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RS Investments' Value Fund First Quarter 2012 Mutual Fund Commentary
Posted by: guruhl (IP Logged)
Date: April 17, 2012 03:23PM

RS Investment Management Co. LLC is a privately owned investment manager handling separate client-focused equity and fixed income portfolios and mutual funds for its clients. This is its first-quarter commentary from its Value Funds:

RS Value Fund

Philosophy and Process
We believe that company-specific value creation is often mispriced in the public equity markets. As such, the RS Value Team employs an investment process that is private equity-like in nature, both in-terms of the business-specific research that we conduct and the returns that we attempt to exploit. We are interested in understanding how companies create value over time, which by definition means dissecting businesses into their component parts to gain insights into how and where capital is being allocated, and the cash flows and returns associated with these capital decisions. When we have identified situations where there is a clear path towards future value creation, and a management team is in place that we believe is capable of executing the business plan, a company qualifies for our "farm team." However, as value investors, we know that risk is not defined as share price volatility, but rather the permanent impairment of capital. As a result, farm team names only come into the portfolio when we can: a) clearly quantify a downside or safety net value, and b) the market provides us with an opportunity to purchase an interest in the company close to or, preferably, below that safety net. We acknowledge that over short periods of time we may underperform a benchmark, but believe that our team structure, philosophy, and process will continue to provide us with the opportunity to generate superior risk-adjusted returns over a reasonable investment horizon.

Returns and Attribution Detail
For the first quarter of 2012, RS Value Fund (Class A Shares) generated a return of 8.81% versus 11.41% for the benchmark Russell Midcap® Value Index1. Utilities and Materials and Processing were the Fund's two best performing sectors on a relative basis during the first quarter, led principally by the Fund's lack of exposure to Electrical Utilities as well as strong performances from chemical companies Eastman Chemical (a business that was sold out of the Fund during the quarter and is highlighted in the Closed Position Review section below) and FMC Corp. (a specialty chemical company serving the agriculture and industrial markets, 3.71% position as of quarter end). Conversely, Consumer Discretionary and Energy were relative underperformers during the quarter. Within Consumer Discretionary, specialty retailer GameStop Corp. (5.50%) underperformed, while oil and gas producers, including Southwestern Energy (4.34%) and Arc Resources (2.05%), led the
underperformance within Energy. Our investment thesis as it relates to natural gas is discussed in greater detail in the Portfolio Positioning section that follows.

Closed Position Review Below we review two investments that were exited during the first quarter in an effort to use tangible examples to highlight our investment process.

Synopsys is the leading supplier of electronic design automation (EDA) software to the semiconductor industry. Semiconductor designers rely on EDA software to design, analyze, simulate, model, implement, and verify electronic designs. EDA software is an essential tool that increases the productivity of engineers, improves the accuracy of complex design, reduces costly errors, and ultimately shortens a product's time to market. Due to the complexity of the learning curve and mission critical nature of its products, Synopsys enjoys very attractive renewal rates (high 90s%), a predictable revenue stream (over 80% of revenues come from recurring subscription fees) and strong cash flow generation. When we first invested in Synopsys in July 2009, the company was trading at a Reinvestment Cash Flow Yield (RICF) well in excess of 10%, had a pristine balance sheet with no debt and over $1.1 billion in cash, and was trading at an enterprise value to maintenance revenue multiple of approximately 2X. As a rough rule of thumb, a discounted cash flow analysis of best of breed software companies (i.e., 90%+ renewal rates) suggests that a run off of a maintenance stream is worth well over 5X trailing maintenance revenue. Given Synopsis' leading position in an industry with ample prospects to grow revenue, we felt that we had ample downside protection based on our entry point.

The EDA industry is dominated by two major players, Synopsis and Cadence, which collectively account for approximately 50% of industry revenues and up to 80-90% in particular sub markets. Historically, Cadence held the #1 position in the industry, however, due to a revenue recognition scandal in 2008, followed by a complete management overhaul and change in business model, Synopsys was able to overtake Cadence's industry leading position. After speaking with numerous industry experts and end customers, we consistently heard that Synopsys had the strongest portfolio of products and had pulled away as the leader in innovation. We also learned that by consolidating EDA suppliers and moving toward a tightly integrated platform, customers could realize significant cost savings. As a result, we felt that Synopsys was very well positioned to continue to take market share over the next few years. Moreover, our due diligence suggested that Synopsys was at the bottom of a multi-year renewal cycle. By analyzing historical patterns in the company's deferred revenue balance (a leading indicator of GAAP revenue recognition), we concluded that the company's annual renewal pipeline was poised to grow each year through at least 2012. Coupled with our expectation of market share gains in conjunction with contract renewals, we felt that the future was bright for Synopsys. As we built further conviction in our thesis, we took advantage of market pullbacks to add to our position on two separate occasions between December 2009 and June 2010. Over our ~2.5 year holding period, Synopsys' seasoned and reliable management team executed quarter in and quarter out. Deferred revenue growth turned positive in mid 2010 as the industry recovered from the recession and has been steadily accelerating ever since, while RICF has more than doubled, having grown from $175 million in FY09 (Oct.) to $385 million in FY11 (Oct.). As we watched our thesis play out and the stock appreciate toward our price target, we began harvesting profits in November of last year and fully exited the position in February of 2012.

Eastman Chemical (EMN) is a chemicals, fiber and plastics manufacturing company. Our position in Eastman was established in October, 2005. The investment thesis was based on an assessment of the company's feedstock cost advantage derived from its coal gasification technology, and on the expectation that a combination of balance sheet deleveraging and rationalization of its business would result in a portfolio of higher return, more differentiated products with fairly limited capital requirements. At the time of entry, we felt that we were paying a reasonable price for the existing assets as currently configured, and that future improvements in both asset turns and margins were
not being reflected in the stock price. Furthermore, after years of expansions and volatile cash flows, it was apparent that management, under the leadership of Brian Ferguson, was intent on reducing cyclicality and improving returns. This initiative started in 2004, and the company began to successfully execute against the business plan. While a large scale coal gasification project was put on hold in the midst of the global financial crisis, the company was able to effectively transfer leadership to Jim Rogers, the former head of the Fibers and Chemicals business, and reduce its fixed cost base while continuing to redeploy capital into attractive growth opportunities while, at the same time, maintaining its financial flexibility. By the beginning of 2012, the thesis had largely played out, with Eastman increasing returns more than three fold from 2004. In our view, future value creation was more likely to come from capital reinvestment opportunities than organic improvements in returns, and therefore had become more difficult for us to quantify. In addition, we felt that we had lost some downside protection due to the market's recognition of management's successful execution of the business plan; as a result, we exited the position.

