A self-described ‘accounting nerd’ looks for value in unloved stocks.
Our guest this week is Charlie Dreifus. Charlie is portfolio manager of the Royce Special Equity Funds, highly regarded by Morningstar’s Manager Research team. Charlie was named Fund Manager of the Year by Morningstar in 2008 for his work on the Small-Cap Value US Equity Strategy, which he began running in 1998 after portfolio management stints at Lazard and Oppenheimer. Charlie’s investment career began in 1968. He holds degrees from City College of New York and Baruch College.
Background
Royce Small-Cap Special Equity Investment
Steven McBoyle, co-portfolio manager
Small-Cap Value
“Small-Cap Funds Are More Promising Than They Have Been in Years. Here Are the Ones to Buy,” by Lewis Braham, Barrons.com, Oct. 11, 2023.
“Why Value Veteran Charlie Dreifus Balks at Banks and Favors the Rust Belt,” by John Coumarianos, citywire.com, April 21, 2022.
Other
“A Conversation With Investing Legend Charlie Dreifus,” Interview with Russ Kinnel, Morningstar.com, Aug. 14, 2020.
Public Company Accounting Oversight Board
“Irving Kahn, Oldest Active Wall Street Investor, Dies at 109,” by Sam Roberts, nytimes.com, Feb. 26, 2015.
Dan Lefkovitz: Hi, and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Lefkovitz: Our guest this week is Charlie Dreifus. Charlie is portfolio manager of the Royce Special Equity Funds, highly regarded by Morningstar’s Manager Research team. Charlie was named Fund Manager of the Year by Morningstar in 2008 for his work on the Small-Cap Value US Equity Strategy, which he began running in 1998 after portfolio management stints at Lazard and Oppenheimer.
Charlie’s investment career began in 1968. He holds degrees from City College of New York and Baruch College.
Charlie, thanks so much for joining us in The Long View.
Charlie Dreifus: My pleasure.
Lefkovitz: So, it’s not every day that we talk to an investor with 56 years of official experience. So, it’d be great to hear a little bit about your upbringing and how you got your start as an investor and about the academic training that shaped you?
Dreifus: Well, stop me if I keep talking too much. I am first-generation American, first-generation college grad. My parents left Nazi Germany in 1937 and 1938, respectively.
One of my earliest TV interviews, the interviewer said to me, “Charlie, you have such a risk-averse mentality. Where did you get that?” I said, “It‘s in my DNA. My parents were refugees.” And that formulated a lot of my risk-averse. And I would suggest hopefully the downside-capture ratio numbers we’ve posted over the years of losing less. One of your colleagues also once said, “Charlie Dreifus makes clients’ money by losing less.” And that’s true. I underperform the upside.
So, in any event, I grew up in a neighborhood that was a disadvantaged neighborhood, to say the least. My parents, again, the refugee mentality, we never owned a car, they never bought anything they couldn’t pay cash for, they never owned stock. So, to your question about what got me interested in the stock market was my parents had a cousin who would come to us for holidays for dinner. And he was a single German refugee who was a waiter at a restaurant. But he bought stocks for dividends. Every stock he owned had a higher yield than you could get at the bank in those days. And I’m talking this was early ’50s. So, I was born in ’44, so I was, let’s say, seven, eight years old. And I got intrigued, I was always interested in numbers. When I was a little child, my mother who did have some education—although both my parents worked in factories here in New York—she would want to read me bedtime stories. And I said, “No, mommy, give me numbers.” I wanted to add or subtract or divide numbers. And this was as a little kid. So, the fascination when this cousin spoke about stocks really got me intrigued.
