BRIEFING BOOK

Data Information Knowledge WISDOM

CHARLES ‘CHUCK’ ROYCE Charles M. Royce is president and CIO of Royce & Associates and president of The Royce Funds, a position he has held since 1972.

Forbes Townhouse, New York, NY

About Chuck Royce.............................................................................

2

Debriefing Royce………...……………................................................. 3

Forbes on Royce

“Betting on Oddballs,” 04/29/02..……………………………….. “The Big, Bad News,” 08/27/08…………………………………..

6 10

The Royce Interview.......................................................................... 12

- 2 -

ABOUT CHARLES “CHUCK” ROYCE Intelligent Investing with Steve Forbes

Charles M. Royce is president and CIO of Royce & Associates and president of The Royce Funds, a position he has held since 1972. He has 46 years of investment experience, with 36 years as a smaller-company value portfolio manager.

Royce serves as portfolio manager of Royce Pennsylvania Mutual, Total Return, Heritage, 100, Financial Services, European Smaller-Companies and International-Smaller Companies Fund, as well as two of the firm's closed-end portfolios, Royce Value Trust and Royce Micro-Cap Trust.

He also co-manages Royce Premier Fund with Whitney George, Royce Select Fund I with Lauren Romeo, Royce Select Fund II with James Harvey, Royce Dividend Value Fund with Jay Kaplan and both Royce SMid-Cap Value and SMid-Cap Select Funds with Steven McBoyle.

Prior to 1972, Mr. Royce served as the Director of Research at Scheinman, Hochstin, Trotta, a brokerage firm, and as a security analyst at Blair & Co.

Royce served as a Brown University trustee and has funded professorships, as well as a student fellowship program, at the university.

He received a bachelor's degree in economics from Brown University and earned a MBA from Columbia University. Royce made a $5.5 million gift to Brown University to fund six professorships.

Royce is a father of four children: three daughters and one son.

- 3 -

DEBRIEFING ROYCE Intelligent Investing with Steve Forbes

"I look forward to inflation starting." - Royce By David Serchuk What is one misplaced assumption in business today? In the investment spectrum it really is whether it's been resolved that the [reduction of] systematic risk in our markets -- through government intervention -- is taking place. I think we have resolved that in a positive way. I'm not saying all the tactics were the right ones. But if you come to the bottom line here we are nine months later, and all these strange things happened. Now we are at a point where if other banks, for instance, get into trouble they… have a standard operating policy that will be followed. Either let these banks roll up into the top five banks, or they will inject capital, or they will go into a deleveraging of their own. That is a primary assumption. That is the one you have to feel is true or not true. It's a very binary thing. Here's a misplaced assumption for business. It's similar: Will businesses be able to conduct themselves with reasonable access to credit markets, through banks? Will the banking system perform for the average company? Whether it's misplaced or not it’s the $64 question. There is probably more evidence that the systematic risk has been solved for the financial system than for any one business. So many businesses are having to reformat what they can rely on in the way of bank credit. GE, for example, took it for granted, but everybody top to bottom is having to revalue that. It's a big unknown from a business climate standpoint. What is the greatest financial lesson you've ever learned? The biggest lesson is a simple one. That the idea of a money manager is not to lose the money. That is lesson one through nine. You have to repeat that lesson, and redo that lesson every once in a while. Your primary role is not to lose money. We’re gonna lose money this year for sure. It comes with a great deal of pain attached to it. We start with an over-riding emphasis on risk management. Everything we did in our normal course of things in risk management did not have a payout this year. The lesson always is, preserve the capital. The second goal is to make the money. Unfortunately we're going through a reminder period right now. Who is the greatest financial mind working today?

