Accounting for His Success - Morningstar Advisor

Morningstar Advisor Magazine October/November 2009 Issue

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Accounting for His Success

Relatively, Charlie Dreifus blew the doors off the competition in 2008. His fund, Royce Special Equity, beat the S&P 500 by 17 percentage points and the small-value category by 13 percentage points. But he doesn't view the year as a success. Far from it. For a manager whose first ambition is to produce a positive return, losing 19.6% is hard to swallow.

"It's a big absolute negative number," Dreifus says. "People come to me for defensive action, and historically, I've defended well. You could argue I defended well last year, but I got damaged. It was just a bad year."

So imagine Dreifus' surprise when he got a call from Morningstar informing him that he was named 2008 Domestic-Stock Manager of the Year. But as much as Dreifus was able to limit losses last year, he was honored more for his body of work. His long-term performance and stewardship are excellent. (He has more than $1 million of his own money in the fund.) Few managers are able to weather down markets as well as Dreifus, and although he'll rarely lead in small-cap rallies, he makes enough of the upside to stay far ahead of rivals through full market cycles. Since its inception in 1998, the fund has earned three times the annual returns of its category peers.

To find his companies, Dreifus does some heavy lifting. An accountant at heart, he pores through balance sheets with a critical eye, looking for cash-rich companies selling for less than they're worth. He fixes on what he can see. "Too often investors fall for a story or future something," Dreifus says. "My way of investing is on the here and now. I don't pay for futures."

1. Congratulations on being named Domestic-Stock Manager of the Year. How have you achieved your good record?
It's based on a disciplined, price-sensitive methodology that is focused on economic reality. Basically, I determine if an entity is selling below its economic value. If you and I were to throw our wallets in the middle of the table and decided that we were going to buy a business, this is the way we'd go about doing it.

2. As a value-oriented stock-picker, with stock prices far off their highs, is this a time of optimism for you?
I don't know if I have a great deal of optimism. I am finding more opportunities, but I'm trying to be opportunistic with those opportunities. I'm taking itty-bitty baby steps, buying small quantities on the market's down days. It's an institutional version of dollar-cost averaging.

3. People like to call you an "accounting cynic." What do they mean by that?
I was blessed to do my graduate accounting work under Abe Briloff, who taught me how to critically interpret financial documents. My wife tells me that I'm the Shirley MacLaine of the accounting world. The documents talk to me. I can fairly quickly discern the integrity of the numbers. It's another layer of downside protection and avoiding the things you should have known about by reading the documents.

4. Why do so many of your stocks become takeover candidates?
I like to say that the stocks in my portfolio are events waiting to happen. It's not that I buy companies with the expectation of them being taken over. But the characteristics that they possess make them interesting to other people.

5. What do you love about investing in small companies?
The great chance of discovery. They're not has heavily analyzed as larger stocks, and there's more chance to add value as an analyst.

6. What was the first stock you ever bought?
Burlington Industries, a textile company. I bought it 51 years ago with my bar mitzvah money. It was not a good investment.

7. Is this the toughest market you've seen?
This is the worst in my 40 years of experience, because it's spread over so many industries. The closest to it is 1973-74. Things got so bad at the end of '74 that rather than face the humiliation of all the mistakes that I made, I simply turned off the Quotron machine. I saw things that I thought were cheap go down another 25%. That experience taught me things that I'm implementing today: Be cautious and dollar-cost average.

8. Since the crisis began, are you placing greater importance on certain metrics of yours?
Yes, I've dusted some off, such as net net working capital, which was developed by Ben Graham in the early 1930s. It says, let's sum up cash inventories and receivables, deduct all liabilities, and relate the remainder to the market capitalization of the company. It's a classic liquidator's view of buying a business. I'm also paying more heed to yield. People are going to realize that a big part of prospective total returns is going to come from dividends.

9. Where in the market are your metrics leading you?
Industrial and consumer companies. People are missing that many of the industrials have products that enhance productivity and reduce costs. On the consumer side, yes, people are spending less and saving more. But Americans love to consume. If we get this thing righted to any degree, people will be back shopping.

10. Special Equity is not for everyone. Who should invest in the fund?
One of your colleagues at Morningstar once said that Special Equity is like sushi. It's an acquired taste. The fund is for people who are willing to give up some of the upside of U.S. equities in return for a vehicle that will protect them should there be further downside.

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