Philosophy and Process: We believe that company-specific value creation is often mispriced in the public equity markets and, as a result, the RS Value Team employs an investment process that is largely predicated on business analysis. Specifically, we are 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 our client's capital. As a result, farm team names only come into the portfolio when a) we can 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 our benchmark, but believe that our team structure, philosophy, and process will continue to provide us with the opportunity to generate excess risk-adjusted returns over a reasonable investment horizon.
Returns and Attribution Detail
For the third quarter of 2012, RS Value Fund (Class A Shares) generated a return of 6.31% versus 5.80% for the benchmark Russell Midcap® Value Index. 1 Many of the companies and sectors that have hampered recent results contributed positively to relative performance during the third quarter. Stock selection in Financial Services and Consumer Discretionary, along with an overweight in Energy, were the largest positive contributors during the quarter. CBRE Group (a new investment in the largest global real estate services business; 1.81% position as of quarter end) led Financial Services, while specialty retailer GameStop (4.39%) and Talisman Energy (1.50%) were the top performers within Consumer Discretionary and Energy, respectively. Conversely, stock selection in Healthcare and Utilities were drags on results. Within Healthcare, Warner Chilcott (a specialty pharmaceutical company; 2.61%) performed poorly during the quarter, as did Questar Corp. (2.58%) in Utilities.
Year-to-date, the RS Value Fund (Class A Shares) generated a return of 8.94% versus 14.03% for the benchmark. Stock selection in Materials & Processing and Healthcare, and an underweight position in electric utilities, generated positive results for the year-to-date period. 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. (1.97% position as of quarter end) in Materials & Processing, while Life Technologies (3.70%) and Warner Chilcott drove the results within Health Care. Conversely, stock selection in Consumer Discretionary, Technology and Financial Services, along with an overweight in Energy, have more than off-set those positive returns year-to-date. Within Consumer Discretionary, GameStop Corp. remained the largest detractor year-to-date, despite positive results in the third quarter. In addition, Atmel (1.32%) has performed poorly this year in Technology, while insurance broker Willis Group (2.90%) led the underperformance within Financials.
Select Position Review
Below we review three investments in an effort to use tangible examples to highlight our investment process. We begin with Associated Banc-Corp (an investment we exited during the third quarter), then discuss HanesBrands (a new name that brings some additional balance to the portfolio) and finally conclude with a brief discussion of Southwestern Energy (highlighting an exciting opportunity we see within Natural Gas).
During the third quarter, we exited our position in Associated Banc-Corp (ASBC). Headquartered in Green Bay, Wisconsin, ASBC owns the largest bank franchise in the state with over $22 billion in assets and 280 branches. The bank serves customers with a full range of traditional banking services in Wisconsin, Illinois, and Minnesota; along with other financial products. ASBC has a strong market presence, holding top ten market share positions in 28 of the 31 MSAs in which it competes, and a top five position in 13 markets. ASBC also has 93% of its loans funded with sticky low cost core deposits. Under previous management, ASBC lost sight of its core, in-market business – eliminating incremental investment in its Wisconsin franchise in order to focus on asset growth in higher risk Shared National Credits (SNC). The credit cycle forced the company into a $525 million TARP bailout and poor management prompted regulators to issue a Memorandum of Understanding (MOU), governing capital and credit management.
In December 2009, Phil Flynn joined ASBC as the new President and CEO to help guide the bank out of the credit crisis. Phil was previously the Chief Credit Officer at UnionBanCal – a highly regarded San Francisco based bank – were he gained a reputation as a strong credit operator while guiding UnionBanCal out of its own SNC credit issues in 2000-2002. More recently, Phil has strengthened the ASBC team with a number of professionals from his time at UnionBanCal. Our original investment thesis focused on new management leading a structural change at ASBC from a retail deposit funded SNC lender to an institutional quality commercial bank with a significant cost advantage stemming from its retail presence. (ASBC has maintained a presence in Wisconsin for over 100 years and enjoys a cost of deposits of just 0.48%.) We believed our downside was protected by a strong capital and liquidity base, as well as management's focus on risk-adjusted Return on Invested Capital (ROIC). We had the added benefit of strong growth potential at ASBC, given the disruptive acquisition of chief market rival M&I Banc-Corp by Bank of Montreal. Although the controllables in our thesis largely played out, our upside was limited due to the material drop in interest rates and the requirement by regulators that all banks hold more capital than originally anticipated. We believe these factors materially limited the size of potential improvements in returns that could be achieved by new management, while also limiting the return on our overall investment. As such, we decided to exit the position in ASBC during the third quarter in order to fund another investment with a more attractive risk/reward profile.