So, fast-forward to my bar mitzvah in 1957, I got some bar mitzvah money, which is common. And I started buying stocks. But I also was haphazard, there certainly wasn’t any discipline. And in the formative years, and you have to understand, this is leading up to sputnik. I’ve seen many bubbles starting in the late ’50s when we had a, not a tech bubble, but a sputnik bubble. So, everything like AI today, everything that had Cape Canaveral in its company, did well. So, that got me going. And I started watching the newspapers and optically looking for—obviously, this is late 1950s. There were no computers, there were certainly no iPhones. I would optically scan for momentum. And I bought momentum to the point. And this is either weird or shows my passion, probably a bit of both. So, in high school, when other kids after school would go to the yard and shoot baskets, I went to the public library and was flipping through Moody’s manuals.
So, I’m 15, 16 years old. And I started day-trading in high school, circa 1960ish. And the way I was able to do this—public high school in Brooklyn, we moved from Manhattan to Brooklyn—I gave the guidance counselor stock tips. And in return, he gave me a hall pass—you needed a pass to leave the room, to go to the bathroom or whatever. But I needed a pass to go down to the public telephone to call the broker. So, I was literally day-trading at age, I don’t know 16, in a very novice kind of way in the sense I was doing momentum. But at the library, when I flipped through the Moody’s manuals, what intrigued me then and what has been a hallmark in the Special Equity product, which indeed has been around for 44 years in different firms, is unappreciated, undiscovered inefficiencies.
When I went through the Moody’s manual, I found names of companies that were not in the stock tables in the newspaper. And that piqued my interest. And that led to what continues to be our focus on trying to find mispricings, anomalies in the marketplace.
Benz: I think it’s safe to say that you’re not a momentum manager now. So, maybe you can talk about turn of events that led you to have the sort of stock-picking approach that you employ today?
Dreifus: Great question, Christine. So, undergrad, I was an accounting major, I went through straight A, the school, and everyone was incredibly disappointed because I was getting offers from major, the top eight—those days was in the top four—that the school had never been approached by before. And I turned them down. And when they asked me that you went through straight A, you got all these firms that are after you, why? So, I said, it’s incredibly boring, I hate it.
I enrolled in a PhD program, fast-forward, I have an ABD, all but dissertation—I never finished my dissertation, I did everything else. But in the graduate school, I encountered a professor that changed my attitude about accounting and changed my life and my investing style. So, that gentleman was Abraham Briloff, prolific writer in Barron’s during the ’70s, ’80s, ’90s, critiquing companies using aggressive accounting, both for either the balance sheet or income statement—and this got him into hot water—criticizing the auditors for not being the ombudsman that they should be. So, Abe taught me that I was a deconstruction of the financials rather than constructionist. Why did the company choose to show revenue this way or treat expensive that way? And the whole issue of governance, which is a very important—we call it accountability because it includes governance and the veracity of accounting. And we do really, really deep dives into that.
So, what Special Equity, which launched initially in May of 1980, has the first no-load fund at Oppenheimer under the company Quest for Value, reincarnated when I went to Lazard. It was the Lazard Special Equity fund, and obviously for the last 26 years, it’s been the Royce Special Equity fund. But as an aside, keep in mind, this product has like more than 10,000 NAVs. So, I have a basis to know what to expect that I try very hard when I am explaining the potential outcome, performance outcomes to clients what to expect, which again, is underperformance on the upside, but better performance, either less down, or in some cases actually up when the market declines. And that’s where we gain our advantage. So, Christine, I hope I’ve answered.
And then we have the other thing that formulated it. Incidentally my PhD was in business. So, I took graduate finance courses, and I got more intrigued by M&A. And I got wind, so to speak, of valuation metrics, which had nothing to do with P/Es. I can’t recall if it was a partner at Lazard. I got to know a lot of M&A partners. And to my best knowledge, there has never been an M&A deal done based on P/E. It’s all done on what I think is an exaggerated number, but it’s EBITDA—earnings before interest, taxes, depreciation, and amortization—divided by enterprise. So, multiple of EBITDA/enterprise value.
