The title of this post is a question posed by Tobias Carlisle to his guest Micheal Green of the Logica Fund, on his The Acquirers Podcast. Micheal’s answer to this question was pretty interesting, to say the least, and beautifully formulates the investment framework of Chuck Royce and the Royce Funds.
Michael Green: “First of all, Chuck has just an incredible mind and an incredible awareness of the embedded optionality in securities. And so, his philosophy as it relates to securities selection at Royce [Funds] was that he focused on small cap stocks, but he required that they have very low levels of leverage. And the reason why he did that…I think he intuitively knew this but I don’t think certainly he was explicitly modelling it in the same way I would be forced to do.
When he recognized this, that they had option-like characteristics, right, owning a portfolio that has small cap names in it is the greatest potential to exhibit that lottery-like winner capability. And he was very agnostic between value and growth from that standpoint. Always looking for that option-like characteristic. But his simple rule was that the company couldn’t have enough leverage that would lead to aggregation or a shortening of that option duration.
So he was effectively trying to pick infinitely lived option-like assets. And he just did it extraordinary well. I mean, he had seen so many management teams and he had seen so much. I met him in 2003 for the first time and he had been running Penn Mutual Fund which was the core of the Royce universe. Which he acquired for $1 in 1974. People forget how bad things got.
There is maybe a little bit of this feeling in the active manager community today. But he was able to buy Penn Mutual Fund for $1 dollar. Because the owner, it had assets, and it had a bit of a track record. But the owner was incapable of paying directors salaries, registration fees etc. So he bought it for a dollar and then it proceeded to lose money for some time as he paid directors and others. But it turned into this extraordinary vehicle on the back of his talent.
Tobias Carlisle: My interpretation of the Royce firm is that they seem to have a holding in every single stock I ever look at. A tiny holding.
Michael Green: So, I think that’s true. I think that is again a reflection of Chuck’s philosophy that each of his securities represents this option like characteristics. A typical portfolio of Royce would have somewhere in the neighborhood of 160 to 300 stocks. There would be multiple portfolios.
Portfolios would typically be launched in a new fund when we thought it was a peak of a market. Which sounds counter-intuitive. Until you realize that what this actually means is that you have launched a vehicle that has an excess of cash in an environment of high valuations. And so as the markets sell off, that cash creates actually an out-performance characteristic.
So when the next cycle emerges, not only did you have cash to deploy at more attractive valuations, but you benefited from the cash component. And I mean, that type of insight. And again, I highly doubt that Chuck modeled it, but he just knew it intuitively. And that’s part of what I referred to with my respect to Chuck. I think he is probably the single finest investor I have encountered.