Portfolio Positioning
Within the consumer sector, we continue to allocate capital to companies that have specific opportunities for improvement and reinvestment that we believe are not being fully recognized by the market. These opportunities exist in both good and poor economic times. One of the overarching megatrends taking place in the consumer landscape is the accelerating growth of e-commerce. Consumers are quite simply becoming increasingly comfortable purchasing goods and services online. This trend started years ago and will continue to unfold over the next decade and it has huge implications, both positive and negative, for many companies within the consumer sector. We will continue to invest in companies that we believe can participate in or are protected from this structural change. In addition, we continue to allocate capital to companies that have significant opportunities for reinvestment outside the US, particularly in the emerging markets. We believe that China, for example, will become the largest consumer market in the world by 2025. We want to invest in companies that have an opportunity to participate in this growth.

Within financials, we are encouraged by continued improving credit trends, more robust capital markets activity, and some signs of a reemergence of loan growth. We believe that financials are in a materially better position than they were in 2008 based on capital levels, leverage, and tougher underwriting standards. That said, persistently low interest rates, increased regulatory scrutiny, and a continued fragile economic environment will continue to challenge returns for the group. For industrial businesses, we continue to favor durable, high quality businesses with pricing power and attractive reinvestment opportunities. Our exposure is weighted toward companies that i) produce products designed into customer applications while accounting for a small fraction of overall costs, ii) offer an attractive Return on Investment (ROI) to the customer, iii) sell into a highly profitable customer base and iv) operate in consolidated or consolidating industries. Further, several of our businesses benefit from high return reinvestment opportunities, ranging from internal growth capital projects to acquisitions of competitors, where increases in market share drive improved pricing and higher asset turns.

Within natural resources, the outlook varies by commodity. While oil prices and, as a result, oil stocks look expensive based on our assessment of the marginal cost of supply, we believe natural gas stocks are attractively valued. As such, we have increased our exposure to the natural gas space. A very warm winter and the rapid development of unconventional resources have caused the commodity to languish at $2.00-$2.50/mcf – below the variable cost of production for some companies. As we look across the supply cost curve, however, there are very few assets that we believe can generate an attractive return, even in a higher commodity price environment. Furthermore, the historic disconnect between natural gas and other hydrocarbons has incented a demand response. Over time, we expect the supply/demand equilibrium to recover. As always, the cure for low commodity prices is low commodity prices.

Outlook
Entering 2012, our outlook was one of cautious optimism. Many of the fundamental factors that have plagued the market over the past few years – a constrained consumer, high commodity prices, mounting budget deficits, unfunded entitlement programs, potential changes to US tax policies, concerns regarding Europe, historically high corporate margins and returns, limited reinvestment opportunities as reflected in large corporate cash balances and the inevitability of deleveraging – remain in place. However, there are other signs that were more positive, including the impact on industrial America of an advantaged energy source combined with the disintermediation of global supply chains due to rising transportation and local labor costs, a vastly improved local and regional banking industry, and initial signs of improvement in the housing market. Moreover, our portfolios were trading at attractive valuations, with reduced downside risk to our assessment of warranted value. Three months into the year, our assessment of the fundamentals remain largely unchanged – the US economy appears to be slowly and fitfully improving, despite the efforts of our country's leadership, while the European situation is far from resolved. Elevated concerns over China's growth rates are misguided, in our opinion, as the laws of compounding dictate that at some point growth rates must slow to a more sustainable level. We continue to find it difficult to understand the intentions of a central bank that confuses outputs – stock market returns - with inputs as it attempts to navigate the current economic environment, while depressed levels of trading volumes and very low levels of volatility are, at a minimum, a source of questions. Finally, after a 10-15% rally, valuations are a bit less attractive, although the best performing stocks over the past five to six months have been low Return on Equity (ROE), non-earning, fast growing businesses, which we tend to find less interesting as long-term investments. Instead, we continue to cull through our universe, seeking those companies with a business plan in place that will drive future value creation for owners, where we can define our downside risk and be adequately compensated for deploying both our investors' capital and our own. Over the last several years, the market has been characterized by periods of elevated levels of correlations across and within asset classes. As fundamental business analysts, these conditions can be frustrating. However, given the depth of our team and a highly repeatable process, we remain confident that we will continue to find ways to exploit the company-specific value creation that we believe remains largely ignored by most investors in today's public equity markets.

We are, as always, thankful for your patience and support.

Sincerely,

MacKenzie Davis, CFA
David Kelley
Andy Pilara
Ken Settles, CFA
Joe Wolf


RS Large Cap Alpha Fund

Returns and Attribution Detail For the first quarter of 2012, RS Large Cap Alpha Fund (Class A Shares) generated a return of 10.24% versus 11.12% for the benchmark Russell 1000® Value Index1. Utilities and technology were the Fund's two best performing sectors on a relative basis during the first quarter, led by the Fund's lack of exposure to utilities as well as strong performances within technology from software-giant Microsoft Corp. (4.98% position as of quarter end) and Symantec Corp. (a computer security, storage, and systems management business, 4.47%). Conversely, financial services and select names within the natural resources space were relative underperformers during the quarter. The Fund's lack of exposure to the large diversified financial services companies weighed on performance during the quarter. In addition, Goldcorp (2.18%) underperformed within Materials & Processing and oil and gas producer Southwestern Energy (4.32%) led the underperformance within energy. Southwestern's primary business is in natural gas production; our investment thesis as it relates to natural gas is discussed in greater detail in the Portfolio Positioning section that follows.

Closed Position Review Below we review an investment that we exited during the first quarter in an effort to use a tangible example to highlight our investment process.