- 4 -

Part of me wants to say Warren Buffett. It's cliché unfortunately. Do I have a hero in that sense? Probably not. It's almost easier to answer who isn't. There I firmly say it's [Alan] Greenspan, who led us into this setting. I'm sure it was not conscious, but I think he failed to think about the consequences of low price on debt, and the impact of all the things surrounding that; the leveraging of America. I am not sure I can remember a single serious comment about that (at the time). Why did so many get it so wrong on Greenspan? The outcomes were good up until ten minutes ago. The '90s were a prosperous period. Form an economic standpoint, it seemed like things were going well. The dollar started to go down at some point. There was probably enough evidence… we had the blowup of Long Term Capital, that clearly involved leverage. Clearly the major investment banks began leveraging themselves. Apparently that was knowable. And we sort of made housing a public policy issue, to grow housing stock. And everybody should own a house. Not sure if that was a Greenspan policy, but it was very much in the mix. And one particular thing I noticed, which I never could explain, is why he did not modify margin requirements … when so much speculation was going on? And why were there so many loopholes in margin rules? Investors could somehow avoid margin through arrangements with banks. Margin requirements never went up. So clearly it was a decision to not have them go up. We had speculative moments in the late '90s, and I found that peculiar. What is your bold prediction for the future? I'm afraid my answer isn’t very bold. I have core optimism that we will muddle through. Some responses from government have enormous consequences we don’t really know. We will continue with this semi-free market system. The clever people will prosper. We know the Goldman Sachs(es) and Morgan Stanleys of the world can no longer operate as they did. That part of the world, which is an important part of how business was conducted, has changed. They will conduct themselves on a much more modified leverage basis. Outside that, we all know there are too damn many banks. Wherever you live, there are community, regional and big banks. You don’t need the physical presence of that many banks. This was all related to the inherent attractiveness of these small bank. They would start community banks and flip them 10 years later into regional banks. Somebody told me there are 8,000 banks in this country. There will be consolidation in the banking industry. I suspect this will be a huge factor around the country, going on for many years. So that part of life will change. Again, not the substance of this country. We have always had a very

- 5 -

free market mentality in most areas, and that will continue. I think the hope and optimism is based on … the world will go on, and deal with recessions and issues of trade. But we always had one of the great gifts to the world, a very aggressive management style, which I think will continue. You have said that the 25 year bond bull market could be at an end. Why? It's essentially true. We are, the present moment being the exception -- we are flooding the market with Treasuries. We have forced and been successful in forcing rates down, in the 3-5-10 year range. This is probably it. I am not sure how this compares to the lows of when the short term rates right before this hit their lows, which I think was in the summer of 2003. I do think the bull market for bonds, that lasted from 1983 until now, is over. Why? Because rates are not gonna go lower, and at some point we will have inflation. And since the bulk of these instruments are abroad the market -- through supply and demand -- will discipline our interest rates, in a way to force them higher. I look forward to inflation starting, we've been in this deflation for a year. A little bit of inflation is okay. A lot is not okay. If you're talking about money supply, we're in a pre-inflationary moment that is not even measurable in the history. So there will be implications for that. It will come around when we have an economic recovery. When almost everything is so discounted how do you determine what is a value? How do you separate the fabulous from the almost fabulous? The really beautiful ones from the extraordinary riches? If we had more money we would be buying more stocks. The truth is, this is, if we get through this period of systematic risk, which I do think we’re coming through, the opportunities will give huge rewards over 3-5 years.

- 6 -

FORBES ON ROYCE Intelligent Investing with Steve Forbes

Betting on Oddballs Rob Wherry, 04.29.02

Nevermind star brands. Chuck Royce thrives on obscure small caps in mundane markets.

The past year has been sweet vindication for Charles (Chuck) Royce, president of his namesake family of ten mutual funds that invest in small-cap and microcap companies. He sat out the tech boom--a painful call when high-tech stocks soared, but a decision that now looks prescient. Instead of going with glamour, Royce placed his bets where most funds weren't looking: a curious amalgam of obscure companies in distinctly unsexy businesses. No Microsofts, IBMs or Wal-Marts grace his portfolio. Ever hear of these guys? Fab Industries. Wescast. Preformed Line Products. Paul Mueller. They make knit fabrics, exhaust manifolds, cable anchors and milk coolers for dairy farms, respectively. Other stocks he owns involve teddy bears, radiation detectors and recreational vehicles. Oddballs, certainly--trailer trash to some pros. Royce rejects that characterization. "People say low-priced stocks are worthless, but there are as many fabulous small-cap companies with great earnings [as large ones]," he says. Royce likes to buy into companies whose management has been in place five years or more--buy them cheap and hold on. His funds look dumb during a speculative bubble such as the one that swept through fin-de-siècle Nasdaq. In the long haul they look smart. His Pennsylvania Fund, the oldest in the family, has averaged a 14.7% annual return in the past 20 years. In that period the Russell 2000 index of small companies averaged only a 12% return. In the past five years Royce's $1.3 billion (assets) Low-Priced Stock fund has climbed 22% annually. Comparable funds at Merrill and Fidelity lagged Royce Low-Priced by about 10%. Now Royce has timing on his side. Historically, stocks in small-cap companies ($2 billion or less of market value) and microcap companies (less than $400 million) tend to lead recoveries from recessions. In 1991 and 1992 small-cap funds outpaced their big-stock brethren by up to 20 percentage points. For Royce, the outlook is even more promising, given the mayhem that followed the terror attacks of Sept. 11. "It was perhaps the most indiscriminate period of

