% return. Valuation is important.

Those are the three tenets that drive our philosophy. Putting them all together, to get a great business with a rock-solid balance sheet and a very attractive valuation, doesn’t usually happen in a vacuum. It’s usually because there’s an issue, whether it’s the market in general providing a low valuation, or a company sector providing a lower evaluation, or an issue about the product, the market, or the competition.

There is usually something that leads to the anomaly of that low valuation. We try to figure out if the issue is temporary or permanent—and it’s not usually permanent. Then we try to figure out what has to change, what shouldn’t change, and what strategy the management team has in place. We consider whether the strategy addresses the issues, how long it will take to solve the problem or for the issue to go away, and whether we think the valuation is low enough to compensate us for taking on that risk. We are willing to accept operating risk, but not financial risk.

This is a summary of the core tenets of most of The Royce Funds. Then, when you drill down to the next level, to the Total Return Fund, it gets back to the idea that dividend payers have less volatility and better returns over time, so we try to find businesses that generate free cash flow and have the wherewithal and core management and philosophy to return some of that cash to their owners in the form of dividends.

Q: How would you describe your investment process?

A: We quantify the ideas of financial strength, returns, and valuation to narrow the investment universe. Another good differentiator for us is the experienced team we have behind us at the firm. We have folks here who have been investing in small cap stocks almost exclusively for a long time.

We have a deep domain knowledge of many companies, a broader universe of companies than we might be currently invested in. That allows us to go above and beyond the normal screening process that everyone talks about, based on our three core tenets. It allows us to take advantage of events and news flow of the companies that might not be on our radar screen. Because someone here has a pretty good working knowledge of most companies, we can get up to speed quickly to get more current, and take advantage of opportunities when they arise.

The practical reality of the small-cap world is that small-cap companies do not usually become large-cap companies. They may have a good run and maybe get up to mid-cap, but then they stumble and they’re back to small caps again. Ultimately, if they are really going to be successful, they get bought and taken over. So, the companies that we know best tend to stay in our universe for a long time—and so our domain knowledge lasts a very long time. Everyone has a screen and a funnel, and we have those too, but there also are some subtleties in our approach that are different.

Stocks in the small-cap market tend to not be as liquid as large caps, except when there’s news. But when there is news, our stocks, which may not be very liquid under other circumstances, then become more liquid for a few days. In this way, beyond the day-to-day screenings and the talking with analysts, there is a window of opportunity based on news flow to do something, to buy or sell, if we can figure out why the news is happening and if it’s an opportunity.

We have low turnover in the Total Return Fund, so we tend to hold stocks for a long time. This allows us at various points in time to add to a position or trim one back as the stocks move around.

Q: Can you pick a name that illustrates your research process?

A: I have owned shares of a company called Reinsurance Group of America since 2001 here at Royce and even owned shares before I got here; I bought it at its IPO in 1993 and have owned it on and off for 25 years. It grew from a small cap into an $8 billion company since we have owned it, and the long-term chart from 1993 until now has had only a few blips.

RGA’s core business is the reinsurance of life insurance. It started being mostly in the United Stated and has grown globally. Life reinsurance is a very large business with only five main competitors, all of which are either private or divisions of bigger global insurance companies. There is virtually no other public company that looks quite like this one. It’s never been terribly well covered, or well understood, but we figured out a long time ago that it was an attractive, steady, really wonderful kind of business. If you price life insurance correctly—and more importantly, if you price life reinsurance correctly—you can earn a nice return and a big earnings stream that goes on for a long time.

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc