Talking with CharlieSubmitted by Karstens Investments on August 6th, 2019
Pictured left to right are: Mike Karstens, Charlie Dreifus, Darren Obrecht, Mark Johnson, Steve Olafson.
Early in May, the Karstens Investments’ team of advisors had the special honor of having Charlie Dreifus, tenured manager of Royce Funds, visit our office for an hour of face-to-face dialogue. Charlie Dreifus was born the son of immigrants to a New York working class family. Or as Charlie said, “The sort of folks who never owned a single stock.” Charlie fell in love with the stock market at a young age and would even use a dime to call his broker to trade stocks during high school. He continued his upward trajectory by earning his bachelor’s degree from City College of New York/Baruch School and master’s degree of business administration from Baruch College where legendary accountant, Abe Briloff, was one of his teachers. Dreifus continued to study forensic accounting under Mr. Briloff after graduation and they developed a lifelong friendship. The story of Charlie’s career since then is decorated with various awards and accolades including the Morningstar Manager of the Year. Mr. Dreifus has served as a Portfolio Manager at Royce and Associates since 1998.
Meetings with Charlie are a special occasion for people in the investment realm - especially value investors - because Charlie is truly one of the great money managers of our time. In this extensive discussion, Charlie highlighted a number of key points about his thoughts on current stock market valuations; he shared his thoughts on accounting principles; and finally, he entertained us with a few stories from his upbringing.
Charlie gives much credit to his mentor Abe Briloff. Under Briloff’s tutelage he learned to take a deep and skeptical dive into a company’s financial statements. Charlie believes that you can learn a great deal by deconstructing a company’s financial statements. He expressed his dismay of the deviation of modern accountants and CFOs from the Generally Accepted Accounting Principles. He argued that moving to lenient and subjective accounting principles has prompted the inflated and false valuation of companies across the board. When researching companies, Charlie and his team at Royce often uncover inconsistencies in the ledgers that had gone unnoticed by other analysts for years. He chuckled as he recounted numerous stories of phone calls with CFOs during which he and his team found numbers that were wrong or questionable in their accounting statements. He said many of those CFOs would later get back to him and say that he was the only person to ever notice the errors or question the numbers.
Charlie talked in broad terms about the current stock market and the difficulties that mutual fund managers face in today’s market environment. As a value manager, Charlie only buys companies if he believes that he can buy them at a discount to their intrinsic value. Finding these opportunities is incredibly difficult, especially when the fund managers are having to navigate particularly fuzzy accounting practices. For this reason and many others, some mutual fund managers - especially those focused on value - are holding much more cash than they usually do. All of them would love to use that cash to purchase more stock, but value managers like Charlie have very strict rules to ensure they are buying the stock at a good price. Charlie gave one example of how he would evaluate a company to determine if he should purchase it. In simple terms, he said that he compares the cap rate of a company to the current junk bond yield. To do this, he gathers the EBIT (earnings before interest and taxes) data from public filing documents and divides that number by the company’s enterprise value or “market cap.” By comparing this number to the junk bond yield he essentially analyzes the rate of return he would get from the stock and what it would cost him to borrow money to purchase it. Charlie said that he has been using that calculation since the very beginning of his career and although it is admittedly simple, it gives him a good sense of direction when he first examines a company’s financial statements.
It has been over a decade since the last stock bear market and sometimes as an investor it is easy to forget the implications these declines can have on your long-term investment performance. Looking at a market index over a long period of time it is clear that stocks have the potential for attractive returns, but sometimes those averages mask the underlying short-term drawbacks or volatility. Without careful design and active management, these short drawbacks can ruin a mutual fund’s long-term performance. Fund managers call this “Downside Capture” or in other words, how much did a portfolio participate in a market decline? If a 50% market decline causes a portfolio of $100,000 to shrink to $50,000, that investor has realized the entirety of the market decline and now requires a 100% rate of return just to get back to the previous value of $100,000. Strategies as simple as diversification on the other hand could make it so that portfolio might only be down by 25% to 30%. Admittedly, it is not pleasant to open up a statement and see that your portfolio is down, but when that happens it is important to analyze how your returns compare to the market as a whole. Charlie stated that instead of only looking at 3-year or 5-year return numbers on a particular mutual fund, investors should analyze the downside capture ratios as well. He said that investors can smooth out the ride and experience less downside risk by purchasing high quality stocks at reasonable prices and maintaining consistent diversification.
Charlie was noted as saying, “We don’t need more accounting principles. We need more accountants with principles.” This statement remains a standard to value investors in a time where the true value of what a company produces remains largely discounted. Where obscure accounting principles and market euphoria drive the prices of many companies, Charlie and his team’s attentive accounting methods continue to provide increased value to their clients. Charlie is truly one of the great investors in the industry and of our time. Hearing his insights each year gives us further confidence in our philosophy, our value-based approach to investing and our long-term belief in the capital markets.