Charles ("Chuck") Royce is currently president and co-chief investment officer of Royce & Associates LLC. Royce is well known as one of the pioneers of small-cap investing, and his eponymous Royce Funds now manage in excess of $32 billion. Prior to founding Royce & Associates in 1972, Royce served as the Director of Research at Scheinman, Hochstin, Trotta, and as an analyst at Blair & Co.
Michael van Biema is the founder of van Biema Value Partners, of which Royce is a board member. Prior to establishing the firm, van Biema served on the faculty of Columbia Business School for over a decade. At CBS, he taught value investing, corporate finance, and securities analysis. He has written several books on value investing, and has consulted at CitiGroup, Gabelli Asset Management, Goldman Sachs, Salomon Brothers, and other prominent firms in the financial industry.
In advance of the van Biema ex-US Small-Cap Challenge, Kevin Harris from SumZero sat down with Royce and van Biema to discuss small-cap investing, active management, and the state of the market.
Kevin Harris, SumZero: Can you compare the hunt for value in small caps in the U.S. versus the rest of the world?
Chuck Royce, Royce & Associates: I think it is in many ways similar. Attempting to find undervalued, underappreciated small companies faces the same issues and presents the same opportunity around the world as in the U.S. We see more similarities than dissimilarities.
Harris: What ex-U.S. markets currently present the most compelling values?
Royce: Japan, Hong Kong, and Canada.
Harris: Many emerging markets have been "emerging" for decades (e.g. Latin America, Southeast Asia). What's your macro outlook for these regions?
Michael van Biema, van Biema Value Partners:
We really don’t do macro in the traditional sense. We do keep our ear to the railroad tracks by listening to our local managers and trying to determine where the greatest value opportunities exist. This gives us some sense of what the “macro” opportunity is in a country or a region. It also frequently tells us when to pull our head away from the tracks and get out of the way of a train.
Harris: How do you identify small cap opportunities in markets that have little to no analyst coverage?
Royce: Actually, that is the opportunity, itself. There are so many companies, maybe 20,000 or more, in the small-cap space, and most have minor, if any, coverage. I don’t avoid companies without analyst coverage, and I don’t even seek out analyst coverage.
Harris: How has investing in managers changed with the advent of new tools like SumZero’s Cap Intro?
Van Biema: Tools like SumZero are great for us in that they help us discover managers that we might not come across otherwise, and to do so at very early stages. They can also make our process much more efficient. We get a lot of incoming requests for meetings, and typically decide which of those meetings to take based on what we can glean from the marketing decks and letters managers send. When we subsequently meet, we spend the bulk of our time talking through individual investments to determine whether the manager is a good fit for us. Though it may seem obvious, the fact that services like SumZero enable us to read managers’ investment write-ups before choosing to meet with a manager means we can make better decisions about who to meet with, potentially saving us a lot of time.
Harris: What do you see as the biggest difference between U.S. and ex-U.S. value managers that you’ve allocated to?
Van Biema: There is really very little difference between our U.S. and non-U.S. managers. We favor concentrated, small managers here and abroad. We also favor managers with lots of local knowledge. Since we ourselves have some first-hand local knowledge of the U.S., local knowledge overseas is even more important to us, especially for investing in emerging and frontier markets. First and foremost, it is a big advantage just to be able to read the language. Although many companies issue financials in English, they are sometimes delayed relative to local versions, and often abridged. And that leaves aside other local reading materials, and of course conversations that wouldn’t happen without those language skills. Second, one needs to know the players, their reputations and their family relations. While some managers can invest successfully from afar – and we do invest in some very good global managers – in our experience they do not have the same level of insight into local opportunities. Interestingly, one might think that operational infrastructure is more likely to be a problem with non-U.S. managers, but we have actually not found this to be the case. Many of the managers we have invested with, in Asia in particular, have extremely good back offices.
Harris: How do you do your due diligence from 10,000 miles away? How has the due diligence process changed with the advent of the internet?
Royce: It’s a very similar process of looking at published materials. Most companies have websites, detailed financial statements, and reports they make to their equivalents of the SEC. We start with those basic documents and then move to the more qualitative part of the analysis. That involves the internet, which is invaluable for all forms of research -- picking up on other observations, locating people who are familiar with the company who we can talk to, understanding what other investments the primary shareholders – for example, the lead families – might have. That’s been a wonderful tool
Harris: With pressure on fees in the investing world, can the two layered fee structure of the fund of funds model compete?
Van Biema: In theory, a fund with a dual-layer fee structure should be able to compete if its net returns outpace those with single layers of fees.
In reality, many investors won’t even consider a dual-layer structure anymore. But our business has evolved over the past several years, and the bulk of our assets are in our advisory business where we advise clients on custom portfolios of value managers. That business works for institutions and other investors without the resources or expertise to put together and manage a portfolio of managers that will best achieve their investment goals. In addition, most recently, Chuck and I have formed a joint family office to invest our families’ capital. We plan to have other families invest along-side us, and are in the process of setting up a group of small funds managed by some excellent value managers we know well for this purpose. These funds, which are also well suited for our advisory clients, will have a single layer of fees.