- 7 -

selling we have seen in 25 years," he says. Accounting scandals at Enron and Arthur Andersen sparked more balance-sheet scrutiny. All of a sudden Royce had a crack at companies that had been out of his reach just months earlier. The temptation was real. Instead he moved to add to his existing holdings--cheaply. "I would like to tell you that we discovered gold in the hills or a cave where they were minting money," Royce says, but in most cases, "the stocks that are doing well for us today are the stocks that we have owned for years." One stock that has done spectacularly well for Royce is one that you could never own shares in: the management company that handles his $5.3 billion fund family. Royce got it for next to nothing in 1973 by agreeing to be the manager of the tiny $5 million Pennsylvania Mutual fund. He sold the business to Baltimore-based Legg Mason last September for $115 million up front and as much as $100 million more if he meets certain goals for returns. Smaller, though, is riskier, given that small caps have low liquidity and share prices that can fluctuate wildly on a wee bit of bad news. That's where good management comes in. Royce has almost two dozen analysts screening stocks for long-term value metrics such as historical earnings, revenue growth and longevity of management. Informal price targets give him an idea of when to cash out. You pay for this scrutiny: Royce fees average about $1.25 per $100 invested. Comparable funds at Merrill or Fidelity cost $1.04 and $1.02, respectively. Royce analysts hit the streets and divine stock picks by watercooler conversation as well as at formal sales meetings, the president says. Conceivably, he hears about it when a secretary gets shoddy service while buying sneakers in the Finish Line or another employee comes across a great wireless gadget over the weekend. The informality came in handy in 1998, when Royce was highly skeptical of the plans of one of his holdings, sunglasses maker Oakley, which was charting a foray into footwear. It was hard to believe boasts from Oakley management, especially when the smaller company would have to take on Nike and Adidas for shelf space. Several staff members visited chain stores to check on the placement of the product and to see how the shoes were selling. Royce was unimpressed with distribution, but he kept a position in the company. He halved the Pennsylvania fund's holdings in Oakley in 2000, when the stock price rose. Royce developed his disenchantment with glamour stocks and his preference for oddballs in the early 1970s. He watched Wall Street pump up Nifty Fifty stocks like Polaroid and Kodak, only to see them plunge spectacularly. "I realized it wasn't about a compelling story," he says. "A company had to have a strong balance sheet also." By the late 1990s the day traders stampeding into Qualcomm had forgotten this simple lesson--or were too young to ever have

- 8 -

heard it. In 1973, Royce's first year managing the Pennsylvania fund, he lost 40%. But in his sophomore year, 1974, he made a stunning comeback with a return of 120%. What he didn't realize was that he was on the cusp of an extraordinary bull market in small caps that would last eight years. By the 1980s he had built up his family--both at work and at home (Royce has four kids). He started a parallel fund in 1983 and a closed-end fund in 1987; he added six more from 1991 to 1996. You can get a good idea of the flavor of these funds by perusing the industry categories cited in Pennsylvania Mutual's 2001 annual report. Two percent of the assets are tucked away in the "pumps, valves and bearings" sector, in such names as Roper Industries and NN. There's transportation, with Pittston Brink's Group and Frozen Food Express Industries. Some of this stuff sounds positively 19th century: Midwest Grain Products, Woodward Governor, Ash Grove Cement Co. No hair-trigger trader here. Average annual turnover at the Pennsylvania fund since 1996: 28%. FORBES' 1984 profile of the fund mentions Kimball International, the piano and organ company. The Pennsylvania fund still owns it. Royce will buy technology, too--if he can get it cheap enough. One recent winner: Early last year Royce bought into ESS Technology, when the stock was in the single digits, more than 50% off its previous high. The Fremont, Calif. company is a maker of chips for DVDs and MP3 players. Royce discovered the company several years ago while browsing the booths at an industry conference. He knew DVD players were becoming standard on most PCs. He also liked the fact that the company's management had been on board for 15 years. Revenue in 2000 had hit $303 million, up 40% in two years. Net income had swung to $48 million from a $28 million deficit in 1998. ESS also had $58 million in cash. This particular tech speculation paid off. In 2001 high demand for DVD players pushed the stock over $15. Royce cashed out with a $12 million gain in December--and three months later the stock had hit $25. Why get greedy? Royce picked up FLIR Systems, a maker of infrared cameras at $15 a share and watched the stock fall to $3.50 a share in December 2000. Then terror struck, Wall Street got hot on defense stocks and FLIR broke $40; he sold in November 2001 with a $5.2 million gain. But he stumbled on Washington Group International. Royce liked what he saw in Dennis Washington, a serial entrepreneur who had turned around companies like Anaconda and Montana Rail Link. Now Washington vowed to turn Washington Group into a construction giant. Sales in the first quarter of 2000 jumped 36%, but then Washington bought a dud division of Raytheon for $53 million in cash

