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RS Investments Value Fund Second-Quarter Commentary
Posted by: Holly LaFon (IP Logged)
Date: July 18, 2012 11:14AM
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 largely predicated on business analysis, with the assumption that stock prices will track economic value creation over time. We are, therefore, interested in understanding how companies create value, 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 visible 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 price. 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 solid risk-adjusted returns over a reasonable investment horizon.
Returns and Attribution Detail
For the second quarter of 2012, RS Value Fund (Class A Shares) generated a return of -5.82% versus -3.26% for the benchmark Russell Midcap® Value Index1. Stock selection in Healthcare, Materials & Processing and Energy, along with an underweight in Producer Durables, were the largest positive contributors during the quarter. Warner Chilcott (a specialty pharmaceutical company; 3.51% position as of quarter end) led Healthcare, while FMC Corp. (a chemical company serving the agriculture and industrial markets, 3.30% position as of quarter end) and Southwestern Energy (5.87%) were the top performers within Materials & Processing and Energy, respectively. Conversely, stock selection in Technology and Consumer Discretionary, and underweights to electric utilities and REITS, were drags on results. Within Technology, both Atmel (2.81%) and Symantec (3.86%) performed poorly during the quarter, as did specialty retailer Gamestop (4.46%) in Consumer Discretionary.
For the year-to-date period, RS Value Fund (Class A Shares) generated a return of 2.47% versus 7.78% for the benchmark. Stock selection in Materials and Processing and Healthcare, and an underweight position in electric utilities, generated positive results for the year. The Fund saw strong performances from chemical companies Eastman Chemical (a business that was sold out of the Fund during the first quarter) and FMC Corp. in Materials & Processing, while Warner Chilcott and Life Technologies (4.16% position as of quarter end) drove the solid performance within Health Care. Conversely, stock selection in Consumer Discretionary, Financial Services and Technology, along with an overweight in Energy, have more than off-set those positive returns. Within Consumer Discretionary, GameStop Corp. led the underperformance. Our investment in insurance broker Willis Group (which is profiled in the Position Review section below, 3.13%), combined with our lack of exposure to both REITs and Financial Data businesses (which were up over 34% for the year within the index; primarily due to the strong performance of credit card provider Discover (0.00%), led the underperformance within Financials.
Select Position Review
Below we review two investments, one that we exited during the second quarter (Advanced Auto Parts) and another that remains a core holding (Willis Group), in an effort to use tangible examples to highlight our investment process.
Advance Auto Parts (AAP) is the second largest auto parts retailer in the U.S. operating over 3,600 stores in 39 states. The company sells primarily non-discretionary automotive parts such as car batteries, brake pads, spark plugs, and mufflers to both do-it-yourself customers as well as commercial garages via its parts-delivery truck service. Our investment in Advanced Auto Parts was predicated on the following thesis: (1) solid industry fundamentals with acyclical demand drivers, defensible competitive positioning, and reasonable reinvestments opportunities; (2) a companyspecific opportunity to meaningfully improve the Company's financial performance as measured by sales productivity, operating margins, asset turns, and overall Return on Invested Capital (ROIC) relative to its two primary competitors (AutoZone and O'Reilly); and (3) a new leadership team with a solid business plan for narrowing this performance gap.
At the time of our initial investment in 2007, Advanced Auto Parts was operating with sales-persquare- foot of $180, operating margins of 8.5%, a payables-to-inventory ratio of 50%, and was generating reinvestment cash flow of approximately $280 million on an invested capital base of $1.6 billion. Through successful implementation of a wide variety of operating initiatives, including greater parts availability, enhanced price optimization, better vendor terms, and improved labor productivity, CEO Darren Jackson and his team meaningfully improved the financial performance of the company. Today, Advanced Auto Parts operates with sales of $230 per foot, operating margins approaching 11%, a payables-to-inventory ratio of 80%, and is generating reinvestment cash flows of approximately $460 million on a reduced invested capital base of $1.4 billion. Overall company ROIC has improved from 13-14% in 2007 to approximately 20% today. Advanced Auto Parts' share price has tracked this improvement in ROIC, appreciating from a stock that traded in the high $30s at the time of our initial investment to $90 per share more recently. Over the past five years we have both added to and trimmed our position size, depending on the relative risk/reward in the market, and we ultimately exited the position at the beginning of the second quarter at a substantial gain.