Synopsys is the leading supplier of electronic design automation (EDA) software to the semiconductor industry. Semiconductor designers rely on EDA software to design, analyze, simulate, model, implement, and verify electronic designs. EDA software is an essential tool that increases the productivity of engineers, improves the accuracy of complex design, reduces costly errors, and ultimately shortens a product's time to market. Due to the complexity of the learning curve and mission critical nature of its products, Synopsys enjoys very attractive renewal rates (high 90s%), a predictable revenue stream (over 80% of revenues come from recurring subscription fees) and strong cash flow generation. When we first invested in Synopsys in March 2009, the company was trading at a Reinvestment Cash Flow Yield (RICF) well in excess of 10%, had a pristine balance sheet with no debt and over $1.1 billion in cash, and was trading at an enterprise value to maintenance revenue multiple of approximately 2X. As a rough rule of thumb, a discounted cash flow analysis of best of breed software companies (i.e., 90%+ renewal rates) suggests that a run off of a maintenance stream is worth well over 5X trailing maintenance revenue. Given Synopsis' leading position in an industry with ample prospects to grow revenue, we felt that we had ample downside protection based on our entry point.

The EDA industry is dominated by two major players, Synopsis and Cadence, which collectively account for approximately 50% of industry revenues and up to 80-90% in particular sub markets. Historically, Cadence held the #1 position in the industry, however, due to a revenue recognition scandal in 2008, followed by a complete management overhaul and change in business model, Synopsys was able to overtake Cadence's industry leading position. After speaking with numerous industry experts and end customers, we consistently heard that Synopsys had the strongest portfolio of products and had pulled away as the leader in innovation. We also learned that by consolidating EDA suppliers and moving toward a tightly integrated platform, customers could realize significant cost savings. As a result, we felt that Synopsys was very well positioned to continue to take market share over the next few years. Moreover, our due diligence suggested that Synopsys was at the bottom of a multi-year renewal cycle. By analyzing historical patterns in the company's deferred revenue balance (a leading indicator of GAAP revenue recognition), we concluded that the company's annual renewal pipeline was poised to grow each year through at least 2012. Coupled with our expectation of market share gains in conjunction with contract renewals, we felt that the future was bright for Synopsys. As we built further conviction in our thesis, we took advantage of market pullbacks to add to our position on two separate occasions between December 2009 and June 2010. Over our ~2.5 year holding period, Synopsys' seasoned and reliable management team executed quarter in and quarter out. Deferred revenue growth turned positive in mid 2010 as the industry recovered from the recession and has been steadily accelerating ever since, while RICF has more than doubled, having grown from $175 million in FY09 (Oct.) to $385 million in FY11 (Oct.). As we watched our thesis play out and the stock appreciate toward our price target, we began harvesting profits in November of last year and fully exited the position in February of 2012.

Portfolio Positioning Within the consumer sector, we continue to allocate capital to companies that have specific opportunities for improvement and reinvestment that we believe are not being fully recognized by the market. These opportunities exist in both good and poor economic times. One of the overarching megatrends taking place in the consumer landscape is the accelerating growth of e-commerce. Consumers are quite simply becoming increasingly comfortable purchasing goods and services online. This trend started years ago and will continue to unfold over the next decade and it has huge implications, both positive and negative, for many companies within the consumer sector. We will continue to invest in companies that we believe can participate in or are protected from this structural change. In addition, we continue to allocate capital to companies that have significant opportunities for reinvestment outside the US, particularly in the emerging markets. We believe that China, for example, will become the largest consumer market in the world by 2025. We want to invest in companies that have an opportunity to participate in this growth.

Within financials, we are encouraged by continued improving credit trends, more robust capital markets activity, and some signs of a reemergence of loan growth. We believe that financials are in a materially better position than they were in 2008 based on capital levels, leverage, and tougher underwriting standards. That said, persistently low interest rates, increased regulatory scrutiny, and a continued fragile economic environment will continue to challenge returns for the group.

For industrial businesses, we continue to favor durable, high quality businesses with pricing power and attractive reinvestment opportunities. Our exposure is weighted toward companies that i) produce products designed into customer applications while accounting for a small fraction of overall costs, ii) offer an attractive Return on Investment (ROI) to the customer, iii) sell into a highly profitable customer base and iv) operate in consolidated or consolidating industries. Further, several of our businesses benefit from high return reinvestment opportunities, ranging from internal growth capital projects to acquisitions of competitors, where increases in market share drive improved pricing and higher asset turns.

Within natural resources, the outlook varies by commodity. While oil prices and, as a result, oil stocks look expensive based on our assessment of the marginal cost of supply, we believe natural gas stocks are attractively valued. As such, we have increased our exposure to the natural gas space. A very warm winter and the rapid development of unconventional resources have caused the commodity to languish at $2.00-$2.50/mcf – below the variable cost of production for some companies. As we look across the supply cost curve, however, there are very few assets that we believe can generate an attractive return, even in a higher commodity price environment. Furthermore, the historic disconnect between natural gas and other hydrocarbons has incented a demand response. Over time, we expect the supply/demand equilibrium to recover. As always, the cure for low commodity prices is low commodity prices.