So, I flipped that. I first of all took, rather than EBITDA, I used EBIT, giving no credit to depreciation and amortization. Depreciation is a real expense. At some point, you’re going to have to replace machinery. Amortization may not be, but again, being super cautious, belts and suspenders, I got an award here once at Royce and it showed a gentleman wearing belt and suspenders being so risk-averse and guilty. But that triggered my valuation model, and you have to understand also in the ’80s—and Oppenheimer was part of this phenomenon—the leverage buyouts, LBOs, became very popular. And that was the metric that was used for LBOs.
Prior to the launch of the first quest for value product, I developed EBIT/enterprise value. So, earnings before interest and taxes, and in that I used the lower. Again, I stacked all the odds against us to bulletproof to the extent I possibly can, the downside risk. There are potential mistakes, and I’ll get to those.
In that EBIT number—earnings before interest and taxes—I used a lower of trailing 12 months or future 12 months, never anything higher. Again, all deals and all analyst reports are always based on future numbers. And we don’t do that. So that results, if you do that, EBIT/enterprise value—enterprise value is the sum of market cap plus interest-bearing debt minus cash. So, you get a cap rate, you get the return that buyer would earn if they bought the whole business. And if you compare that against a proxy, and that’s all it is, a proxy for the cost of capital, it’s not the intricate, academic, 10-decimal-place cost of capital, but rather what we have used over all these many years is the junk-bond yields. And if necessary, adjusting it if it’s way too low, as it was during the zero long-term interest-rate environment, we just add it to what the then-junk-bond yield was. So, if there’s a positive spread, you’re buying absolute value, but you could buy the whole business and you could take out capital, dividends, earnings every year. And that’s important that absolute value, again, having 44 years of NAVs, when the market loses its bearings, when it doesn’t know what the right multiple is any longer, and it always happens. Then if you have something that is intrinsically worth its price as a business, it doesn’t go down as much. Sometimes it doesn’t go down at all. It may even go up. And it also gives rise ultimately to discovery or a transactional event, then brings it up or beyond what we consider true value.
And to digress a bit, but one of my earliest investors, and I could mention his company because unfortunately, he died at a young age, was a guy named Brian Little of the firm Forstmann Little, which was a big M&A leverage buyout firm in the ’80s and ’90s. He was a classmate of a colleague of mine at Oppenheimer and he set up a meeting between us and they were doing private equity. He became a shareholder in my first fund, but he said to me, “Charlie, what you’re doing is the extreme version, and I applaud that because you’re being much more cautious and conservative. And furthermore, obviously, because it’s a mutual fund, your prices are real. They’re validated in the marketplace every day. When we take something private, we take a stab at it every so often to share with our investors.” And that gave me the confidence that I was on to something. When Brian Little bought Special Equity in, I believe it was 1980, and we went through that exercise, and we kept on meeting for some time, it struck me that this really is based on economics and accounting. And those two disciplines can be forgotten and pushed to the side temporarily. I don’t think they’re ever going to be totally ignored. And the market comes back to that. And when it does, we have the wherewithal. When the market gets expensive, this cap rate that I mentioned works in reverse. We have a self-governing device that gets us out of the market.
I may have, and my colleagues I work with—I have two fabulous colleagues, assistant portfolio managers that work with me on Special Equity. And incidentally, one is in his mid-50s, and one is in his early 30s. And I’m approaching 80. So, that partially answers the issue that people should ask, which is succession.
But the point being that this methodology gets us out of the market, albeit almost always too early, the market keeps rising. Once there’s no differential between the cost of capital and the cap rate. And incidentally, that could happen the good way by the stock going up and the cap rate coming down. Or it can happen because interest rates rise, and the stock hasn’t moved. And then this year, you squeeze that cap rate, or, which I wanted to mention and alluded to before: we make mistakes. When I order pencils, I make sure they come with erasers because I know we’re going to make mistakes. And the mistake is when you use that stagnant EBIT number, lower up trailing the next 12 months, it has to persist. And sometimes, despite our good research—we have a devil’s advocacy policy, no holds barred in terms of the three of us. When we discuss a stock, we are mindful of value traps, or in the old days they were referred to as cigar butts. But we try very hard not to buy a value trap or a company where we made a mistake about the persistency of the EBIT, but it happens. And fortunately, because we didn’t overpay going in, we’ll take a loss, but it’s not going to be major.
