Royce 100 Comes Roaring Back In '09

• Doug Rogers
• On 7:04 pm EDT, Wednesday September 16, 2009

Royce 100 Fund takes the investment firm's 36-year-old small-cap expertise and applies it to a focused portfolio.

While the typical small-cap fund tracked by Morningstar Inc. has 223 holdings, Royce 100 (NASDAQ:RYOHX - News) has about ... well its name says it all.

New York-based Royce & Associates concentrates its efforts in small caps because that's where the firm's founder built his expertise. Chuck Royce was assigned to the field as a junior analyst in the 1970s and never found a reason to move on.

"The more that I was involved, the more it became apparent that this universe is special," Royce said. "It's evergreen. There are always IPOs, spinoffs and companies falling down. There is a perpetual source of new ideas. And the universe is very large, 6,000-8,000 companies."

The broad universe gives Royce a good chance of finding solid companies selling at good prices. Valuation is a big part of his investment process. Not content with relative performance against benchmarks, he's going after absolute returns. So limiting the risk of losing wealth is always a top concern.

The process has worked well long term and very well as the market has rebounded. The six-year-old fund was up 32.46% for the year going into Tuesday vs. 27.94% for its small-cap growth peers tracked by Morningstar and 18.68% for the S&P 500.

An emphatic pursuer of absolute returns, Royce missed with a 2008 decline of 29.2%. But that was enough below the S&P 500's -37% to give shareholders relief, especially in light of the solid five-year return.

For the past five years, the $169.9 million fund produced an average annual return of 8.92% vs. 1.72% for its peers and 0.83% for the S&P 500.

Why 100? At that number, the firm has found it can hope to increase returns by focusing on its best ideas without having a mistake affect returns much.

Going For Quality

Winnowing down to the century mark involves upgrading the portfolio to higher-quality companies. "Risk control is the point," Royce said. "We can't take a chance on just any interesting small company that comes along."

Don't look for highfliers. Royce 100's holdings might end up on top, but when the fund picks them up they often don't have the hallmarks of stallions. And that's how Royce likes it.

He loves the bargain, but not just any bargain. He's looking for the Picasso at the yard sale.

Gauging quality is a big part of what the Royce team does.

Royce prefers companies that don't need a lot of capital. They generate a lot of free cash and can finance their own growth without much borrowing. So a strong balance sheet is a must.

Small service companies tend to need little capital, so lo and behold they're a huge overweighting in Royce 100.

Having a history of strong performance is key to passing Royce's quality test.

"We have to believe in them and become convinced they have the right strategy," Royce said. "They have to have produced high returns. We never invest in brand-new companies."

Royce keeps a working list of 200 to 400 companies. "The rest is how you construct a portfolio," he said. "That's the magic we bring into the process that gives us an edge."

The fund is weighted in services. "I have accumulated biases that are reflected at some level in the holdings. I like non-capital-intensive companies," Royce said. "I have plenty of those. I like niche models that are unique. I don't care for leveraged companies at all. I don't want to take on that kind of risk. I don't like companies I can't understand."

But there is no outright ban on companies that make things. In fact, a few have been among recent top holdings: Reliance Steel & Aluminum , Oil States International and Sims Metal Management Ltd.

Buzz up!