Outlook Entering 2012, our outlook was one of cautious optimism. Many of the fundamental factors that have plagued the market over the past few years – a constrained consumer, high commodity prices, mounting budget deficits, unfunded entitlement programs, potential changes to US tax policies, concerns regarding Europe, historically high corporate margins and returns, limited reinvestment opportunities as reflected in large corporate cash balances and the inevitability of deleveraging – remain in place. However, there are other signs that were more positive, including the impact on industrial America of an advantaged energy source combined with the disintermediation of global supply chains due to rising transportation and local labor costs, a vastly improved local and regional banking industry, and initial signs of improvement in the housing market. Moreover, our portfolios were trading at attractive valuations, with reduced downside risk to our assessment of warranted value. Three months into the year, our assessment of the fundamentals remain largely unchanged – the US economy appears to be slowly and fitfully improving, despite the efforts of our country's leadership, while the European situation is far from resolved. Elevated concerns over China's growth rates are misguided, in our opinion, as the laws of compounding dictate that at some point growth rates must slow to a more sustainable level. We continue to find it difficult to understand the intentions of a central bank that confuses outputs – stock market returns - with inputs as it attempts to navigate the current economic environment, while depressed levels of trading volumes and very low levels of volatility are, at a minimum, a source of questions. Finally, after a 10-15% rally, valuations are a bit less attractive, although the best performing stocks over the past five to six
months have been low Return on Equity (ROE), non-earning, fast growing businesses, which we tend to find less interesting as long-term investments. Instead, we continue to cull through our universe, seeking those companies with a business plan in place that will drive future value creation for owners, where we can define our downside risk and be adequately compensated for deploying both our investors' capital and our own. Over the last several years, the market has been characterized by periods of elevated levels of correlations across and within asset classes. As fundamental business analysts, these conditions can be frustrating. However, given the depth of our team and a highly repeatable process, we remain confident that we will continue to find ways to exploit the company-specific value creation that we believe remains largely ignored by most investors in today's public equity markets.

We are, as always, thankful for your patience and support.

Sincerely,

MacKenzie Davis, CFA
David Kelley
Andy Pilara
Ken Settles, CFA
Joe Wolf



RS Partners Fund

Returns and Attribution Detail
For the first quarter of 2012, RS Partners Fund (Class A Shares) generated a return of 9.90% versus 11.59% for the benchmark Russell 2000® Value Index1. Technology and Financial Services were the Fund's two best performing sectors during the first quarter, led by Parametric Technology Corp. (provider of computer-aided design (CAD) and product lifecycle management (PLM) software to customers primarily in the industrial, aerospace, machinery and auto industries; 1.91% position as of quarter end) and AOL Inc. (online products and services; 4.06%), as well as banking businesses First Horizon National Corp. (3.27%) and Associated Banc-Corp. (2.03%) within Financials. Conversely, Consumer Discretionary and Energy were relative underperformers during the quarter. Within Consumer Discretionary, specialty retailer GameStop Corp. (4.76%) underperformed, while oil and gas producer Peyto Exploration & Development (3.80%) led the underperformance within Energy. Peyto's primary business is in natural gas production; our investment thesis as it relates to natural gas is discussed in greater detail in the Portfolio Positioning section that follows.

Closed Position Review
Below we review two investments that were exited during the first quarter in an effort to use tangible examples to highlight our investment process.

During the quarter, we closed our position in Concho Resources (CXO). Concho is an independent oil and gas company that operates in the Permian Basin in Texas and New Mexico. We entered the position during the second half of 2008. As is the case with any of our investments in natural resources, our investment thesis was predicated on our belief that management would be able to grow the value of the company by reinvesting in low-cost, high-return oil and gas wells. This view was based on our analysis of the company's project economics; it was not based on the view that oil prices would increase to over $100 per barrel. As it turned out, Concho's net asset value grew by nearly 25% per year over our holding period (excluding the change in the value of the company's proved reserves resulting from increased oil prices). However, due to the increase in oil prices over that timeframe, the stock compounded at a rate that was nearly double the increase in net asset value. With the stock trading above our assessment of net asset value, the margin of safety that we once enjoyed in 2008 was no longer present at the current valuation. As such, we decided to exit our position during the quarter, in spite of the fact that we expect that the company will continue to grow net asset value by at least 10-20% per year, even in a lower price environment.

Susquehanna Bancshares (SUSQ) is a commercial bank with $15 billion in assets serving eastern Pennsylvania, Baltimore, and New Jersey. The bank has a strong market presence, claiming top 10 market share in 19 of the 22 Metropolitan Statistical Areas (MSAs) that it serves. This market share translates into an attractive deposit franchise (88% core), which is the first thing we look for when investing in a bank. We initiated our position in Susquehanna at $8 per share by participating in the company's March 2010 capital raise; this equated to 1.1X tangible book value and was roughly equal to our safety net valuation for the deposit franchise. We felt we had adequate downside protection given that, even in the event of a draconian double dip scenario, the company's balance sheet would be well supported by the recent equity raise, strong cash flow generation, aggressive loan loss recognition and a sizable remaining loan loss reserve. In late 2009 and early 2010, much of our analysis on banks was focused on credit risk. Susquehanna was the only bank that we encountered that had proactively invited regulators to attend their monthly credit meetings. The assurance that regulators were deeply involved, along with our in-depth conversations with Susquehanna and in-market peers, provided us comfort that credit was being managed properly at the bank.

The 2010 equity raise provided us with the opportunity to invest in what we view as a high-quality community bank, which had a significant opportunity to drive improving risk-adjusted returns through both further penetration of its current customer relationships and market share gains. At only 23% core fee income to total revenue, we felt the company had a significant opportunity to increase penetration of its fee income businesses – a non-capital intensive source of low risk cash flows. Additionally, stress at in-market peers and market dislocation due to recent mergers would allow Susquehanna to both improve the company's ability to gain traction with the fee income businesses and take market share.

The primary drivers in our initial investment; protection against a downturn in credit and ability to take market share, each played out. Credit losses peaked in Q4 2009 (before we invested) and since then have been steadily declining. Additionally, during the credit cycle Susquehanna increased its balance of core deposits by 21% and increased loans 11%, underscoring the bank's ability to gain share during the downturn. We decided to exit our investment on concerns that the company was too growth-oriented and lacked the commitment to improve the current franchise to its full potential.

The company announced two acquisitions in 2011. While both acquisitions were in-market and made strategic sense, the prices seemed rich and the rationale for M&A was not entirely clear to us. We saw significant organic opportunities for the company to increase risk-adjusted ROIC through better penetration of its current relationships; we continue to believe that this is the proper way to build long-term shareholder value at a bank. Management, however, appeared to be more focused on growth. As such, we exited our investment in Susquehanna in January 2012 at a modest positive total return.