Lefkovitz: Well, we’d definitely like to come back to value traps later on. But I did want to ask you, given your decadeslong experience, what has changed about the market over the course of your career? Do you think it’s less efficient or more efficient than it was? You’re obviously competing with trillions in capital, public market investors, private market investors?
Dreifus: Great question, Dan. And a lot has changed. Of course, data availability and therefore, inefficiencies are less prevalent. And you have to dig deeper to find them. They’re still there, and we find them. One way is, an easy way, you search for companies that have no coverage or minimal coverage. But we also go through our own screens. And from time to time, I try to get a hold of—I haven’t done recently, I hope it still exists—the Pink Sheets. This is where pre-Nasdaq, all the over-the-counter stocks resided. And you’ll find names of companies.
Again, goes back to my teenage years going through the Moody’s manuals, trying to find inefficiencies. So, couple of years back on the screen, we came across a company called Computer Services in Paducah, Kentucky. And they did bank software. And they had like 51 years of consecutively increasing dividends of the past 25 years, 23 had up earnings, and it sold at a ridiculously low price. And it obviously had no coverage, and no one cared about it. CSVI was the symbol. It got taken over ultimately. And from memory, we paid $10 for it, and it was taken out at $60 or higher. So, it was a huge win.
More recently, we bought—three, four years ago, we started to buy a company called Encore Wire, symbol WIRE. Makes electrical wire for EV, for enhancing the grid, obviously for construction as well. It had no coverage at that time, incredibly—great financials. There are a lot more metrics we use besides that cap rate. We stress free cash flow; we stress low debt. There are a lot of other ingredients in the matrix, financial criteria. But subsequently, it got attention. And obviously, copper prices went up during the pandemic. So, it became our largest position. It was an 8% position as of June 30 in Special Equity. It was taken out—it was bought out by a European wire company at $290 a share; our average cost was in the low 70s.
So, the market has changed. It’s much more difficult. I totally would agree with you, Dan, that the discovery factor has more hurdles to it today than it had in the late ’60s or early ’70s, or for that matter, early ’80s. But it still can be done. It’s not as plentiful, but we have such names in our current portfolio.
Benz: Charlie, I wanted to ask you about Chuck Royce and his influence on your career. He has recently retired from portfolio management duties, but he’s a legendary small-cap investor and founder of the firm that has employed you for the past 25 years, even though the ultimate owner is Franklin Templeton. Can you talk about Chuck’s impact on you and your career?
Dreifus: Chuck and I first met in 1974, 1975. He was a sole practitioner doing the Pennsylvania Mutual Fund at the time. We were introduced by a sales lady at Oppenheimer, who at the time he was dating. And we hit it off. Obviously, we were friendly competitors, and we were both using very crude screening techniques. I forget who he used, but at Oppenheimer, we had the computer people at Merrill Lynch run screens for us. That’s how we got into screening.
They were computer programmers that I had to teach financial ratios to so that they could put that into the computer coding. So, we met in the mid-1970s, and we kept in touch. We always kept in touch. And what sealed the deal was in 1987, Chuck and I, along with three others—there were five of us in total—were picked to manage a closed-end fund in Australia. It was called the US Masters Fund. And we did, four of us—one of the managers opted not to do the Dog and Pony show. For two weeks, we traveled through New Zealand and Australia together. And Chuck and I were the only ones who weren’t out on weekends and whenever other possibilities existed, playing golf and doing leisure, we would try to do work. And I would see him every morning as I was also doing, sending telexes. That was the only way you could be keep in touch with your office in terms of buys and sells. So, I saw his passion. And I said to myself then, if I’m ever going to leave Lazard—which I was at and left 11 years later, I left in 1998, and this was 1987—I’ll ask Chuck if I can join him. Because not only were we investing in the same asset class, but we were as passionate. Chuck is 24/7—I think, I’m 24/7 consumed by it. Chuck fortunately has more outside interests than I do. But his passion and his focus and his different investment style—he will pay higher valuations for more growth-oriented companies, compounders, as he would call them. I’m absolute value.
