Few people understand the importance of sticking to one's investing discipline better than Charles Dreifus.
As manager of the
Royce Special Equity Fund, Dreifus has an unwavering belief in his investment strategy, which borrows heavily on the value investing philosophies laid out by Benjamin Graham, the father of value investing. While the stock market struggles to find an upward path, Dreifus's fund has posted an impressive year-to-date gain of 18.5%, making it the best-performing small-cap value fund out there, according to Morningstar.
His stellar performance is due, in part, to his disciplined approach to investing, relying on metrics such as return on capital, valuation and accounting quality. Unwilling to time the market, Dreifus sells stocks once he feels they're fully valued, even if that means missing additional upside. Ultimately, Dreifus sticks to his approach whether times are tough, as they were in 1999 when the fund dropped 9.6% in its first full year, or times are good, as they were in 2001, when the fund gained 31%.
In a down market, this conviction has reaped healthy gains. While some fund portfolios have become a "who's who" list of Wall Street's most scandal-ridden companies, Dreifus' portfolio is a "who's that?" list of small unknowns like
, which makes rubber treads for tires, and
, the leading shipper of precured tobacco leaf. As unexciting as it may seem, value investing can really pay off.
Sales charge: No-Load
Managed Since: February 1998
1-Year Return: 34.3%, beats 99% of its peers
3-Year return: 17.9%, beats 82% of its peers
Top Holdings: Universal (UVV), Landstar System (LSTR), Bandag (BDG)
Assets: $219 million
Source: Morningstar.com, figures as of June 19, 2002
1. How would you describe your investing strategy?
We use a disciplined approach with a philosophy and grounding in the theoretical contributions by Ben Graham, the granddaddy of security analysis and value investing. I took from him the notion of not overpaying for stocks. He termed it the "margin of safety." He had a lot of valuation metrics, some of which I use, some of which I don't use, but it's just the notion that you put the odds in your favor by finding the anomalies in the marketplace.
His greatest student was Warren Buffett. And Buffett's tweaking to Graham's principles was that while you can buy inexpensively, you often end up with poor companies. So he proposed the notion of franchises and niche companies. And since niche kinds of companies have a high return on capital, I use a metric that measures return on capital, in addition to a metric for valuation.
The final leg of the stool is that we have a healthy cynicism of accounting. And that was from a professor I had named Abraham Briloff. During the '60s, '70s, '80s and '90s, he was a strong advocate of auditor independence in terms of consulting and the notion that it's the auditor's responsibility to see to it that the company portrays its financials to be the most reflective of economic reality.
2. How does this work in practice?
My process is culling over databases based on metrics -- quantifiable items. The two most pivotal are valuation and return on capital based on 12-month trailing data. And then, once I find candidates, I have all of the SEC filings for the company printed out and I review that sense of accounting veracity. It's something I've been doing for over 25 years and it comes naturally.
I look for the choices that a company made, and it's usually not that a single item says a company is very aggressive. It's like a painting. It's a blending of factors. When you examine the financial statements and the footnotes, it's much like grading a paper.
Don't Call it a Comeback
* -- as of June 20, 2002
3. Has this approach helped you avoid trouble, given the state of corporate accounting?
The names that have made headlines are generally much larger names than I would invest in. But over the years, I've passed on companies that have turned out to perform poorly. But six, nine, 12 months ago, the market didn't care that much about these accounting issues.
It's a matter of controlling risk as I see it. What I'm looking for is companies I believe have stronger financials, not only in the sense of less leverage, pristine balance sheets and transparent profits and losses, but generally those companies who are telling it the way reality appears to be.
One way it has helped me -- it's led me to the kinds of companies with financial strengths
that the market had previously overlooked. Much of what I invest in has an insider family that owns 20%, 30%, 40% of a company. And they're loathe to give out stock options and aren't interested in having the stock advance rapidly. They don't benefit from stock options and have a whole different mentality. It's a business run for the long term.
4. Your buy discipline is pretty clear, but what about your sell discipline? Last year you had a turnover rate of 124%.
The high turnover last year was not typical. The fund was much smaller and because we had done so well pre-Sept. 11, we ended up with a great deal of redemptions post-Sept. 11 because we were one of the few funds people had gains on. I don't know how representative that turnover was.
To answer your question about sell discipline, it's the mirror of the buy discipline. Because I have very precise notions of valuation and I will sell it when I no longer believe that it is selling below intrinsic value. Which, incidentally, does not mean that the stock stops going up there. It may go much higher, but to my methodology, it's no longer an anomaly or inefficiently priced. So I sell it.