- 9 -

and $450 million in debt. By early 2001 Washington Group was burning through $100 million a month. Its stock plunged from $12 in February to $1 shortly before it filed for bankruptcy protection. Royce took a $15 million hit. Sometimes, Royce concedes, even an unsexy oddball can let you down.

A Small-Cap Sampler

Chuck Royce will buy a biotech company if he can get it cheap enough, but he's just as likely to be turned on by gravel, drilling mud or knit goods.

Company /business Recent price 52-week high P/E

Dril-Quip /offshore drilling equipment $24.70 $34.85 36

Woodward Governor /engine controls 66.50 91.00 14

Florida Rock Inds /aggregates 40.10 43.59 16

Garan /knits 54.20 56.24 9

Urban Outfitters /hip clothing 21.55 27.50 25

- 10 -

Snapshot The Big, Bad News John Chamberlain 08.27.08, 6:00 PM ET

On July 31, 1998, the S&P 500 closed at 1120.67; 10 years later, it stands at 1267.38. That works out to an average annual price return of only 1.2% a year over the last 10 years. Factor in dividends and the total return does not look much better at 2.9%. On the other hand, the Merrill Lynch Corporate and Government Master Index averaged 5.7% during that time.

So, were the last 10 years a complete washout for U.S. equity funds? By calculating the performance of U.S. stock funds on a year-by-year basis and weighting each fund's return by its mid-year assets, we get a picture of how these funds performed. Since we measure performance for each year, funds that sponsors later liquidated or merged out of existence still count for the years they were around; asset weighting makes sure that the performance of larger funds counts for more than smaller ones that attracted fewer shareholder dollars.

So how did the 25 largest fund families as measured by the total assets in their domestic stock funds do? The results are not encouraging. True, no family posted a loss and the average asset-weighted performance of all but five of them would have beaten the S&P 500, but that is a low hurdle. Only eight of the fund families managed to top the returns on bonds. Royce, which tends to focus on smaller capitalization stocks, was the best of the lot, averaging 11.4% annually over the last 10 years.

Fidelity and Vanguard, the largest no-load fund families, land in the top half of our fund-family performance table. In 1998 Fidelity's Magellan was the largest mutual fund with $74.6 billion in assets; the next largest was Vanguard's S&P 500 fund with $64.3 billion. Ten years later, Magellan, at $35.7 billion, does not even figure in the top 25 funds. Today, no less than seven funds exceed $100 billion in assets. American Funds' Growth Fund of America is the largest of all, at $178.4 billion. The next largest fund is a bond fund, Pimco Total Return, with $129.6 billion in assets.

Top 25 Stock Fund Families, By Assets Distributor

Average 10-Year Total Return

Equity Fund Assets 7/31/2008 ($Bil)