So, there’s a difference. But we hit it off so well in 1988 on that two-week tour of Australia and New Zealand that starting that Christmas, we had, and we still have, Christmas parties where we invite outsiders. And he invited me, a friendly competitor. And I would attend, and we would see each other at least that way, but we saw each other otherwise as well. And his endurance and his unwillingness to cave in to market fads. Market fads, again, I said this at the early on, I’ve seen so many bubbles starting with sputnik in the late ’50s. And then we had guns and butter sort of bubble in the end of the ’60s. Then we had the Nifty 50, dot-com. It keeps on happening. And you’ve got to have confidence in your discipline. You have to stick with it. And hopefully, you have clients who understand that because your performance is going to lag during those periods of time.
Lefkovitz: I wanted to get your perspective on small-cap value. If you look at the Morningstar Style Box, it is the worst-performing corner of the market for the past 10-plus years now. Ironically, there’s academic research that says that it should outperform over the long-term because there’s a compensation for risk. But curious why you think small-cap value has lagged so badly?
Dreifus: I think a lot of it has to do, and I think the time frame you suggest is correct, perhaps increase it to 13 years or something like that. It has to do with post the great financial crisis and then the pandemic, quantitative easing. The low interest rates, the deficits, and obviously in the extreme case when pandemic hit, we had aggressive monetary easing as well as fiscal stimulus. We had fiscal stimulus, monetary stimulus. And in a period of time when interest rates are low, everything looks cheap. And until the stimulus came about during the covid pandemic, there was low growth. So, people drifted toward areas that were growing—the growth stocks generally, whether it was tech. And if you remember in the mid- to circa 2015, 2016, we had a biotech bubble. People gravitated toward that and ignored small-cap value. Also, in zero interest rates, even the worst small-cap companies—and you have to understand the small-cap indexes have a large proportion of nonearners and with atrocious balance sheets. But in that environment where there’s zero cost of capital or near-zero cost of capital, they’re all survivors.
Not only was the asset class itself shunned in favor of large-cap growth, but with those areas within small-cap that did better, not exclusively, but tended to be not the pristine, high-quality, low-debt, high free cash flow companies that are embedded in Special Equity. So, we had some good years in there where we defended well when the market actually did go down, and where we met the market when the market went up. But generally, it was a very tough environment.
And frankly, with small periods of time… So, the methodology that I explained before, the cap rate and using it both in terms of self-governing, getting us out of stocks. So back in late 2019, the market looked expensive. We couldn’t find new names to buy, and the things we owned had low to disappearing cap rates. So, we sold them, and we ended up with a lot of cash. People say, aha, the cash is where you earn your outperformance. No.
First of all, we’re holding cash too long, we’re underperforming with cash for quite a period of time. We do benefit when the market initially goes down, but the real alpha comes about by deploying the cash when our screens tell us we’re a kid in the candy store, where it’s raining our kinds of names on us. And as an example, in the period of March, April of 2020, when the pandemic hit and the market bottomed, we added between 10 and 12 names, more than we—I don’t know, let’s call it a four-, six-week window—more names than we added the previous year entirely. And that’s where the cash-hoarding or cash-build benefits the investor.
Initially, as it has now, we have a high cash position, partly, caused, incidentally, I should tell you… I mentioned earlier, Encore Wire was an 8% position. We also had another company, US Silica, which was taken out a little later in July. Those two combined were over 8.5% of the portfolio. So, all of a sudden, we had 8.5% in cash on top of a previously midteen kind of cash position, and we can’t find new names. Some of our names are still attractive to buy. Some of the names have risen to the point where we’re turning them. So, we have not yet found ourselves the kids in the candy store, but it comes. Again, having done this for 44 years in the same methodology, same product there’s a huge advantage in doing that. And I know it will arrive. What I can’t tell you is that a month from now, six months from now, or two years from now. And in the meanwhile, we’re going to underperform most likely.