Portfolio Positioning
Within the consumer sector, we continue to allocate capital to companies that have specific opportunities for improvement and reinvestment that we believe are not being fully recognized by the market. These opportunities exist in both good and poor economic times. One of the overarching megatrends taking place in the consumer landscape is the accelerating growth of e-commerce. Consumers are quite simply becoming increasingly comfortable purchasing goods and services online. This trend started years ago and will continue to unfold over the next decade and it has huge implications, both positive and negative, for many companies within the consumer sector. We will continue to invest in companies that we believe can participate in or are protected from this structural change. In addition, we continue to allocate capital to companies that have significant opportunities for reinvestment outside the US, particularly in the emerging markets. We believe that China, for example, will become the largest consumer market in the world by 2025. We want to invest in companies that have an opportunity to participate in this growth.

Within financials, we are encouraged by continued improving credit trends, more robust capital markets activity, and some signs of a reemergence of loan growth. We believe that financials are in a materially better position than they were in 2008 based on capital levels, leverage, and tougher underwriting standards. That said, persistently low interest rates, increased regulatory scrutiny, and a continued fragile economic environment will continue to challenge returns for the group. For industrial businesses, we continue to favor durable, high quality businesses with pricing power and attractive reinvestment opportunities. Our exposure is weighted toward companies that i) produce products designed into customer applications while accounting for a small fraction of overall costs, ii) offer an attractive Return on Investment (ROI) to the customer, iii) sell into a highly profitable customer base and iv) operate in consolidated or consolidating industries. Further, several of our businesses benefit from high return reinvestment opportunities, ranging from internal growth capital projects to acquisitions of competitors, where increases in market share drive improved pricing and higher asset turns.

Within natural resources, the outlook varies by commodity. While oil prices and, as a result, oil stocks look expensive based on our assessment of the marginal cost of supply, we believe natural gas stocks are attractively valued. As such, we have increased our exposure to the natural gas space. A very warm winter and the rapid development of unconventional resources have caused the commodity to languish at $2.00-$2.50/mcf – below the variable cost of production for some companies. As we look across the supply cost curve, however, there are very few assets that we believe can generate an attractive return, even in a higher commodity price environment. Furthermore, the historic disconnect between natural gas and other hydrocarbons has incented a demand response. Over time, we expect the supply/demand equilibrium to recover. As always, the cure for low commodity prices is low commodity prices.

Outlook
Entering 2012, our outlook was one of cautious optimism. Many of the fundamental factors that have plagued the market over the past few years – a constrained consumer, high commodity prices, mounting budget deficits, unfunded entitlement programs, potential changes to US tax policies, concerns regarding Europe, historically high corporate margins and returns, limited reinvestment
opportunities as reflected in large corporate cash balances and the inevitability of deleveraging – remain in place. However, there are other signs that were more positive, including the impact on industrial America of an advantaged energy source combined with the disintermediation of global supply chains due to rising transportation and local labor costs, a vastly improved local and regional banking industry, and initial signs of improvement in the housing market. Moreover, our portfolios were trading at attractive valuations, with reduced downside risk to our assessment of warranted value. Three months into the year, our assessment of the fundamentals remain largely unchanged – the US economy appears to be slowly and fitfully improving, despite the efforts of our country's leadership, while the European situation is far from resolved. Elevated concerns over China's growth rates are misguided, in our opinion, as the laws of compounding dictate that at some point growth rates must slow to a more sustainable level. We continue to find it difficult to understand the intentions of a central bank that confuses outputs – stock market returns - with inputs as it attempts to navigate the current economic environment, while depressed levels of trading volumes and very low levels of volatility are, at a minimum, a source of questions. Finally, after a 10-15% rally, valuations are a bit less attractive, although the best performing stocks over the past five to six months have been low Return on Equity (ROE), non-earning, fast growing businesses, which we tend to find less interesting as long-term investments. Instead, we continue to cull through our universe, seeking those companies with a business plan in place that will drive future value creation for owners, where we can define our downside risk and be adequately compensated for deploying both our investors' capital and our own. Over the last several years, the market has been characterized by periods of elevated levels of correlations across and within asset classes. As fundamental business analysts, these conditions can be frustrating. However, given the depth of our team and a highly repeatable process, we remain confident that we will continue to find ways to exploit the company-specific value creation that we believe remains largely ignored by most investors in today's public equity markets.

We are, as always, thankful for your patience and support.

Sincerely,

MacKenzie Davis, CFA
David Kelley
Andy Pilara
Ken Settles, CFA
Joe Wolf


RS Investors Fund

Returns and Attribution Detail
For the first quarter of 2012, RS Investors Fund (Class A Shares) generated a return of 10.29% versus 11.16% for the benchmark Russell 3000® Value Index1. Technology and Utilities were the Fund's two best performing sectors on a relative basis during the first quarter, led principally by software-giant Microsoft Corp. (5.95% position as of quarter end) and AOL Inc. (online products and services; 5.00%) within Technology. In addition, the Fund's lack of exposure to Electrical Utilities as well as a solid quarter for Calpine Corp. (4.27%) led to outperformance within Utilities. Conversely, Financial Services and Consumer Discretionary were relative underperformers during the quarter. Insurance broker Willis Group (2.77%) as well as the Fund's lack of exposure to the large diversified financial services companies weighed on performance within Financials during the quarter. Finally, within Consumer Discretionary, specialty retailer GameStop Corp. (7.52%) underperformed.

Closed Position Review
Below we review two investments that were exited during the first quarter in an effort to use tangible examples to highlight our investment process.

Based in Columbus, Georgia, AFLAC Inc. (AFL) is the largest provider of low-premium, fixed-benefit voluntary supplemental health, cancer, and life insurance products in Japan and the US. The company has over 21 million policies in force in Japan and nearly 5 million in the US. Nearly 80% of the company's cash flows are generated in Japan with the remainder in the US. AFLAC has over 20% market share in both the US and Japan. AFLAC generates cash flows from the collection of premiums (86% of revenues) and the reinvestment of float income (14% of revenues) into fixed income securities. Through its affiliated corporate agency business model, where agents are embedded in more than 90% of the 2,000+ companies listed on the Tokyo Stock Exchange, and its distribution agreements with over 90% of all Japanese banks, AFLAC enjoys material pricing power and significantly higher returns relative to its peers. Because AFLAC's products are low cost, paid typically through direct deposit, and viewed as a necessity in Japan (in order to combat rising healthcare costs), persistency remains in excess of 90%, providing AFLAC with stable cash flows. In Japan, a continued aging of the overall population coupled with a declining birthrate has led to overall population decline, which is taxing the national health care system. As a consequence, the Japanese government has increased out-of-pocket expenses to its citizens, leading individuals to seek out supplemental coverage to bridge the gap. With the Japanese population in structural decline, we believe that pressure on the national healthcare system will only mount, causing further pressure to decrease the government's burden, which will in turn lead to higher demand for supplemental coverage. With AFLAC's significant distribution model and scale efficiencies, the company is at a significant cost advantage relative to its competitors.

