A Contrarian Fund Hangs Tough


A Contrarian Fund Hangs Tough

Royce Special Equity had a bang-up 2008, compared with the competition, by following its time-tested approach.

Losing 20% in almost any other year would hardly be cause for celebration. But losing 20% in 2008 landed Royce Special Equity (symbol RYSEX) near the top of the mutual fund performance charts. It beat more than 99% of all diversified domestic stock funds last year.

Charlie Dreifus, a 40-year industry veteran who has managed the small-company value fund since its 1998 inception, says his stock-picking approach is an amalgam of the teachings of three financial luminaries. In a nod to Benjamin Graham, considered the father of security analysis, Dreifus buys stocks only when they're dirt-cheap. Like Warren Buffett, he looks for companies with a sustainable competitive advantage. And following the tenets of Abraham Briloff, his accounting professor at City College of New York, Dreifus brings, as he says, a cynical eye to "trying to gauge the veracity of financial statements."

Dreifus is a numbers geek to the core. "My mother always told me that as a child, I'd ask her to read me numbers rather than stories," he says. He views price-earnings ratios as "meaningless" and instead prefers valuation measures based on enterprise value, a company's stock-market value plus outstanding debt net of cash-in other words, he says, "what you'd pay at market if you were to buy the entire company."

He also screens for return on assets and invested capital. Companies that score highly in those areas typically have "some kind of niche, franchise or pricing power," Dreifus says. He avoids companies that carry much debt, but embraces those that generate plenty of cash.


Dreifus has beaten bear markets with this approach before. In the 2000-02 down market, for example, the fund gained 53%, compared with a loss of 41% for the Russell 2000 index of small-company stocks. He thinks his fund hasn't fallen as hard as others during the current bear market because companies in his portfolio "have those two precious commodities: abundant equity and abundant cash." He also prefers companies with large insider ownership, which can ease the selling pressure on their stocks during routs.

Dreifus's meticulous selection process leads him to some 60 minuscule-to-midsize companies that you've probably never heard of. One of the fund's big winners, at 6.5% of assets at last word, has been National Presto Industries (symbol NPK). Shares of the kitchen-appliance maker returned a whopping 59% in 2008.

The portfolio is also heavy on industrial-materials stocks, which accounted for 40% of its assets at last word. Dreifus says that the big allocation doesn't represent a top-down call-he just thinks materials stocks are cheap relative to likely economic outcomes. "The prices on industrial stocks strike me as having embedded in them all the nastiness the economy is likely to deliver," he says.

Because of Dreifus's cautious approach, Special Equity tends to lag in bull runs. "In those really up phases, I'm going to underperform," he says. For example, when the Russell 2000 index rocketed 47% in 2003, Special Equity gained 28%, putting it in the bottom 2% of small-company value funds.


But investors with long horizons should give this fund serious consideration. Its 7.7% annualized gain over the past ten years through January 14 beat the Russell 2000 by an average of six percentage points per year. And Dreifus has gotten there largely by losing less than the other guys when times are tough.