1. “We seek opportunity at the intersection where Quality meets Value.”
--Chuck Royce
Avoiding value traps is one of the persistent challenges of the value investor. An asset
may appear to be a bargain along any number of dimensions, but how do you know it
won’t get cheaper still? How do you know that the asset is not permanently impaired? In
short, how do you know when you have arrived at the intersection of Value and Quality?
Last week we sat down with one of the maestros of Small Cap Value investing to
explore that and many other questions.
At our latest Small Cap Ideas Summit, we were honored to have Chuck Royce join us to
discuss his nearly five decades as a pioneer in the small company investment
community. It is not an overstatement to say that Chuck Royce invented the institutional
Small Cap Equity business in 1972 when he purchased the assets of Quest Advisory
and its Pennsylvania Mutual Fund. He has remained at the helm of “Penn” for 43+ years
–generating nearly 13% annual returns since inception and beating the R2 by 150 BPs
for thirty years! In the meantime, he built a firm that managed as much as 40B in small
cap dedicated assets and expanded his investments well beyond Wall Street. Chuck is
more than just the Dean of the Small Cap world--he is a Renaissance man with a
passion for restoring old and beautiful things—places where Quality and Value
intersect.
We unexpectedly got a look at how this mantra impacts Chuck’s life in and out of the
office when he hosted a harbor cruise for our group aboard his restored 74 foot motor
yacht, Aphrodite. Clad in a linen blazer and pants, cashmere sweater, crisp white shirt
and straw hat, the absence of his signature bow tie was Chuck’s only sartorial
concession to being on the water. Like her owner, Aphrodite was perfectly turned out.
Her bright work gleams like a mirror in the sun, and her mahogany decks and cabin are
varnished to flawless perfection.
But it was not always the case for this maritime objet d’art. Aphrodite was built in 1937
for industrialist and U.S. Ambassador John Hay “Jock” Whitney to commute from his
home on Long Island to his office on Wall Street. Evidently Whitney was tired of being
“beaten” to work by his brother-in-law and demanded that his new commuter yacht be
the fastest of its day. The craft enjoyed a glittering period playing host to the likes of
Fred Astaire, Spencer Tracy, Katherine Hepburn and Nelson Rockefeller. It was even
the venue for a young Shirley Temple’s birthday party. After Pearl Harbor, Whitney
donated Aphrodite to the war effort where she mostly ferried dignitaries about and
transported President Roosevelt up the Hudson to his Hyde Park home.
Alas, after the war the boat was passed along to a series of owners who, despite their
best efforts, could not keep the ravages of time at bay. By the year 2000, she lay in a
state of disrepair and dilapidation almost beyond recovery. Grass grew up in and
around her decaying hull. Enter Chuck Royce, who purchased the craft and undertook a
painstaking multi-year restoration effort to bring Aphrodite into the 21st century.

2. The Brooklin Boat Yard took Aphrodite apart from stem to stern, cataloguing and coding
every piece and undertaking to rebuild and replace every inch of the yacht from its
signature “torpedo” stern, to its double-planked copper-riveted Philippine Mahogany
decks to its unique cabin and superstructure. The result is a beautifully preserved piece
of American nautical history. In Aphrodite, pioneering small cap investor Chuck Royce
saw both quality and value. The quality of the original craft and its reborn incarnation is
obvious. The inherent worth or value of Aphrodite as it lay rotting in dry dock in 2000 is
something it perhaps takes a keen value investor to have seen.
Back in the early 70’s the young financial entrepreneur immediately had his mettle
tested by the grinding ’73-74 bear market. It was a challenging time to launch an
investment firm but, as Chuck remarked, “The fat pitches come when the market is
down.” That vicious bear set up the 1975-1982 small cap bull market that put the asset
class on the map for asset allocators and retail investors alike.
In 1972 there was no such thing as a Small Cap asset class—indeed Chuck observed
that Russell did not even establish the R2 until 1983 but reconstructed them back to
1978 using historical data. Asset allocators and pension consultants were not driving
the move into small caps, instead that is where the value and the “volatility” were-- that
is where Royce saw opportunity. Mutual funds were relatively new in the 70s, and the
“no load” component of the Royce Funds were a novelty at the time. Great performance
and no upfront sales charges created nicely positive fund flows.
Chuck reminisced that the Small Cap market was inefficient, poorly covered by the sell
side, and ripe for investment in the early days. “We had Value Line--that was where we
started. Back then just by doing the work--visiting the companies, talking to
management, reading the Ks and the Qs--you could get an informational advantage.
We did the fundamental work and could use the insights to make good investment
decisions. Prior to Reg FD, there was nothing wrong with finding and exploiting an
informational advantage. Now, obviously, information is a commodity.” Today he says,
“Time is the final arbitrage. Having a longer time horizon and holding companies that
can compound for you--that is where the excess returns are now.” He says his turnover
is low at 25% but when you dig into the turnover it can be characterized as “one year
mistakes and five year winners that we hold on to.”
Royce credits his recruitment of partners Buzz Zaino and Charlie Dreifus in 1998 as
being central to the growth of the business. He had been pursuing the pair for years,
and they serendipitously both arrived with days of each other almost two decades ago.
That infusion of experienced talent allowed Royce to grow the business, as he
continued to do after the sale to Legg Mason in 2001.
Like many Value-oriented and Active investors, Royce has suffered through a rough
patch in the post-crisis era. However, he and his firm were heartened by the
performance of both value and active management in 1Q16 (Penn finished 1Q ahead of
the R2 by 770 BPs+ and is still smartly ahead through late 2Q). Royce believes that

