RS Investments Second-Quarter Commentary
Returns and Attribution Detail
For the second quarter of 2012, RS Partners Fund (Class A Shares) declined 3.51% versus a decline of 3.01% for the benchmark Russell 2000® Value Index1. Stock selection in Technology, Materials & Processing and Energy, along with an underweight in Producer Durables, were the largest positive contributors during the quarter. AOL Inc. (online products and services; a 4.88% position as of quarter end) led Technology, while Compass Minerals (a salt and sulfate of potash producer, 4.44%) and Peyto Exploration (a Canadian oil and gas company, though its primary business is in natural gas production; Peyto is profiled in the Position Review section below; 4.95%) were the top performers within Materials & Processing and Energy, respectively. Conversely, stock selection within both Financial Services and Consumer Discretionary weighed on results during the quarter. For Financials, banking business First Horizon National Corp. (2.69%) performed poorly during the quarter, as did specialty retailer GameStop (3.93%) within Consumer Discretionary. The Fund's underweight to REITs was also responsible for the relative underperformance of Financials during the quarter.
For the year-to-date period, RS Partners Fund (Class A Shares) generated a return of 6.05% versus 8.23% for the benchmark. Stock selection in Technology, and an underweight position in electric utilities, generated positive results for the first half of the year. The strong performance within Technology was led by AOL Inc., Acxiom Corp. (a marketing technology and services provider: 4.16%) and 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; 1.56%). Conversely, stock selection in Consumer Discretionary and Financial Services off-set those positive returns during the year-to-date period. Within Consumer Discretionary, GameStop Corp. led the underperformance. Finally, our investment in MoneyGram International (a payment services provider; 1.52%), combined with our underexposure to REITs, led the underperformance within Financials.
Select Position Review Below we review two investments in an effort to use tangible examples to highlight our investment process.
Redwood Trust, Inc. (NYSE:RWT) (2.05%) is a $1 billion market cap mortgage REIT that invests in jumbo-prime residential mortgages and commercial mezzanine loans. The company's primary focus is on rebuilding the private-label securitization market, which was once a trillion-dollar market but has been largely dormant since the beginning of the credit crisis. Redwood partners with banks, such as First Republic, and independent mortgage companies to originate loans. Redwood offers its 22 originator partners the ability to expand their product suite to include jumbo mortgages, while allowing them to retain control of their customer relationships. Redwood is likely to add more bank partners over the coming years, as new bank regulatory capital requirements go into effect that make it less attractive for banks to hold jumbo mortgages on their balance sheets.
We believe that Redwood is well-positioned to benefit from the federal government's eventual withdrawal from the jumbo-prime mortgage market. Through the Government Sponsored Entities, or GSEs, the federal government has dominated the mortgage market since 2008. The GSEs currently account for more than 90% of mortgage originations, a substantial increase from just 35% in 2006. This leaves only 10% of mortgages available for investment by Redwood. Much of the market that was historically considered jumbo has more recently become eligible for inclusion in GSE programs. However, as the GSEs reduce their loan limits to comply with their mandate to shrink by 10% per year, we expect that Redwood's addressable market will grow.
After investing heavily in its residential and commercial mortgage origination platforms during the downturn, Redwood is now seeing greater activity on both fronts. Since 2009, it has completed six jumbo-prime residential mortgage securitizations for roughly $2 billion of proceeds and is on pace to originate over $3 billion of residential mortgages in 2012. In addition, Redwood's commercial business has originated $200 million of commercial mortgage loans with an average yield in excess of 10% and is on pace to double its portfolio in 2012. Redwood has also improved its capital efficiency, obtaining low-cost financing for its mortgage loans awaiting securitization and permanent, non-recourse financing for its investments in residential mortgage-backed securities. Higher throughput (the rate at which the company is able to produce revenue) on its origination platforms, combined with greater capital efficiency, is driving improving returns on capital at Redwood. This progress is exemplified by the fact that the company posted a 12% return on equity during the first quarter of 2012 versus a 3% return on equity for the whole of 2011.
Redwood's high-quality management team, led by Chairman George Bull and CEO Martin Hughes, has successfully navigated the firm through multiple economic cycles. The core principles of management's philosophy, namely disciplined credit underwriting and a conservative balance sheet, remain in place today. We believe that our downside risk is lower because of Redwood's solid balance sheet ($150 million of cash and $1 billion of available-for-sale securities against $441 million of short-term recourse debt), conservative underwriting and investment decisions, and valuation, which remains at a deep discount to our calculated warranted value.
Peyto Exploration & Development (PEYUF) is an independent oil and gas company focused on the Deep Basin in Alberta. As is the case with any of our investments within energy, our Peyto investment is based on our expectation that the company will be able to create value, even in a low price environment, by reinvesting in low-cost, high-return liquids-rich gas projects. Our investment in Peyto is not premised on, nor does it depend on, a significant improvement in natural gas prices, even though we do expect that natural gas prices will move back toward the marginal cost of supply over the next 3-5 years. Indeed, our analysis shows that while commodity producer stocks are positively correlated with changes in the price of the underlying commodity over short periods of time, commodity producer stocks tend to be driven more by the value that they either create or destroy over longer periods of time. As one of the lowest cost producers of natural gas in North America (e.g., just 35 employees for a $2.8 billion market cap company), our research leads us to believe that Peyto will continue to create value at a rate of 10-20% per year, just as it has over the past 5 years.
During the second quarter, we deployed incremental capital and reduced cash levels by over 220 basis points as the market sold off and valuations became more attractive. Several new positions were established during the quarter, and overall the net number of names in our portfolio increased from 37 to 39. This was principally driven by valuations as well as the fact that our team, which has grown meaningfully in the past five years, is becoming increasingly efficient, creating heightened competition for capital. Overall, we used the market dislocation to establish a more balanced portfolio, finding business-specific opportunities that should 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 the sector remains 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. 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. 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. Investing in small- and midsize 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 exchangerate 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.
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 1.50%. 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
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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
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