Willis Group Holdings (WSH) is the world's third largest insurance broker, in an industry where 78% of the market share is held by the top six players. The company operates as an intermediary in placing both insurance and reinsurance coverage. Approximately 70% of company revenues are generated through commissions and over 93% is recurring. Willis Group's is the world's largest reinsurance broker and more than half of its cash flows are generated outside the US. The company holds minority interests in Gras Savoye (31%), a French brokerage firm, and Al-Futtain (49%), a Dubai brokerage firm. CEO Joe Plumeri was the primary architect responsible for transforming the company after it was acquired by KKR Holdings in the late 1990s.
We believe that Willis Group is very well positioned to benefit from a sustained increase in property and casualty insurance pricing, which should reverse a multi-year downturn that has significantly reduced returns for underwriters. We believe that improved pricing is inevitable because: (1) the insurance industry is now cash flow negative on an underwriting basis, with paid losses now outpacing paid losses + changes to overall reserves; (2) Investment yields have declined dramatically due to low interest rates. New money yields now average 2.75%, compared to five years ago when they exceeded 5%. Given the industry's dependence on investment income and the underwriters' use of leverage, returns have declined materially; (3) The industry has been living off of reserve redundancies for the last several years, such that now reserves are developing adversely, which is putting additional pressure on balance sheets and capital positions; and (4) 2011 was the third worst catastrophe loss year on record, which led to over $100 billion in insured losses.
Willis Group produces consistent cash flow generation and, therefore, its stock price is less volatile during pricing downturns. The company enjoys long-term relationships with its clients, which range from small businesses to global Fortune 500 companies, and these revenue streams are very sticky (93+% persistency). Property and casualty insurance is a necessity for business customers and requires that they return to their broker at least once a year; and the broker collects the same commission regardless of whether it is for new business or renewal. Even during cyclical downturns, most brokers are able to increase the amount of insurance a business receives by changing terms and conditions so as to keep absolute pricing relatively flat. Despite the recent soft pricing environment and the global credit crisis, organic growth for the industry has remained positive for each of the past 12 years. For these reasons, we remain confident in our belief that our investment in Willis Group provides our investors with a compelling investment opportunity with ample downside protection.
In the second quarter, we deployed a significant amount of capital, reducing cash levels from 14.8% to 4.0% as the market sold off and valuations became more attractive. Several new positions were established, and overall the net number of names in our portfolio increased from 29 to 36. This was principally driven by valuations and the fact that our team, which has grown meaningfully in the past five years, is becoming increasingly more efficient, creating heightened competition for capital. Overall, we used the market dislocation to establish a more balanced portfolio, finding business specific opportunities in areas such as staples and producer durables, which help reduce the cyclical exposure of the strategy.
From a sector perspective, we continue to believe that our exposures in North American natural gas and, increasingly, oil provide the basis for outsized returns. We remain underweight in interest rate sensitive areas such as REITS and regulated utilities as we see limited opportunity for further reductions in the discount rates and, as such, valuations in these sectors remain unattractive. In previous commentaries, we have expressed our concerns about the fragile nature of the US consumer. Therefore, within the consumer sector, we are allocating capital to companies that have more defensive demand profiles or those that in our view have meaningful company-specific opportunities for improvement and reinvestment that we believe are not being fully recognized by the market. For example, we have identified compelling value creation opportunities in businesses that are able to participate in the secular shift toward e-commerce. In addition, we continue to allocate capital to companies that we believe have significant prospects for reinvestment outside the US, particularly in the emerging markets. Given the maturity of the US consumer market, we seek to invest in companies that can participate in the growth of these developing markets, without paying for said opportunity.
In technology and business services, we are focused on out of favor companies with large, recurring, and highly profitable "maintenance" cash flow streams. In particular, we are finding compelling investments in companies that are exposed to strong multi-year secular growth drivers, such as storage, cloud computing, security, electronic payments, and wireless/mobile.