3. when the environment gets “better for value investors, that will be a more favorable
backdrop for active investors.” We asked why he thought the post-crisis era had been
so tough on active manager,s and he pointed to a laundry list of headwinds including
massive market distortions born of ZIRP, passive market share gains, and the relative
absence of volatility. The virtue of active management according to Chuck is that high
quality companies protect capital in down markets. A normalization of rate structure, a
shift to value leadership, and modestly higher volatility should set the stage for a
resurgence of active management. High ROIC, prudently leveraged and well-managed
businesses that are Royce’s sweet spot should more consistently outperform.
Royce expressed some concern that the no load mutual fund might no longer be the
vehicle of choice for that average American looking for access to professional money
management. He says the rise of the “mutual fund supermarkets” have made it difficult
for managers to have a direct relationship with their customers. He calls it the biggest
negative change in the industry of the past 10-15 years. As such, he sees a place for
separate account products which allow an active dialogue between manager and client.
He also sees a future for actively managed ETFs which address some of the tax
challenges associated with mutual funds. “No one wants to buy someone else’s capital
gains,” admits Chuck.
In terms of current opportunities, Royce says “Value and Quality intersect today in
Cyclicals like Industrials and Materials.” He contends that the dollar is peaking and that
rates must rise globally. He also sees tremendous opportunity in Global Small Cap.
Royce is one of the few fund families with the scale and scope to launch an international
small cap effort, and he feels there are tremendous investment opportunities abroad.
“There are still many family-controlled businesses--family-controlled in a good way--and
often they will sell at single-digit multiples with mid-teens or better growth rates. If I were
starting over today, International is probably all I would do.” In addition to the three
global small cap products Royce has launched, Chuck says the domestic funds often
have 10-15% of their capital invested overseas.
As we wound down our fireside chat, one of our guests asked Chuck what prompted his
investment diversification into Watch Hill Hotels and real estate. The immaculately
restored, fifteen-star Ocean House Hotel in which we met sits atop a hill in charming
Watch Hill, Rhode Island, with sweeping views from the Atlantic to Little Narragansett
Bay. It is perhaps Royce’s grandest investment in Value and Quality.
A long-time summer resident of Watch Hill, Chuck admits that when he purchased the
property in 2006 all he really wanted to do was keep the eleven acres from being carved
into lots for “McMansions.” “I come from Greenwich, home of the McMansion. The last
thing this world needs another one of those.” Initially, Royce sought to renovate the
existing structure, but after a year and a half he realized that, like Aphrodite, the original
Ocean House was too far gone, and began another painstaking rebuilding and
restoration. One of the hotel’s staff members tells a story of Chuck’s punctilious
attention to detail during the renovation. “The fieldstone fireplace in the lobby was
carefully dismantled and rebuilt over a three-year period of time, each stone being

4. numbered and coded. Towards the end of the rebuilding, Mr. Royce was dissatisfied
with its aesthetics and asked that it be taken down and rebuilt a second time.” That
drive for perfection is manifest in the final product. The reborn Ocean House is certainly
the finest and perhaps the only remaining example of a “Grand Dame” summer hotel
the likes of which dotted the Eastern Seaboard in the late 19th century. Upon entering
the imposing yellow and white Victorian atop the hill you, are instantly transported to a
simpler, slower-paced and more relaxed era. In a soon-to-be-razed fire trap, Chuck
Royce saw value and today the reincarnated Ocean House epitomizes quality in every
way.
All of us at Furey Research Partners are grateful to Chuck for sharing his insights on
five decades of small cap investing and being such a gracious host at his impeccable
Ocean House and aboard the classic Aphrodite. From the Royce Funds to Watch Hill,
on both a personal and professional level, Chuck Royce embodies the intersection of
Value and Quality.