The other reason for selling is that I've made a mistake. I do a lot of screening using 12-month data and I presume things will persist and won't get worse. And often times they do. I order pencils with erasers because I make mistakes.
5. Early on in your fund's career, in 1998 and 1999, you had losses and got off to a rocky start. How did you tweak your model after that?
There was no substantial tweaking and I take exception to you calling it a rocky start. In 1999, which was the worst period, we were down 10%, which is hardly disastrous, but it was down.
Behind the Boardroom Door at Mutual Funds Also, answering a critic on celebrity fund managers.
Alpha Strategies: A Mutual Fund Using Hedge Tactics More mainstream investors are embracing this hybrid product.
A New Definition of Active Management Fund managers take a more active role in corporate governance.
The reason we did poorly in 1999 had nothing to do with our stock selections. Fundamentals were fine. It had to do with the market environment where the Nasdaq was up 88% that year. And people were valuing and modeling securities on an irrational basis. Obviously, rational valuations did not work. And worse yet was the outflow of money from the sub-sector of small-cap value.
We made mistakes that year, but probably no more than I did last year, when we were up 31%. We have performed very well in 2000, 2001 and so far in 2002. There are always minor tweakings, but the basic framework has been constant through that time.
6. This year, your strategies are paying off, while most of the market is down. What advice do you have for individual investors?
It's clearly more difficult. These issues of governance and accounting come up. The fair question is, how many individual investors are equipped to analyze those and make decisions? Or read a proxy statement or 10K and walk away with some sense of what the company is all about? That's a real dilemma. We can all obviously learn and improve ourselves, but realistically, to what extent?
I guess the answer is to find professional managers who are doing what they're supposed to do. They're passionate about what they're doing. It's true that no style works forever. You need managers who can look at all these issues. I'm not sure that individuals are qualified to do so.
7. Two months ago, you had 20% of your portfolio in cash, yet as of May 31, you had about 13% in cash. What prompted you to take cash off the sidelines?
I build portfolios from the bottom up. Similarly, the cash position is really a residual. It generally isn't planned to be at X%. What happens is that money has come in so rapidly that it's imprudent to just throw it at the market without taking more time to investigate more names and additional ideas. Money sometimes leaves portfolios, which reduces cash.
When you take a snapshot, it can be high or low for a multitude of reasons. Sometimes, it's a matter of playing catch-up. There's no secret that small-cap value funds, particularly at the beginning of the year, were taking in huge quantities of money. If you're disciplined, it's going to take time to spend it.
8. Where have you been putting that money to work?
As I said, we're very bottoms up. I've been in the business for 34 years and I sort of don that generalist's hat in that I really don't focus on any particular industry. I go where the valuation and productivity of capital leads me to. It does happen that whole industries get ignored. Six months ago, perhaps nine months ago, the shoe industry, for some strange reason, showed up on my screens. I can't say every single shoe company, but virtually every shoe company.
9. Anything right now that's popping up on your screens?
I don't speak to individual companies, but in terms of sectors, I end up owning prosaic, dull businesses. If you're going to be concerned about valuation and efficiency of capital, oftentimes, you're led to very mundane, slow-growing, dull businesses. When you look through the lists, these tend to be companies that sell shoes or clothing or make small appliances or toys or salad dressing. We're not talking anything exotic here.
On the other hand, these companies do have a great deal of attraction to me. What happens is I'll end up with a lot in consumer-related companies. I had owned a lot of the retailers, when they were incredibly cheap a year or so back. Right now, I'm not seeing any sectors or industries that seem undervalued. But there are always ideas. There are five SEC filings on my desk just waiting to be looked at.
10. What about the opposite? What are you avoiding?
I don't wear that hat. People have asked me why I haven't owned more technology over the years and frankly, it's hard to get that combination of good valuation and high returns in tech. It's surprising how few technology companies that sell inexpensively enough have high returns on capital. So, I don't have any real blinders on, but this methodology doesn't lend itself well to utilities all that well.
Also, if you're classically cynical about financials, the more complicated and intricate a financial statement is -- and many financial companies, like banks and insurance companies, have very complicated financials -- you tend not to own them. They're not as easily amenable and workable as these others that I've been able to find over the years.
It's like Warren Buffett said -- if you don't understand it, you don't buy it. That's pretty good advice.