Benz: I wanted to ask about valuations. There has been a gulf in valuations between small caps and the rest of the market for some time now. First, I‘d like you to talk about whether you think there is a huge gulf in valuations, and also can you address how that compares with the late-’90s period when, by a lot of measures, small caps and especially small value got very, very cheap relative to some of those big-cap tech stocks?
Dreifus: Great question, Christine. So, yes, they are—statistically, with the easing of interest-rate mentality and the fact that they’re sensitive to economic growth and that they are US-centric, small caps generally, and small-cap value, have done somewhat better. So, the valuation isn’t as extreme as it was a couple of months ago, but it still is relatively extreme.
In terms of the comparison, it does remind me a lot of ’99, 2000, the dot-com, and I performed miserably then. Because again, the names in my portfolio didn’t have growth. They weren’t tech, and they weren’t growth. So, they languished. But the market, as we know, corrected in March of 2000. The market reached a low. And there were some stocks of the big tech companies that haven’t even reached the values—forget about the ones that went bankrupt, but there are some that still haven’t reached the levels they sold in those days. But interestingly enough, and this is a point—it’s a single number and one shouldn’t take this as representative of our performance. But it shows how the markets’ mentality can swing. And the importance of the deep dive into the accounting that we do. Fast-forward from 2000 to 2002—2002 was the year of Enron, WorldCom, all of the accounting implosions. For that year, the Russell 2000 Value was down 11.4. Special Royce Special Equity was up 15.3—26-, 27-point differential. How is that possible? There were no tricks, there was no new issues, there was nothing done that would have influenced that other than the inherent strength of the portfolio. What happened is everyone got religion in 2002 after Enron.
And they went for companies that had the kind of financial footings that we insist upon. Again, I stress that it’s a one-off, it’s a one year. But we’re facing something—it’s not as bad as what was going on in 2002 in terms of the accounting in those days. But I have taken Abe Briloff’s mantle, and I’ve given lectures—this is largely prepandemic—across the country at CFA societies on the evils of non-GAAP accounting to the point actually where the PCAOB, the Public Company Accounting Oversight Board, caught wind of it and actually interviewed me on the subject. There are all kinds of shenanigans played with non-GAAP earnings. And it can seep its way in very unfortunate ways and consequences to the proxy statement because a lot of the incentive compensation these days is based on non-GAAP measures. And if you define what you’re going to be measured against rather than Generally Accepted Accounting Principles, you can obviously game it so that you win more often than perhaps you should.
Lefkovitz: That’s interesting. What are some common practices that you see as red flags?
Dreifus: What I can’t stress enough and what really differentiates us with perhaps most other small-cap value is, so my two colleagues are both CPAs, I never did that because I never joined an accounting firm. But we are accounting nerds, so to speak. And we read the documents, and we find every little detail. We then contact the company we’re looking at. We look at these incidentally separately and then we come into a room and that’s where the devil’s advocacy comes in, and we just go over page by page what we found. And then on the important points, we get back to companies, and this is the most fascinating thing. We get back to companies we say, “Well, footnote 12 in 2022’s 10-K said this. We had difficulty understanding it, could you elaborate.” And the response we get: “Thank you for asking, no one has ever asked us.” And this is a document that could have been out now two years. And they say, “We were wondering why people didn’t ask us. We understand that it’s confusing, and we’re willing to help you better understand it.” And that goes to the root of again—to use a Benjamin Graham, margin of safety. Our investing is margin of safety.
It’s interesting, Christine. In reading, a review of your new book, entitled How to Retire, you touch upon something, which is critical I think in retiring, which I would think and hold Special Equity addresses—people have to withdraw from their retirement funds. And unfortunately, they may have to withdraw when the market is at a low point.