Royce Funds 11.4% $26.3

Allianz 8.6 23.2

T. Rowe Price Group 7.5 135.4

Lord Abbett & Co. 6.7 34.1

American Funds 6.6 420.1

Franklin Templeton 6.5 60.8

- 11 -

Fidelity Investments 5.9 434.0

Van Kampen Investments 5.9 32.8

Legg Mason 5.6 47.0

Davis Funds 5.6 44.4

The Vanguard Group 5.5 516.0

Janus 5.4 66.4

Goldman Sachs 4.9 29.2

JPMorgan Chase 4.5 30.2

American Century 4.0 44.6

BlackRock 3.9 35.9

Oppenheimer Holdings 3.8 44.4

Charles Schwab Corp. 3.6 22.7

Invesco Aim Management Group 3.4 34.2

Fidelity Advisor 3.2 57.4

MFS Investment Management 2.9 35.6

Princor Financial Services 2.8 28.3

Ameriprise Financial 2.8 27.5

Putnam Investments 2.6 33.8

Columbia Management 0.8 80.2

Source: Forbes

- 12 -

THE ROYCE INTERVIEW Intelligent Investing with Steve Forbes

[00:08] Steve: Saving Detroit Welcome, I’m Steve Forbes. It’s a pleasure and a privilege to introduce you to our featured guest: Chuck Royce, chief investment officer of The Royce Funds. Chuck’s a legendary value investor who has, for years, profited from the small and mid-sized companies that represent the cutting edge of American entrepreneurship. He'll share lessons and insights from his 46 years of investing. But first, In the 1960s, general motors held back on sales because it feared an antitrust suit. Now it's going to the government with a tin cup. The U.S. auto industry can regain its prestige and profitability, but a bailout alone won't do it. Ford, GM and Chrysler need structural changes so that profitability will become a possibility. U.S. automakers usually make good money overseas. GM and Ford make very good small, fuel efficient cars in foreign markets. But they’re not allowed to bring them into the U.S. It's madness. Let them import the cars they build overseas. Thrifty Americans will love them. All parties must sacrifice. Shareholders are already virtually whipped out. Bond holders will take a big bath, losing at least two-thirds of their principle. Top executives will suffer big pay cuts. Labor must also make concessions now in order to preserve jobs and opportunity in the future. Among the changes: flexible work rules, such as we see in American facilities of foreign auto makers. Big reforms are needed on fringe benefits-- the cash pay difference between workers of the big three and those working here for foreign auto companies is not that big. Such basic changes will turbo-charge Detroit and make it a source of tax money for Washington instead of a recipient of money from taxpayers. And now, my conversation with Chuck Royce. [02:04] Small Stocks, Big Money

- 13 -

STEVE FORBES: Chuck, thank you for being with us. CHUCK ROYCE: My pleaure. STEVE FORBES: First, if you could explain your approach. You like small-cap, micro-cap stocks. And so what are your basic philosophies you've brought to market? CHUCK ROYCE: Well, the theory, which didn't necessarily work in the last year, is that these are essentially non-correlated assets with large-cap, that they have embedded in them more inefficiency, that you can sort of sort, that very large number of stocks, there’s thousands of small cap stocks, 5,000, 8,000 depending. STEVE FORBES: Well first define, as you see, the small-cap and the micro-cap stock. CHUCK ROYCE: We've used traditionally, although we change it every few years, two and a half billion and under with micro being 500 million and under. We have ratcheted that up over the last 20 years, but that's sort of where we are now. STEVE FORBES: And precisely because these are small, institutions tend to overlook them. You can find bargains. CHUCK ROYCE: Well, that's the theory. The theory is that this is a historically inefficient area, that there's less broker research, there's less institutional interest, that people tend to sort of come and go and it sets up tremendous opportunities from time to time, and that over the long term, possibly you can get a higher return, maybe in a hundred basis points or more. And I think that's sort of been the general principle behind that. STEVE FORBES: Because these things are relatively small, you don't feel you have liquidity problems with these? CHUCK ROYCE: Definitely. If we had to sell all the stocks in one day, we would have liquidity problems. So liquidity is a very real thing and it's an important part of it. But liquidity is a risk. And you would like to think you're going to get paid for that risk. So the illiquidity, which is embedded especially at the smaller end of small, is a positive in the long term. Because we will through our, hopefully our, clever picks and our trading expertise, we will work against the liquidity issues and create successful enterprises that will grow in capitalization. And then there's more liquidity. So that's the theory.