During the time we held AFLAC in the Fund, the company continued to generate modestly improving returns and began de-risking its investment portfolio. The investment portfolio had been an ongoing issue for the company because of its exposure to European sovereign debt. Although we felt comfortable with AFLAC's exposure, given its excess capital position and highly predictable and consistent cash flow generation, it persisted as an issue for the company. In November of this year, the AFLAC hired a new CIO with the intent of exiting its exposure to Europe. In so doing, the company began selling many of its holdings, taking losses on the investment portfolio. Although we applaud management's plan to continue to de-risk the investment portfolio and remain comfortable with AFLAC's business model and capital position, we were concerned that the pressure on capital from the selling of assets at a loss could put the company in a challenging situation if there was a material negative outcome in Europe. A secondary consideration in our exit decision was the company's significant and unhedged exposure to the Japanese economy and specifically the Yen. Although we continue to feel comfortable holding AFLAC in the broader accounts, given these risks, it was difficult to continue to justify it as a best idea. As such, we decided to sell the Fund's position in AFLAC during the first quarter.

Myriad Genetics (MYGN) is a leading molecular diagnostic company focused on developing and marketing novel predictive molecular tests. These diagnostic tests provide valuable information that helps physicians customize therapy specifically to the genetic profile of individual patients. Myriad's business is very attractive due to its strong pricing power, very high margins, low capital intensity and almost no competition. We followed Myriad for a long time, but it always traded at a premium valuation. We were given an opportunity to initiate a position in May 2010 at $18/share, which translated to a valuation of 14% Return on Invested Cash Flow (RICF) or 5.5x Enterprise Value/Earnings before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA), following a disappointing quarter that led growth investors to exit the stock. The market was concerned about slowing growth and patent litigation, which we viewed as perceived risks rather than real risks to the fundamental business. Our thesis was based on our belief that return on capital would improve as
the company undertook a strategy to spin out its high-risk, money-losing biotech business and reinvest into its higher margin and more sustainable diagnostic business. After extensive due diligence, we were confident that the market remained under penetrated and the company's investment in expanding its sales force would create value. We closely tracked the contribution of new sales people to incremental revenue and gained conviction that the company would earn an attractive Return on Investment (ROI) on its sales and marketing investment. We added to the position as the stock bottomed at $15, which was equal to our very conservative downside target. We also were comfortable with our downside protection, given that 25% of the company's market cap was in cash and the company generated a double-digit free cash flow yield.

Our thesis began to play out as company executed on its business plan by launching new products and investing in sales and marketing. As a result, the diagnostic business grew by double digits, exceeding Street expectations. Management also returned significant cash to shareholders by repurchasing 15% of the company's stock over the past 2 years. When the stock price recovered by more than 50% from its trough, sentiment became more constructive and the risk reward asymmetry less compelling. As a result, our thesis was less differentiated. We also anticipated potential volatility around ongoing market concerns related to reimbursement and patent renewals. As a result, we started trimming our position in the mid $20s. Ultimately, we decided to replace our Myriad position in March 2012 with a new position in Life Technologies (3.15%), which offered us a more compelling risk reward relationship. Our process of deep fundamental due diligence and our longer term time horizon often allows us to have a contrarian view, relative to the Street. This, combined with our focus on downside protection by gaining a thorough understanding of downside risks, gave us confidence we needed to add to our position in Myriad when the stock initially went against us. Our conviction and willingness to purchase more stock at a time when market expectations for the company were unnecessarily low, ultimately led Myriad to be a successful investment for the Fund.

Portfolio Positioning
Within the consumer sector, we continue to allocate capital to companies that have specific opportunities for improvement and reinvestment that we believe are not being fully recognized by the market. These opportunities exist in both good and poor economic times. One of the overarching megatrends taking place in the consumer landscape is the accelerating growth of e-commerce. Consumers are quite simply becoming increasingly comfortable purchasing goods and services online. This trend started years ago and will continue to unfold over the next decade and it has huge implications, both positive and negative, for many companies within the consumer sector. We will continue to invest in companies that we believe can participate in or are protected from this structural change. In addition, we continue to allocate capital to companies that have significant opportunities for reinvestment outside the US, particularly in the emerging markets. We believe that China, for example, will become the largest consumer market in the world by 2025. We want to invest in companies that have an opportunity to participate in this growth.

Within financials, we are encouraged by continued improving credit trends, more robust capital markets activity, and some signs of a reemergence of loan growth. We believe that financials are in a materially better position than they were in 2008 based on capital levels, leverage, and tougher underwriting standards. That said, persistently low interest rates, increased regulatory scrutiny, and a continued fragile economic environment will continue to challenge returns for the group. For industrial businesses, we continue to favor durable, high quality businesses with pricing power and attractive reinvestment opportunities. Our exposure is weighted toward companies that i) produce products designed into customer applications while accounting for a small fraction of overall costs, ii) offer an attractive Return on Investment (ROI) to the customer, iii) sell into a highly profitable customer base and iv) operate in consolidated or consolidating industries. Further, several of our businesses benefit from high return reinvestment opportunities, ranging from internal growth capital projects to acquisitions of competitors, where increases in market share drive improved pricing and higher asset turns.

