Mutual Funds

Everyone Wants to Be Like Chuck

Charles Royce bucked the bear market. But is he biting off more than he can chew?

By Jeffrey R. Kosnett, Senior Editor

From Kiplinger's Personal Finance magazine, August 2003

Charles Royce didn't foresee the hurricane that struck the stock market. Nor did Royce -- founder of the only fund group dedicated to bargain-priced, small-company stocks -- root for the collapse of the market's behemoths so that he could shine by comparison. But that's exactly what happened. If you want stock funds that will sidestep disaster, and maybe even make some money when the market stinks, Royce is the choice.

Consider Royce Special Equity fund. It invests in strong companies in such prosaic businesses as shoes and tires. Between the stock market's March 24, 2000, peak and the October 9, 2002, low, Special Equity gained 54%. (During the same period, Standard & Poor's 500-stock index tumbled 47%, and the Russell 2000 index of small stocks dived 43%.) Another example: Royce Total Return, which invests in small companies that pay dividends. During the down market, it returned 19%.

What distinguished the Royce family during this bleak period was damage control. Of Royce's nine established open-end funds (it also runs three closed-end funds, which have a fixed number of shares and trade like stocks), three made money during the bear market and two essentially broke even. The others lost from 7% to 22%, but that was much less than the average stock-fund loss, let alone the 70% and 80% meltdowns that befell many aggressive funds. "We're not in business to create losses," says Royce, known as Chuck to friends and colleagues.

With success, however, has come new money -- gobs of it. Over the past year, investors chasing hot performers deposited $1 billion into Low-Priced Stock, now Royce's largest fund, much the way they once tossed money at the Janus funds, and at Fidelity Magellan in its heyday.

To Royce, whose ever-present bow tie tends to make him look studious, this is no sweat. "Having money come in during a down market is fabulous," he says in a conference room in the firm's nondescript New York City headquarters. Royce, 63, says he and his colleagues can choose among 10,000 stocks with a total market value of $1.5 trillion, so his funds can handle far more than the $9 billion they currently contain. Whether they can do so as efficiently as before remains to be seen.

Not all that tame

The Royce funds are by no means safe harbors. The funds do not build big cash positions in anticipation of market downturns, and you won't find the likes of Coca-Cola or Pfizer among their holdings. The small companies they invest in can be far more dangerous. "Very small companies are exceptionally fragile," says Royce. "Products blow up; there are management problems. Perpetual growth is not possible."

The Royce team mitigates risk by buying stocks on the cheap. Royce and his five portfolio managers and nine analysts will consider a stock only if it trades at a price well below their estimate of a company's true worth. This value-oriented discipline has produced a core list of favorite stocks that several of the funds have held for years. Among them are insurer Erie Indemnity; Florida Rock Industries, a gravel and cement supplier; Lincoln Electric, a welding-equipment producer; and Simpson Manufacturing, a maker of building materials.

As new cash has piled in, however, the Royce funds have had to expand their horizons for potential prey. So Whitney George, manager of Low-Priced Stock since its creation in 1994, now buys stuff that requires a strong stomach. George, who seeks to earn 50% on a stock in three years or a double in five, has more than $200 million of his $2-billion fund in biotechnology stocks, which are notoriously difficult to value. The fund has 20% in technology and telecommunications stocks, and even has a 10% stake in gold-mining shares -- heroes of late, but wild and unpredictable. George figures that if he buys cheaply enough, no single holding can decline more than 20% from his purchase price.

Not many risk-averse, value-oriented managers dabble in such supercharged sectors as biotech and software. Chuck Royce insists that his affection for these groups isn't just a product of the Nasdaq crash. He thinks tech and telecom are vital parts of the economy and so widely represented in the stock market that it's always possible to identify overlooked companies that meet his exacting price criteria.

So it wasn't totally out of character that he launched Royce Technology Value last year. To run it, Royce tapped an outside money manager, Jonathan Cohen, who was known for being prematurely negative on Internet stocks while an analyst at Merrill Lynch. Cohen, whose bearishness was ultimately vindicated, seeded the Royce fund with a slew of battered Web stocks. For the 12-month period to June 2, his fund gained 22%, while technology-sector funds lost 9%, on average.

Slicing and dicing

Technology Value and Low-Priced Stock stand out from the Royce pack. It's harder to discern differences among the rest of the product line. Susan Warren, an office manager in Tallahassee, Fla., chose to invest in Total Return because it buys dividend-paying stocks. "To me, the fact that these companies are willing and able to pay a dividend means the businesses have grown past the start-up phase," she says.

But then again, maybe it doesn't matter which Royce fund you choose, particularly if you're a long-term investor. The three open-end funds with ten-year records -- Pennsylvania Mutual, Royce Micro-Cap and Royce Premier--have produced annualized gains of 11% to 12%. Over five years, the returns vary more widely, from an annualized 7% for Micro-Cap and Pennsylvania Mutual (Royce's first fund, which he took over in 1972) to 12% for Opportunity and Trustshares. Although most of the Royce funds exhibit smaller gyrations than the typical stock fund, there is considerable variation among them. Special Equity and Total Return, for instance, have been about one-third less volatile than the average diversified U.S. stock fund. But Opportunity has been about 15% more volatile than the average fund.