- 14 -

STEVE FORBES: So you look for managements that have been in there for awhile? CHUCK ROYCE: Absolutely. Management is important. Balance sheets are important. Small is, well, there are lots of mythologies around small; they're not so small. These are companies with 10, 15, 20 year track records with highly specialized businesses, often a narrow marketplace business. Unlike GE or unlike Triple M [3M], they are not made up of hundreds of business. So at some level, they're actually easier to get your arms around. [05:03] Greenspan's Mistakes STEVE FORBES: You mentioned the past year, which I think has humbled just about everybody. What do you think brought about the events of the past year, which certainly we haven't seen in our lifetime. CHUCK ROYCE: Well, we're sorting that out now. Obviously, it's a combination of things. It's not any one thing. Certainly, cheap money available, essentially for a long period of time. STEVE FORBES: That was Mr. Greenspan. CHUCK ROYCE: Mr. Greenspan seemed to think that cheap money was the only outcome. I think that was wrong. I think that is a very important part of the issue. But then through our cleverness in financial instruments, we created, as [Warren] Buffett says, "weapons of mass destruction in derivatives." And some of the derivatives are perfectly sensible, ordinary course of business. Interest rate swaps certainly come to mind. But then we got carried away because our financial people are very good at this stuff. So we created these products that had counterparty issues that we're still sorting out. STEVE FORBES: So this kind of blew up all the patterns of the past? CHUCK ROYCE: Thus far, it was blown up the patterns of the past. As we were talking a few minutes ago, there hasn't been a single asset area that was protected, not sort of tried and true asset areas, not specialized industries, certainly not natural resources, certainly not dividend paying stocks, certainly not real estate REITs. In the whole spectrum of the stock market, there hasn't been a single zone of safety other than cash. STEVE FORBES: And given prospects for inflation, even that may not be a long-term asset. CHUCK ROYCE: Well, cash is a funny animal today. It pays you nothing or negative. And possibly if you're a foreign investor seeking safety, you're going to

- 15 -

assume the risk of a dollar in the same moment. So it's a very funny moment to be in where cash pays nothing. [07:17] Don't Lose Money STEVE FORBES: And you have said that one of the chief tasks of a money manager is not to lose money. CHUCK ROYCE: Right. And I'm embarrassed to say we lost a lot of money. We lost around 30 to 50 percent, depending on which fund, for our funds from their peak in July of '07 until a few weeks ago. The low was November 20th. And it was in the neighborhood of 40 to 50 percent across the board. STEVE FORBES: Well, how does a successful money manager like yourself, who's been able to do very well over the years, cope with a loss like that? What do you learn from it and how do you make sure it doesn't throw you off balance and question everything you've ever done? CHUCK ROYCE: Well, we are questioning the techniques. We have a risk adverse mentality. We are very much attempting to minimize losses on the downside. We measure that all the time. And this is going to stand out as an exception in terms of the outcomes that we would've expected. In general, we like to think we'll be down about half in a bear market and up, maybe approximating a bull market, and therefore creating a nice return set, risk reward. That did not happen this time. And I suppose that proves the old rule that not everything is going to be a hundred percent. [08:40] Leverage Ruled The Day STEVE FORBES: What have you learned from this, other than the peculiar times can lead to peculiar-- CHUCK ROYCE: Well, the systematic risk was not on my radar screen. When this started, August of last year had its high volatility moments. This whole subprime and packaging of securities and the unwinding of some of that, I thought, would just unwind. It would not move on to the entire financial structure. I just didn't see that, nor do I think about that all the time. But I did not assume that we would have the kind of systematic risk that developed quickly in the spring. STEVE FORBES: What do you think brought that about? Because if you look at the actual losses on the subprimes, they're nowhere near the 20 cents or ten cents on the dollar you see as some of these things priced at now.

- 16 -

CHUCK ROYCE: Well, the investment banks, when they were freed from the restrictions, took advantage of that and began leveraging their balance sheets, each kind of mimicking the other. You know, "O'Neill's comment at Merrill Lynch, then “I wish I was like Goldman," you know, he'll live to regret. So leverage became the instrument of the day. Proprietary trading desks all were trying to mimic hedge funds. The facility for doing LBO’s and holding some of the principle in the interim while the loans are sold was a function of investment banks. Pre-marketing of the syndicated mortgages abroad, everywhere around the world, was a function of investment banks. And they were left holding the bag. And 130 times equity, the math is pretty simple. Three percent losses and you're gone. [10:41] Margin of Safety STEVE FORBES: Looking back over this year and the years before, what is the best financial lesson you've learned? CHUCK ROYCE: Well, to me, it's the old [Benjamin] Graham and [David] Dodd margin of safety. Now maybe we've redefined what a true margin of safety is. But margin of safety, it's a wonderful set of words because it implies that you should be spending your time on the risk factor in a company. And we like to think we do that; the balance sheet is critical. Balance sheets mean that you probably are minimizing debts, that the company should have sufficient returns on assets to grow on their own without leverage. What you don't want is highly leveraged; high ROE companies that where the slightest little bad wind can change everything overnight. So this whole concept of margin of safety and there's lots of ways to talk about margin of safety. Certainly the financial margin of safety, though, is probably the most critical, and then valuation and concentration. But I probably want that up on my desk with the lights going off on that every ten minutes now. [11:56] Too Many Banks STEVE FORBES: You talked about companies able to grow without a lot of leverage, which gets to the banking system, the source of capital. How do you see that shaking out? CHUCK ROYCE: Well, we are re-equitizing the banking system. We have too many banks. Somebody told me we have 8,000 banks out there. It's kind of hard to believe. But as you know, and if go anywhere, you see local banks, local banks, regional banks, national banks.

