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Royce: Quality Doubly Important

The Royce Funds president discusses the small-cap shop's search for quality companies, portfolio moves in the downturn, and the factors behind a poor 2008 performance.

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Karin Anderson: Hello. I am Karin Anderson. I am a mutual fund analyst at Morningstar. I am here today with Chuck Royce, the president of The Royce Funds. Chuck, thank you for being here.

Charles Royce: Great.

Anderson: First of all, I would like to get a sense of how you navigated the 2008 downturn. You run several small-cap funds, and you have been through downturns before. So what was different this time around? What were some of the key takeaways?

Royce: Well navigate is probably giving a little more favorable twist to what happened last year. We did poorly, certainly far worse than I would have ever wanted to do on a given year. The world had this absolute blowup starting in mid-September. There was this, what has become known as the "Black Swan Effect" of a variety of circumstances ganging up at once that certainly was not in our mind-set.

We definitely believed that we were going to have a recession. We believed that we were going to have a market correction. We believed we had certain things in mind of what would go on, but really it happened at multiples of that; two or three times that.<TRANSCRIPT>

There was liquidation across all asset categories, all style categories, all types of assets; liquidation across the board, forced liquidation, fear liquidation, that was just beyond our experience and certainly beyond what we were predicting.

So we did not really navigate very well. We were fully invested, more or less. We used the decline to add, but truthfully we were more invested than one would say would have been appropriate if we had known.

Anderson: Maybe you could talk to us a little bit about the type of quality company that you look for and the type of quality company that you were adding to in the downturn.

Royce: Sure. Quality is the theme of the firm. It has been for several years. We have several products devoted to that. But it is a very real theme that is important in difficult times, doubly important. This is certainly a difficult, trying time. So quality has a variety of layers to it. It starts with the balance sheet, or it starts with business strategy. You end up with a good balance sheet... If you have a good company that has high returns, you end up with a good balance sheet.

But certainly we are looking at all of those things. I would say what we are absolutely focused on is understanding the sustainability of the business strategy, understanding the "moat," to use a Morningstar word, understanding how it will work over very long periods of time, and then working backwards to the current circumstance.

So we are very driven by that in many of our activities, certainly in the quality type funds, Royce 100, Premier, Royce Value; these are the utmost part of what we are doing.

So it is an important theme in those funds, but it is also very important in Penn Mutual and some of the others.

Anderson: OK. Could you also talk a little bit about how you are getting to know companies that are abroad as you expand and built out your investment personnel and are launching some new funds in those areas?

Royce: Sure. It has been an evolutionary thing for us, not an overnight thing. We have been involved overseas for a long time. We just didn't sort of count it up and say, "Oh boy. We are overseas investors." It has been a very gradual process and one that we are completely committed to of using exactly the same principles and applying it overseas. We are probably a touch more intentional now. We certainly have some dedicated people now that we really didn't.

But frankly, the dedicated people are totally integrated into our normal principles. We are not going to use special circumstances for the U.K. versus U.S. companies. We are looking for quality. We are looking for outstanding companies with great business strategies. We need to see them many times, not once, just the same way we would do with a U.S. company.

So we are making no compromise in what we are doing. We are a touch more intentional, and we have broadened where we are looking. But it is a very positive thing for all the portfolios, not just the new international portfolios.

Anderson: Well thank you very much for your time today.

Royce: Great. Thank you.

Karin Anderson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.