To some extent, the funds' holdings reflect the managers' personal styles. Royce Premier and Pennsylvania Mutual, both run by Royce and George, look for companies with sound businesses. Boniface "Buzz" Zaino, manager of Royce Opportunity, seeks growth companies that have stumbled and others ripe for a turnaround. Charles Dreifus of Special Equity is the most persnickety, demanding strict adherence to accounting standards. "Voices from the financial statements speak to me," says Dreifus.

Even more than George, Dreifus has had to deal with "hot money" pouring in to a once-sleepy fund. At the end of 2001, Special Equity had $6 million in assets. Today, it has $471 million. "I see an element of speculative greed creeping in," Dreifus says, frowning.

A new direction

A few years ago, as Royce approached his 60th birthday, he decided for estate-planning reasons to sell his company (he has six children, though none are in the business). But except for his family, his civic involvements and his fondness for restoring old houses, the fund business is Chuck Royce's life. Royce even keeps a small apartment across the street from his midtown Manhattan office for use when he doesn't feel like catching a train for the ride home to Connecticut. Indeed, he pledges to stay on the job "until they are walking me down the last aisle."

In searching for a buyer for his company, Royce had two important conditions: First, he wanted an owner who would interfere as little as possible in the funds' operations. And second, he resolved to preserve the shop's status as a purveyor of no-load funds, those sold directly to clients without sales commissions.

By 2001, after cutting some colleagues in on the action, Royce's stake in the firm had been trimmed to about 80%. Then he found the right buyer: Legg Mason, the brokerage and investment-management firm from Baltimore and the home of renowned value investor Bill Miller. So far, Legg Mason, which is in the business of selling load funds, has lived up to its word and allowed Royce to sell funds without commissions. And the firm doesn't interfere with the way the Royce managers invest (in case you're wondering, Miller and the Royce folks don't swap stock ideas). For its part, Royce doesn't even mention the Legg Mason connection in its printed literature or on its Web site, Roycefunds.com.

There is, however, unfinished business. Legg Mason paid $115 million for Royce & Associates in 2001, with a contingency to pay up to $100 million more in 2004 if the firm meets certain undisclosed performance targets. The nature of the deal gives the Royce group an incentive to keep accumulating assets -- they've nearly doubled from $4.7 billion at the time of the acquisition. Royce says he won't close any funds to new customers because there's no need to, given that he thinks the market's rally is for real and there are still cheap stocks waiting to be plucked. In fact, Royce has opened three new funds, including Technology Value, in the past two years. Asked if he's already met the performance targets, Royce says he doesn't know. What matters, he insists, is that Royce continues to sell no-load funds that are run by the same people, who are bound to the funds by love for their work and by long-term contracts.

But the incentive to boost the asset base is the sharp stone in an otherwise comfortable shoe. It's fair to ask whether Royce managers can be as effective with $9 billion in the house as they were for so many years with $2 billion. Some clients are already voting with their wallets. Andrew Walsh, a software engineer from Londonderry, N.H., says he sold his stake in Special Equity in April partly because it had grown too large. "Investors who would like to see management close a fund to protect its longtime shareholders should probably not consider Royce," says Walsh.

That's just one man's opinion, but the threat of asset bloat is an important issue that investors must consider. It would be a shame if Chuck Royce, who merits praise for his common-sense approach to investing and for his insistence on maintaining his funds' no-load status, ended his career by letting his appetite for more assets triumph over concern for his clients' welfare.

--Reporter: Katy Marquardt

Lineup | How the Royce funds differ

A Niche For Every Occasion

How many ways can you carve up the universe of undervalued small-company stocks? Here's how Royce does it. The closed-end funds trade on exchanges just like stocks. Share prices typically trade at discounts or premiums to the value of the funds' assets. For information on discounts and premiums, visit Closed-endfunds.com.

Open-End Funds

• Low-Priced Stock (RYLPX). The largest Ryoce fund; focuses on stocks that sell for $20 or less.
• Micro-Cap (RYOTX). Buys tiny stocks, those with market values of less than $400 million.
• Opportunity (RYPNX). Eclectic fund that looks for companies fixing temporary problems and for good buys in out-of-favor industries.
• Pennsylvania Mutual (PENNX). The original Royce fund; casts the broadest net by investing in microcap and small companies and by emphasizing quality.
• Premier (RYPRX). A concentrated fund that invests in higher-quality companies in the Royce universe.
• Select (RYSFX). Set up like a hedge fund and designed for wealthy investors, requiring a $50,000 minimum. Invests in a concentrated portfolio of small and tiny companies.
• Special Equity (RYSEX). The most cautious fund; its manager pays careful attention to accounting disclosures.
• Technology Value (RYTVX). The name says it all; buys cheap tech stocks.
• Total Return (RYTRX). Buys from among the 2,000 dividend-paying companies with market values below $2 billion. A low-risk choice.
• Trustshares (RGFAX). One of Royce's more aggressive funds; designed for trusts and gifts to minors.
• Value (RYVFX). Just two years old; invests in small and midsize companies.
• Value Plus (RYVPX). New and miniscule, with just $5.6 million in assets; can invest in microcap, small and midsize companies, but currently consists mostly of microcaps.

Closed-End Funds

• Focus Trust (FUND). Similar to Premier, with a concentrated portfolio of higher-quality companies.
• Micro-Cap Trust (OTCM). No surprise; much like the open-end Micro-Cap.
• Value Trust (RVT). Like Pennsylvania Mutual, extremely diversified with more than 400 stocks.

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