- 17 -

And I would say no matter what else goes on over the next five years, a number of banks will decline. Some of them in just perfectly normal ways and some because they no longer are viable. So that process will go on a long time. And I think it's almost separate from the subprime issue. It's just that we have too many banks. We've encouraged too many banks. We made it too easy to be a bank. Most countries don't have anywhere near the number of banks we do. STEVE FORBES: And in terms of availability of capital, what's going to happen in the future on that? CHUCK ROYCE: Well, the government is providing capital. You know, at the end of the day this is probably going to have more private equity funds in the banking system. It has historically not been where private equity funds have migrated, but I could see them taking a role there. I think in the most recent legislation they've been given permission to quickly get bank charters. [13:28] Wall St. Partnerships STEVE FORBES: So do you see a situation where, now that Goldman and Morgan are trying to morph into commercial banks, that.. CHUCK ROYCE: Well, they didn't want to. STEVE FORBES: .. out of an instinct of survival? Do you think we'll see the rise of, you mentioned equity funds, where the old partnerships, where .. CHUCK ROYCE: The Brown Brothers that .. STEVE FORBES: .. yes, the kind of things we grew up with? CHUCK ROYCE: Well, they all were partnerships. So that's a very interesting idea. Will we return to the days of, "My word is my bond, and my partnership account is at risk, and therefore we will lend very carefully?" Well, that would be interesting. There's no sign that that's happening, though. STEVE FORBES: You've mentioned the huge bull market we got in bonds since the early '80s. Some people thought it was going to end five years ago. And is this truly the last leg of it where 30 year treasuries are getting near three percent. CHUCK ROYCE: Right. Well, I would say it has to be. I have begun a systematic short of that particular instrument. I just don't see how it's possible that with the dollar at risk over long periods of time, with our highly inflationary money supply creating an environment that we can hold those rates. We know we can control short-term rates. That's easy. That's the Fed's job. But the long-

- 18 -

term rates are controlled by the world. And will the world let us get away with that? I would doubt it. [15:03] Modest Inflation and Bonds STEVE FORBES: You've said on occasion you look forward to inflation. Explain it, because I think I know what you mean. CHUCK ROYCE: Well, modest inflation is always a good idea. The inflationary forces that are modest are fine. High inflation, obviously, is very disruptive. But a little bit of inflation is perfectly fine. But it's going to be awhile. We need an economic recovery for a little bit of inflation. We've had specialized commodity inflation recently, up until July. That created havoc also. So there are all sorts of forms of inflation. And I think it's going to be awhile, though, before that's an issue. Certainly a year or so. STEVE FORBES: But it gets to your point on bonds. This is as good as it's going to get in the bond world. CHUCK ROYCE: Right. This is as good as it's going to get across the board. And if I was the government, I'd be selling these 30 year bonds like crazy. They should sort of slow down the T-bills and go longer. STEVE FORBES: Well, it tells you something about the fear factor, that you can have zero percent T-bills and be oversubscribed by a factor of three or four. CHUCK ROYCE: And when you look at the last country to do that, it's not a very happy outlook either. [16:23] Volcanic Explosion STEVE FORBES: No. What do you think is the one misplaced assumption in business today? CHUCK ROYCE: I think there is an overemphasis today on the short-term response to this. That if you are a midsized business, if you're a CEO you're probably worried about your job. But if you have the long-term outlook, you're probably not doing as strong a planning for the long-term. You're probably setting into place, "Who can we let go? What kind of plans can we do?" And so that transition between appropriate short-term response and appropriately taking advantage of long-term opportunities, if you're a good company with a great balance sheet, you should be using that moment to take advantage of the moment, to squash your competitors, to take market share, to eat the other guy. So I'm not seeing that yet, in the classic recession, the larger