So, by having very good downside-capture ratios, meaning we decline less of the market, we did studies, it’s hypothetical and therefore the SEC won’t allow us to publish it. But anyone can do this. Start with a million dollars in Special Equity, any day you want. We did it from the inception of a fund and we put a million dollars into the Russell 2000 Value, which is the best benchmark, not ideal because a lot of what in the Russell 2000 Value sector weights are, we don’t own. But if you do that, can you take on the same day each year, 5% out—you pick the date, from Special Equity and 5% out from the Russell 2000 Value. You will find that you will have taken out much more annually over that time period from the Special Equity because it doesn’t go down as much. And because you’ve kept corpus intact.
That’s the other thing. Again, I think it was Russ Kinnel, who said, “I make people money by losing less.” The compounding effect of having corpus to invest and grow on the next leg up allows the ending value of Special Equity to be higher.
Very important for endowments, for anyone who has a spend rate, anyone who has to take money out annually, whether it’s individuals with their retirement funds or it’s an endowment—anyone that has that needs to consider the volatility, the standard deviation of returns, downside-capture ratio. The journey getting to the end point is important because, again, you may find yourself needing to take money out at an unpleasant time in the market.
Lefkovitz: Charlie, I wanted to go back to something you referenced earlier, you were talking about value traps—are a lot of industries out there facing secular challenges? Whether it’s retailers, threatened by Amazon or real estate, commercial real estate threatened by remote work, or even in our own industry, asset managers—active asset managers that are threatened by the rise of passive. So, how do you avoid those kind of value traps and all the secular risks out there?
Dreifus: Some of it we’re aware of. We’re consumers, so early on we noticed the inroads that online retailing was having on retailers. And in other areas, particularly with the addition of our youngest colleague, Tim Hipskind, who is AI-savvy and all of the other technology platforms, we’ve gotten better at it.
So, a company that we made a mistake, and it was a value trap. We bought Netgear, the router company. And this was late in the pandemic, so they had benefited by the work-at-home phenomenon. Great balance sheet. They were still earning decent returns. But there was a concern about the persistency, but the valuation—and we had this very active dialogue of devil’s advocacy when we decided that, yes, we’ll take a small position, which we did. But then Tim—all of this is publicly available information—was able to access the movement of routers at retailers. I assume it’s at Best Buy and all of these other places that would normally carry this stuff. And you saw that things were slowing, that sales were not as robust. We also saw that by buildup in accounts receivables and inventories at Netgear, as I recall. So, we acted upon that when Tim had that additional data point, we sold it. And from memory, we bought it at $31 and we sold it at $28, a loss. And again, I expect to make losses. If you’re not making enough losses, you’re not making enough decisions. It comes with the turf. Portfolio management, you have to be more right than wrong. You will never be totally right. And you have to accept that.
So, we sold it, and I haven’t watched it recently, but I believe it got down to $14 or $15 a share from the $28 we sold it at. So, we end up, unfortunately, not too often, but it can happen, buying a value trap: something that looks cheap and proves out not to be. And when you’re deep value, absolute value as we are, perhaps that’s a greater concern. But I think we’ve addressed that. We have such a robust—and again, you only have to look at the credentials. Tim worked for, before joining us, for a firm that did short reports for short-sellers. So, he has this critical cynical eye, as Steve and I have. Steve, as I mentioned before, as Tim is, is the CPA, but Steve was also an investment banker. And I don’t have any of those credentials, but I have the life’s experience of running these funds. And yes, learning from people like Brian Little, learning from, certainly Abe Briloff, learning from my former partners, M&A partners at Lazard about how M&A really happens. So, I think we deal with it as well, if I dare say, I think better, than most, but that doesn’t mean we won’t make mistakes. We do.
Benz: Charlie, Dan referenced this ongoing flow of assets to passively managed products, especially exchange-traded funds. So, I’m wondering, even for investors who might want dedicated small-cap value in their portfolios, why should they consider an active fund like yours versus just going with something that is a capitalization-weighted index fund for small-cap value?