Within natural resources, the outlook varies by commodity. While oil prices and, as a result, oil stocks look expensive based on our assessment of the marginal cost of supply, we believe natural gas stocks are attractively valued. As such, we have increased our exposure to the natural gas space. A very warm winter and the rapid development of unconventional resources have caused the commodity to languish at $2.00-$2.50/mcf – below the variable cost of production for some companies. As we look across the supply cost curve, however, there are very few assets that we believe can generate an attractive return, even in a higher commodity price environment. Furthermore, the historic disconnect between natural gas and other hydrocarbons has incented a demand response. Over time, we expect the supply/demand equilibrium to recover. As always, the cure for low commodity prices is low commodity prices.

Outlook
Entering 2012, our outlook was one of cautious optimism. Many of the fundamental factors that have plagued the market over the past few years – a constrained consumer, high commodity prices, mounting budget deficits, unfunded entitlement programs, potential changes to US tax policies, concerns regarding Europe, historically high corporate margins and returns, limited reinvestment opportunities as reflected in large corporate cash balances and the inevitability of deleveraging – remain in place. However, there are other signs that were more positive, including the impact on industrial America of an advantaged energy source combined with the disintermediation of global supply chains due to rising transportation and local labor costs, a vastly improved local and regional banking industry, and initial signs of improvement in the housing market. Moreover, our portfolios were trading at attractive valuations, with reduced downside risk to our assessment of warranted value. Three months into the year, our assessment of the fundamentals remain largely unchanged – the US economy appears to be slowly and fitfully improving, despite the efforts of our country's leadership, while the European situation is far from resolved. Elevated concerns over China's growth rates are misguided, in our opinion, as the laws of compounding dictate that at some point growth rates must slow to a more sustainable level. We continue to find it difficult to understand the intentions of a central bank that confuses outputs – stock market returns - with inputs as it attempts to navigate the current economic environment, while depressed levels of trading volumes and very low levels of volatility are, at a minimum, a source of questions. Finally, after a 10-15% rally, valuations are a bit less attractive, although the best performing stocks over the past five to six months have been low Return on Equity (ROE), non-earning, fast growing businesses, which we tend to find less interesting as long-term investments. Instead, we continue to cull through our universe, seeking those companies with a business plan in place that will drive future value creation for owners, where we can define our downside risk and be adequately compensated for deploying both our investors' capital and our own. Over the last several years, the market has been characterized by periods of elevated levels of correlations across and within asset classes. As fundamental business analysts, these conditions can be frustrating. However, given the depth of our team and a highly repeatable process, we remain confident that we will continue to find ways to exploit the company-specific value creation that we believe remains largely ignored by most investors in today's public equity markets.

We are, as always, thankful for your patience and support.

Sincerely,

MacKenzie Davis, CFA
David Kelley
Andy Pilara
Ken Settles, CFA
Joe Wolf


RS Global Natural Resources Fund

Philosophy and Process
Investors allocate capital to commodities and natural resource equities for a number of reasons, including inflation protection, diversification benefits, exposure to emerging market growth dynamics and a favorable long-term outlook for commodity prices. However, there are also risks associated with these benefits, primarily related to commodity price volatility, the potential for company specific value destruction as a result of poor capital allocation decisions, and sovereignty issues. Our job is to provide investors with the benefits of having a long-term allocation to natural resources while, at the same time, reducing the associated risks. As value investors, we believe that capital preservation is the key to long-term wealth creation. This focus is particularly relevant in the natural resources space, which is capital intensive, deeply cyclical and where many companies destroy shareholder value across a commodity price cycle.

Our goal, therefore, in managing the RS Global Natural Resources Fund is to optimize risk-adjusted returns across a commodity cycle. We believe that the best way to generate superior through-cycle returns for our investors is by: 1) owning only those low-cost producers of commodities with steep cost curves that can create value throughout the cycle, 2) investing in the cost-advantaged companies which have management teams focused on generating returns that exceed their cost of capital irrespective of commodity price, 3) limiting sovereign and geological risk, and 4) purchasing stakes in those advantaged producers only when their share prices are trading at or below current net asset value.

We consider our investment process to be private equity-like, in-terms of our investment time frame, our research efforts and the underlying sources of returns we target. Instead of speculating on shortterm moves in commodity prices, we attempt to identify the few companies that have a competitive cost position in a given commodity and thus will be able to generate attractive rates of return across a commodity price cycle. We do this by employing teams of business analysts who spend a significant amount of time in the field, disaggregating companies on a project-by-project basis and interviewing management teams and operators in an effort to better understand the capital allocation discipline within a given company. We build project-specific cash flow models so that we are prepared to deploy capital when the market provides us with an opportunity to purchase a business at a price that affords us with a margin of safety, based on our assessment of net asset value. Having established an ownership position, we expect these advantaged companies to grow net asset value by 10-20% per annum in a flat commodity price environment, due to their ability to deploy capital into assets that possess a favorable position on the cost curve. Our focus on low-cost advantaged producers combined with our valuation discipline is aimed at limiting risk while also providing investors with an important source of returns to complement their exposure to longer-term changes in commodity prices. In short, we attempt to capture many of the same sources of returns sought by private equity strategies, but with greater liquidity and with a wider range of accessible commodities.

We acknowledge that this approach does not maximize investment results over short periods of time when specific commodity prices are rising. More importantly, however, we contend that across a full commodity price cycle, our focus on risk management will provide us a greater potential to generate superior risk-adjusted returns for our clients.

Performance Update
In the first quarter of 2012, the Fund (Class A Shares) increased 3.58%. The S&P North American Natural Resource Index™1 increased 4.24% and the MSCI World Commodities Producer Index2 increased 4.09%. Positive absolute contributors included FMC Corp (3.30% position as of 3/31/2011), a low cost producer of trona, oil producing companies Denbury Resources (3.83%) and Oil Search (4.18%), aggregates producer Martin Marietta (3.68%) and independent power producer Calpine (3.77%). Negative absolute returns were generated by Canadian gold producer New Gold Inc (2.80%), Southwestern Energy (5.35%), a domestic natural gas company and Peabody Energy (3.78%), an international thermal and metallurgical coal company.

Given the volatility and cyclicality of commodities, we believe that the best measure of performance in the natural resources sector is trough-to-trough through-cycle returns. The following table shows our performance for the first quarter of 2012, as well as for the longer time frames which we believe to be more representative of a commodity price cycle as well as our investment process and philosophy.

