This fund’s recent and long-term track records serve as reminders why value investing never goes out of style and caution remains a virtue in both bull and bear markets. In his tenth year helming Royce Special Equity (RYSEX), Charles Dreifus has earned plaudits from Morningstar and a number of other publications for his portfolio’s resilient performance in 2008, a year when the S&P 500 dropped 37 percent and the Russell 2000 Index fell 33 percent.

Though much of the attention lavished on this small- and micro-cap fund stems from its traditional outperformance in down markets, Dreifus is quick to downplay certain aspects of his recent success–as he assiduously notes, the fund lost 19.6 percent in 2008–in favor of its long-term track record and appeal to conservative investors.

“My objective has been and continues to be first and foremost to produce a positive return annually and over a full cycle–that is, in an up and a down market,” Dreifus said. This balance has enabled the fund to beat its benchmark over the past three- and five-year periods by 6.9 percent and 2.5 percent, respectively.

Nevertheless, number-chasing investors who make investment decisions based on short-term results would do well to take a holistic view of the fund’s performance. A strong record of capital preservation often entices investors when the market is flat or down, but prospective fundholders should bear in mind that the portfolio tends to lag more aggressive fare during major upswings–a consequence of the manager’s longstanding commitment to value investing.

From his university days to the first mutual fund he managed at Oppenheimer, Dreifus has adhered to a bottom-up approach to stock picking that’s price-focused and distinguished by rigor and discipline.

“I’m looking for absolutely inexpensive stocks, not only relative to the market and their peers, but also relative to their own business prospects,” Dreifus reflects. “I’m looking for inefficiencies, anomalies–$100 stocks that trade at $50. Generally speaking, if you buy absolute value, you’ll produce absolute results.” And Dreifus stresses that investing in undervalued stocks reduces downside risks relative to other strategies; if such a stock fails to perform, the penalty is less severe than in instances where one overpaid for a security.I imagine I’m buying the whole thing. The question is, when it’s all said and done, what type of return would I get based on trailing 12-month earnings before interest and taxes?”

Other metrics screen for companies that boast a strong franchise or wide economic moat, while analyzing return on investment capital helps to identify firms that wield pricing power. Dreifus also values companies that exhibit a high degree of financial flexibility, namely those that boast an abundance of capital and liquidity and are unencumbered by excessive leverage.

Yield also factors into the decision-making process, though it’s not a prerequisite for investment; strong cash flow generation often goes hand in hand with rising dividends a regular stock repurchases.

Dreifus has likewise elevated his focus on a metric he found useful in navigating the bear market in 1973-74 bear market, which he believes resembles the current environment. By comparing a company’s net assets less current liabilities to its current share price, Dreifus is able to separate the wheat from the chaff.

On top of these quantitative factors, Dreifus pores over company’s Securities and Exchange Commission filings to identify those that favor conservative accounting practices and avoid those that demonstrate a more aggressive accounting approach–a talent he honed under famed accounting critic Abraham Briloff. This doesn’t uncover instances of fraud, but often steers Dreifus toward family-run companies that usually have a more cautious management style as opposed to the technocrats in charge at many firms.

Lancaster Colony Corp (NSDQ: LANC), a closely held specialties food company that boasts a long history of dividend increases, typifies this approach. And although the fund typically invests about 30 percent of its assets in its top ten holdings, that’s not to suggest that Dreifus is less confident in smaller holdings. Because the fund invests in micro- and small-cap companies, it must scale back its positions in some companies to avoid moving the market.

And just as pricing is an important consideration in the fund’s purchase decisions, valuation is at the heart of many of its sell calls. Once the broader market discovers a particular portfolio holding, Dreifus has no qualms about taking a profit when the share price hits his target–or in the event of an unforeseen blowup.

Some investors might believe that investing in a bear market requires substantial chutzpah; Dreifus demonstrates that a conservative, value-focused approach–a dose of rationality in an irrational market–is essential to long-term results in any market. However, investors shouldn’t rush to sink money into the fund based solely on its near-term performance; that happened after the fund managed to post strong results in the difficult market between 2000 and 2002, and many investors were disappointed when subsequent results lagged the broader market.

Royce Special Equity
New York, NY 800-221-4268
www.roycefunds.com; RYSEX
Sales fee: none
Assets: $481 million
Early withdraw: 1%; less than 180 days
No. of holdings: 66
Turnover rate: 29%
Expense ratio: 1.11%
Assets in top 10 holdings:
Min. initial investment:  $2,000; $1,000 if IRA
Largest quarterly loss*: -14.9%; 4th Qtr 2009
Largest quarterly gain*:  8.9%; 1st Qtr 2006

Top five positions (symbol): National Presto Industries (NPK), Bio-Rad Laboratories (BIO), Lancaster Colony Corp (LANC), Arden Group (ARDNA), Hubbell, Inc (HUB.B)

*Past three years

Source: Morningstar