Dreifus: Well, it has to do with the—clearly, I would suggest, it’s certainly an alternative. And, obviously, the mutual fund industry has been challenged by ETFs. And full disclosure, I own some ETFs, but it’s where I’m trying to target a specific area. I’m using this as an example, I don’t own this. But if I wanted to own infrastructure in India, there’s an ETF that I could buy to do that. And that’s the kind of way I go about it.
But the thing that I think distinguishes and, at least I would urge potential investors to look at and consider, is the inherent volatility, again, the standard deviation and the performance and the downside capture. Special Equity has been used in a lot of 401(k) plans by design, because again, investors—we all know this, and it happens to the best of them—when the market goes down and people see losses, they panic, and they sell. And unfortunately, way too often they get back into the market after it has advanced considerably. If you could find the product, and Special Equity is not the only one—but if you could find the product that has lower volatility and a very good downside-capture ratio history, then you should at least consider that, all despite the higher cost that is attendant to owning the mutual fund versus the ETF.
The other thing versus an index, you’re getting stock selection. We have a high tracking error; we don’t resemble the index. If you want to buy the index, certainly, you can buy it. But again, arguing to what we spoke of at the beginning, trying to find mispricings, inefficiencies, I think you’re not going to do as well owning the index. We’ve had a long history, it ebbs and flows clearly of transactional activity in our portfolio, whether it’s LBOs, private equity, strategic buyers, because of the absolute value. And that’s along with all of the other characteristics. So, our portfolio is going to be different than the index. And if that’s what you’re looking for, you’re not going to find it in too many ETFs. And you’re not going to find—and I’ve looked—you’re not going to find anything resembling what Special Equity is in an ETF, at least so far.
Lefkovitz: Well, unfortunately, I think we only have time for one more question, Charlie, because I think we could talk to you all day. But a few years ago, you told our colleague Russ Kinnel that you’re like Warren Buffett, you tap dance to work every day. Do you still feel that way? Curious what aspects of your work keeps you most engaged?
Dreifus: Well, my wife and I have been married for 58 years. She gets it to the point where when our two grown daughters, I suspect older than either of you are, when they were younger, we’d go on vacation down to a beach in Puerto Rico. And I would get FedEx deliveries of 10-Ks and 10-Qs. They’d be reading novels on the beach, and I’d be reading financial statements. They know who I am. I’ve been blessed with a family that puts up with my being 24/7.
I’m an early riser on the computer, real early in the morning. I’m on late at night. I’m on the weekends. Again, and I alluded to earlier, other than family and some philanthropic activities, I really don’t have any outside interests. I have called myself, this is my words, a narrow individual. I am what I am. And fortunately, I’m blessed, I love doing what I do. And I couldn’t imagine not doing it.
So, I still dance to work. And so did my role model; I don’t have his genes. But there was a guy, a value investor actually, not necessarily small cap, but value. Irving Kahn, KAHN, and he and his four siblings each lived past 100. There was an article in The New York Times magazine section about the family. In any event, Irving Kahn, portfolio manager, a value investor died on a Sunday at age 109. The previous Friday, two days earlier, he was in his office. That’s how I’d like my end to come.
Lefkovitz: Well, on that note, Charlie, thank you so much for joining us on The Long View. It’s been great.
Benz: We hope you keep going.
Dreifus: Again, it’s just, it’s in me. And I love doing what I do. I’m blessed. So many people are working in jobs and vocations, professions that they really don’t have the passion about. And whether it’s your lawyer, your doctor, I would argue your investment manager, you want people that are passionate about what they do.
Lefkovitz: Christine, this could be a chapter in your book.
Benz: I’m thinking exactly the same thing. It’s very inspiring to me to hear from someone who still loves what he’s been doing after all these years. It truly is an inspiration, Charlie. Thank you so much.
Dreifus: Thank you. Take care.
Lefkovitz: Thanks, Charlie.
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Benz: And @Christine_Benz on X or Christine Benz on LinkedIn.
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