Our intention is to generate attractive risk-adjusted returns across a commodity price cycle by outperforming the index during periods of market decline and typically performing in-line when markets are rapidly rising. This strategy is born out in the data, which shows that over the last 10years we have typically performed close to par with our primary benchmark during its periods of appreciation and outperformed the benchmark during its periods of decline. To reiterate, it is our belief that capital preservation is the key to long-term wealth creation. As Andy Pilara, who started this strategy 16 years ago, frequently reminds us, "it's not what you make, it's what you keep."

Strategy Update An important part of our process involves visiting the various natural resource projects around the world. We do this to gain perspective on how future projects will impact the supply cost curve for a commodity and to identify the owners of the most cost-advantaged projects in a given commodity. Importantly, we believe that this work provides us with a basis for assessing current and future incentive prices for various commodities, as well as helping us in our efforts to generate project-byproject net asset value models for the companies that we either own today or may own in the future. Traditional valuation metrics used by many public equity investors, such as P/E ratios, price-to-cash flow multiples and other shorthand tools, are not particularly useful in the natural resources sector given the significant differences that exist between companies in terms of their reserves lives, decline rates, maintenance capital requirements and accounting practices. Thus, our project-level analysis is an integral part of our investment process in that it helps us: 1) identify the few companies that will create value because of their positions on the cost curve, 2) estimate long-term commodity prices and 3) more accurately value natural resource companies.

The focus during the first quarter for us was on some of the more traditional commodities. During the quarter, we visited a number of oil and gas companies in Texas. We believe that the changes in horizontal drilling technology, particularly when combined with the existing energy infrastructure and geology in the U.S. and Canada, create the potential for significant value to be created by costadvantaged and returns-focused companies in North America for many years to come. Indeed, the application of new technologies has resulted in a material change in reinvestment opportunities in North America as well as the outlook for returns on that invested capital as many oil and gas projects have moved down the supply cost curve. Nonetheless, these same changes also create the potential for significant value destruction in the nearer term given the possibility that supply growth may temporarily exceed demand growth and its infrastructure requirements. This is occurring today in the North American natural gas market. Our efforts are focused on identifying the most capitalefficient oil and gas projects that will generate the most attractive returns longer-term and the management teams that are capable of managing the likely temporary dislocations in the market. With many market participants more focused on commodity mix than asset quality, we continue to find attractive investment opportunities in low-cost oil and gas companies in North America, particularly those more exposed to natural gas.

In addition, we met with a number of mining companies during the quarter. Our focus in the metals space has been on some of the base metals companies that have attractive reinvestment opportunities in the form of brownfield projects (the expansion of existing projects) as well as lowerrisk greenfield projects (the development of new projects). Whereas many precious metals stocks continue to reflect both rising commodity prices and the perceived value of future projects, the stocks of many base metals producers reflect much lower commodity prices and do not discount the potential value creation associated with future investments in new projects. Interestingly, the valuation disconnect between precious metals and base metals producers exists despite the fact that the commodity mix between precious metals companies and base metals companies is converging as many of the newer projects involve mining polymetallic deposits. Our work will continue to focus on identifying the projects, regardless of commodity mix, that we believe offer the most attractive potential for returns.

Market Update With a few exceptions, commodities prices increased slightly during the quarter. North American natural gas prices, which suffered in part from the lack of winter weather, declined significantly during the quarter. Natural resource equity returns were more variable, with oil-related and agriculture-related equities increasing while natural gas, coal and precious metals stocks were relatively weak.

Going forward, we believe that the demand backdrop is still mixed, as the challenges of working through leverage are off-set by nascent signs of improvement in the US and the expectations that China will continue to effectively manage its economic cycles. Fortunately or otherwise, that is about as far as we go in-terms of the macro. We rely on what we can quantify and understand in a simple, durable framework. For us, that is assessing the dynamics of the supply side of the equation. We remain confident in our belief that the longer-term outlook for commodities is intact, driven primarily by limited spare capacity and rising marginal costs of supply. Thus, while commodity prices may continue to be volatile, we believe that these short-term price movements provide patient, long-term investors with opportunities to deploy capital at very attractive prices relative to asset values. Given the modest gains in natural resource equities during the quarter, the longer-term outlook for returns has not changed much since our last letter. To better understand the outlook for returns, we again examine the three potential sources of returns for natural resource equity investors.

The first, and most important long-term source of potential returns, is the ability of a select group of companies to create value by generating returns on future projects that exceed their cost of capital. This is the same source of returns that private equity seeks to capture. We believe that low-cost advantaged commodity producers in the public equity market have the ability to grow net asset value by 10-20% per year in a flat commodity price environment. This unique return stream, which has nothing to do with commodity prices or the equity market, is a function of the steepness of supply cost curves and the ability of cost-advantaged producers to create value by reinvesting in high-return projects. Importantly, we believe the outlook for this source of returns has not changed. In fact, it has continued to improve as cost curves have continued to steepen.

The next most important longer-term source of potential returns is the rate at which commodity prices increase in the future, with a resulting impact on asset values. Over the last decade, commodity prices have increased by roughly 10% per annum, driven by a combination of demand growth and increasing costs of supply. Given our less optimistic view of future demand growth when compared with the previous decade, we expect the incentive price to increase at a rate closer to 3- 5% per annum over the next several years, although we acknowledge that the rate of increase in longer-term commodity prices could be greater if demand growth accelerates more than we anticipate. By focusing on the source of returns related to company-specific value creation, we intend to offer this potential source of return to our investors for "free" – meaning that we do not incorporate rising long-term prices into our assessment of current or future value.

The last, and least important long-term source of potential returns, is the outlook for beta. We define beta as the difference between share price and asset value, calculated using reasonable long-term commodity price expectations as determined by the marginal cost of supply. Changes to this relationship, or fluctuations in returns from beta, tend to be determined by short-term changes in commod



Guru Discussed: RS Investment Management: Current Portfolio, Stock Picks
Stocks Discussed: EMN, CXO, SUSQ, AFL, MYGN, OIL,
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