We believe that the dominant healthcare theme for next decade will be the increased shift towards value- and outcomes-based medicine, which will be driven by a more difficult reimbursement environment and increased consumerism (e.g., higher co-pays and deductibles). As such, our investments within the healthcare sector are focused on companies that: we believe (1) lower cost to the overall system; (2) are under-exposed to direct government reimbursement or the impacts of increased regulation; (3) have company-specific opportunities to innovate, and (4) ultimately benefit from both increased access and an aging population.
Within financials, credit trends continue to improve, industry capital levels are at historical highs, and we are seeing modest 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 fragile economic environment continue to challenge returns for the group. In light of this environment, we are looking for value in the property and casualty insurance sector, as we believe that the industry is in the very early innings of a multi-year improvement in pricing following 2011's record level of global catastrophic insured losses. This, in our view, when combined with less flexible capital positions and a low interest rate environment, is putting significant pressure on industry returns, which should in turn lead to better pricing. In addition, we are focused on financials that are less capital intensive, provide consistent and predictable cash flow streams, and are not as likely to be influenced by global economic factors.
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, valuations have improved over the course of the quarter, particularly for oil related stocks. As a result, we have incrementally deployed more capital into oil producing companies that possess the attributes we require before risking our shareholders' capital: structurally advantaged assets, a proven management team, a sound balance sheet and limited sovereign risk. In addition, we continue to believe that certain natural gas producing companies are attractively valued, and we opportunistically increased exposures over the course of the quarter.
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, 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 inevitable impact of global deleveraging – remain in place. However, there are other variables that we view as being more constructive. These include the slow re-emergence of US manufacturing, a growing appreciation of our country's advantaged energy position, the partial 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 portfolio was trading at attractive downside risk relative to our assessment of warranted value. Six months into the year, our assessment of the fundamentals remains largely unchanged – the US economy appears to be slowly and fitfully improving, 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 our investors' capital. 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 support.
RS Value Team
As with all mutual funds, the value of an investment in the Fund could decline, so you could lose money. Investing in small- and mid-size companies can involve risks such as having less publicly available information, higher volatility, and less liquidity than in the case of larger companies. Investing in a more limited number of issuers and sectors can be subject to greater market fluctuation. Overweighting investments in certain sectors or industries increases the risk of loss due to general declines in the prices of stocks in those sectors or industries. Foreign securities are subject to political, regulatory, economic, and exchange-rate risks not present in domestic investments. The value of a debt security is affected by changes in interest rates and is subject to any credit risk of the issuer or guarantor of the security. Investments in companies in natural resources industries may involve risks including changes in commodities prices, changes in demand for various natural resources, changes in energy prices, and international political and economic developments.
Any discussions of specific securities should not be considered a recommendation to buy or sell those securities. Fund holdings will vary.
Except as otherwise specifically stated, all information and portfolio manager commentary, including portfolio security positions, is as of June 30, 2012.
RS Funds are sold by prospectus only. You should carefully consider the investment objectives, risks, charges and expenses of the RS Funds before making an investment decision. The prospectus contains this and other important information. Please read it carefully before investing or sending money. To obtain a copy, please call 800-766-3863 or visit www.RSinvestments.com.
Performance quoted represents past performance and does not guarantee future results. Investment return and principal value will fluctuate, so shares, when redeemed, may be worth more or less than their original cost. The Fund's total gross annual operating expense ratio as of the most current prospectus for the Class A Shares is 1.33%. The performance quoted, unless otherwise indicated, does not reflect the current maximum sales charge of 4.75% that became effective on October 9, 2006. If the maximum sales charge were included, the performance stated above would be lower. Current performance may be lower or higher than performance data quoted. Performance current to the most recent month-end is available by contacting RS Investments at 800-766-3863 and is frequently updated on our Web site: www.RSinvestments.com.
Please refer to the most current Fund prospectus for complete details on expenses including fees and also for more information on sales charges as they do not apply in all cases and if applied are reduced for larger purchases. Performance results assume the reinvestment of dividends and capital gains.
Guru Discussed: RS Investment Management: Current Portfolio, Stock Picks
Stocks Discussed: WSH, AAP,