- 19 -

companies should buy smaller companies. But that's come to a complete standstill. STEVE FORBES: What do you see rising up from an earthquake like this? Usually there are new players, new industries and new nameplates. CHUCK ROYCE: What is the right metaphor, I'm not sure. But it's a volcanic explosion. And how quickly will there be new flowers on the side of the mountain? It usually happens faster than you think. No one is dare saying, "We can go up as fast as we're going down." I'm not going to say it either, but there is an extreme sort of. STEVE FORBES: Is that lurking in your heart? CHUCK ROYCE: Well, I hope it's not a good investment strategy. But I do think that this thing will come to some natural end as all recessions do. I'm not sure how that takes place. And we are yet to see the role of the fiscal response that clearly everybody seems to want. So that's going to be interesting. [18:28] This Too Shall Pass STEVE FORBES: And in an environment like this are you able to do much investing? Or do you have to worry about redemptions and that sort of thing? Are you able to look and say, "Okay, two or three years, I know this company's going to hit it out of the park"? CHUCK ROYCE: Well, that's the right attitude. Most of our funds are open-end funds. We do have a few closed-end funds. And, of course, that's where you get more stability of capital. We've had very little, knock on wood, redemptions thus far. And we've had some positive cash days in the last couple weeks, which I'm thrilled with. We are putting the money to work. We definitely believe that out there, three years, five years, a sort of reasonable horizon, there's tremendous, 100 percent, 200 percent, possibilities. In our micro-cap funds, I'm currently rating our stocks in the fund that, "Could they triple? Could they just double?" And I'm doing the triage between them. STEVE FORBES: That's a nice exercise at a time like this. CHUCK ROYCE: Well, it's an exercise. You know, we're not publishing the results because you only have a limited amount of capital. STEVE FORBES: So your bold prediction for the future is, "This too shall pass"? CHUCK ROYCE: Well, I do. I definitely think that equity investment is a very important way of protecting against inflation, a very important way of

- 20 -

compounding wealth, and that absolutely will continue. And I fundamentally believe our systematic risk, the proposition that society is going to fall apart because banks can't trade with each other, I think that's behind us. STEVE FORBES: Do you see coming out of this, then, any major systematic changes that could dim future prospects? Or will it just be more stimulus and somehow the system will recover on its own? CHUCK ROYCE: Well, I wish I knew. But we're going to have an era of reform, with all the possible trouble that that's going to get us into. Wall Street is going through an interesting financial scandal of last week. We had the week of all weeks for financial scandals. Last week, [Bernard] Madoff is extraordinary. I mean, the book obviously hasn't been written yet. But it's going to be an interesting book. STEVE FORBES: I imagine there's several of them starting now. CHUCK ROYCE: Right. They have to move fast. STEVE FORBES: But in terms of real roadblocks in the future, you don't see that? CHUCK ROYCE: I do not. I think that we are a major-- we can’t forget this-- we’re a major world power. And although the dollar has definitely had its issues over the last ten years, I think the dollar will continue to be a major currency, even if it declines. That it's reserve currency status will not change for a long time. That we have the smartest, most clever kind of corporate response, innovation capabilities of any country and that we will have a wonderful future as we come out of the economic recovery, as we come out of the economic sort of bottom here, trough. STEVE FORBES: And final piece of advice to investors. Emotions. Oftentimes people jump in the market when it's going up and flee as it's going into the dumpster. CHUCK ROYCE: Well, there's two things on that. One, turn off CNBC. STEVE FORBES: But not Forbes.com, right? CHUCK ROYCE: Right! Of course, not. So turn off CNBC. Use the old-fashioned thing, dollar cost averaging. I don't know what the bottom is. When we get interested in a stock, we don't say, "We have to buy all our stock this day, this price." We dollar cost average in to all our positions. So it's a very time-tested technique. You're going to get some bad prices. And you'll get some good prices, especially if you keep your convictions intact. STEVE FORBES: Thank you very much, Chuck.

- 21 -

CHUCK ROYCE: You're welcome. Thank you. I enjoyed it. STEVE FORBES: Coming up next week. Insights and expertise from our past guests about the economic crisis, lessons learned, investment philosophies and more on a special edition of Intelligent Investing. [22:55]