Harris: Has the internet and the unprecedented access to information it provides brought more competition to the small cap space?
Royce: Yes, maybe. But honestly, there’s so much opportunity around the world in the small-cap space that competition isn’t the issue.
Harris: What's the best way to get to know company management when you don't speak their language?
Royce: The language barrier might appear to be a problem on the surface, but it really isn’t anymore. With some exceptions, English is really the financial language. Japan, where apparently there is not much incentive to learn English, is the one major exception. But in the rest of the world, the financial community and the local management teams generally speak English, and the websites are in English. Even in Japan, it’s evolving.
Harris: Are small caps systematically underweight due to S&P 500 indexing? If so are there any sectors particularly impacted?
Royce: First, domestic small-cap activity has become a more formal asset class over the last 30-40 years. Because of that, there are many small-cap indexes. So, indexing has in fact come to the small-cap space, pretty thoroughly in the U.S. That’s happened much less abroad. But the indexes here all have substantial diagnostic, quantitative systems for sectors, etc. So, it’s become similar to the large caps.
Harris: What do you think the broader impact of the shift to passive management will be on the small cap universe?
Royce: I think at the end of the day passive investing is less viable – maybe not viable at all – in the small-cap space. Almost by definition, small-caps are more inefficiently priced, and they have a wider dispersion of factors that make them underpriced, so active management will remain dominant, as it is today. The shift towards passive investing will be less of a factor for small caps.
Harris: Fama and French famously claimed that exposure to small caps was just another factor risk and not a source of alpha. How do you see it? Do you care?
Royce: Fama and French’s observation was important early in the game, and it’s because of that observation that capitalization size is now considered a “factor.” Their identification that small caps can bolster performance helped put small caps on the map.
Harris: Are you worried about scaling your strategies given the size constraints of small cap investing? How have you scale up your strategy to correspond with the progressive growth of your AUM?
Royce: Yes, we’re always thinking about what levels of assets are suitable for small-cap strategies.
We run a variety of strategies, including deep- value, low-volatility, micro-cap, pure value, and small/SMID strategies focused on compounding.
We absolutely think about capacity, which is a very valid consideration in the small-cap space.
Harris: Has the crowdedness in large caps begun to spill in the the small cap world as well?
Royce: I think, yes. As the asset class has become domestically more established, the number of managers has increased. There’s some truth to that in the upper ends of the small-cap space, but far less so in the micro-cap space.
Harris: What key personality and investing traits do you look for when investing in a manager? Which is most important?
Van Biema: We are looking for managers with a long view of success, those who want to build durable businesses that will allow them to spend the majority of their time investing so that they can generate outstanding long-term returns. Asset gatherers are a real turn-off for us. We are looking for patient, disciplined allocators of capital who recognize the value of staying small, nimble and opportunistic, and who are willing to sit on their hands and do nothing if there is nothing compelling to do.
Having the right mix of modesty and self- confidence is also important to us – good managers need enough modesty to motivate them to seriously explore the weaknesses in their investment theses, but they also need enough self-confidence to deviate from the herd and pull the trigger on the most shunned businesses once they have done the work.
Harris: What advice would you give a value manager looking to raise assets?
Van Biema: I would give managers trying to raise capital today two pieces of advice. First, take your time, and second, choose your LPs carefully. I have seen a number of good managers fail because they build out their infrastructure in anticipation of raising enough assets to support it. Raising capital is tough and it’s difficult to predict how long it will take. So the build-it-and-they-will-come philosophy is very risky. Most of the managers we invest with are very small, typically one- to two-person firms. The majority of the infrastructure is outsourced, and this can be done at a very modest price. This allows these firms to subsist at very modest asset levels, giving these managers more time. The second piece of advice is harder for young managers to heed, but it’s absolutely critical. Value investing is a long-term pursuit – many of the best investment ideas go nowhere for long stretches of time, and many of them sell off even more before they work out. As a result, some of the best value managers endure periods of significant underperformance. Taking capital (especially too much capital) from investors who lack a long-term view, and who lack the ability to assess a manager apart from his or her short-term performance, can lead to a fund’s early death. Find investors whose investment goals match yours, and who truly understand your approach.
Harris: Michael, in the book you co-authored, "Concentrated Investing: Strategies of the World’s Greatest Concentrated Value Investors," you covered the portfolio management strategies of some great investors. How do you apply these strategies towards your selection of managers?
Van Biema: With some exceptions, we tend to focus our efforts on building portfolios of small (in terms of AUM), concentrated managers. We think this gives you the best of both worlds – highly concentrated, focused, well-informed stock picking on the one hand, and diversification on the other. The other thing that we discovered while writing the book is that most managers are just not selective enough. It is emotionally difficult to do a lot of work on an idea and then not include it in your portfolio. We look for managers who demonstrate that type of discipline. Those managers view such sunk labor as time well spent protecting capital from risky ideas.