HanesBrands (HBI) is a new position added to the Value Fund this past spring. HanesBrands designs, manufactures, and sells primarily branded replenishment apparel goods including t-shirts, bras, underwear, socks and hosiery. Most of what the company sells is staple-ish in nature and, while consumers can defer purchases in the short-run, undergarments are generally the first purchases to be made following a period of deferment. Contrary to popular thinking, brands are important in the undergarment category as consumers are becoming increasingly brand loyal. For example, in men's underwear, we find 80% of overall US sales is represented by national brands (up from 74% just five years ago). HanesBrands is the captain (#1) or validator (#2) in most of the subcategories in which it competes, and the company's brands have shown solid pricing power during recent periods of input price inflation.
HanesBrands was spun-out from Sara Lee in 2006. Prior to the spin, it is our opinion that, Sara Lee maintained a high-cost, uncompetitive domestic manufacturing footprint for Hanes, underinvested in innovation, and basically milked the Hanes unit of its cash flows for reinvestment in other areas within Sara Lee. Since 2006, HanesBrands has:
• Moved its manufacturing to lower-cost geographies including the Caribbean, Central America, and Asia;
• Focused on innovation and reinvestment opportunities such as the C9 Champion line at Target and overseas expansion;
• Pruned and added to its product portfolio with strategic tuck-in acquisitions like Gear for Sports; and
• Paid down debt significantly.
HanesBrands' operating performance during 2011 and the first half of 2012 was negatively impacted by a severe spike in cotton prices, which occurred during late 2010/2011. As a result, margins compressed when price increases were unable to match increased input prices. We established our position in HanesBrands, both as an improving ROIC and a Free Cash Flow (FCF)/de-leveraging story that we expect will play out over the next two years. We forecast ROIC to improve by 200bps (20%) over our investment horizon driven specifically by the following:
• Over the course of the year, HanesBrands will be shutting down its commodity screen printing t-shirt business, which is generating approximately $40 million in operating losses during 2012. Management has decided this business is non-core to the company's branded strategy and is basically ceding market share to competitors Gildan and Fruit-of-the-Loom. Simply shutting this business down will improve operating margins by approximately 100bps and operating profits by 10%.
• Due to the rise in cotton prices in 2011, HanesBrands absorbed a roughly $250 million use of cash due to higher average unit costs (AUCs) for cotton-based inventory carried on the balance sheet. As this high cost inventory works its way off the balance sheet, it will become a major source of cash for HanesBrands – beginning in 2Q 2012 and continuing for the next 12 months.
• Bolstering the ROIC-improvement story is a meaningful deleveraging story. We believe HanesBrands will generate approximately $700-800 million of free cash flow over the course of the next 18 months. We expect HanesBrands will use all of this cash to reduce over 40% of its long-term debt, including a $500 million tranche of notes with an 8% coupon, by the end of 2013. Leverage will be reduced to less than 2X, annual interest expense will fall from $156 million in 2011 to under $75 million by 2014, and the company's financial flexibility will be greatly enhanced to initiate additional shareholder-friendly actions, such as dividends and/or share repurchases.
Southwestern Energy (SWN) is an independent oil and gas company with low-cost natural gas operations in the Fayetteville Shale in Arkansas and the Marcellus Shale in Pennsylvania. While the company's shares have been negatively impacted by the decline in natural gas prices over the last few years, our investment in Southwestern is premised more on the view that the company will be able to create value by reinvesting in high-return gas projects, even in a low price environment, by virtue of its low-cost asset base. 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 much more closely correlated with changes in net asset value and returns on invested capital over longer periods of time – as is the case in any industry. After studying Southwestern Energy's reinvestment opportunities and analyzing the unit-level economics of the projects that the company will be pursuing over the next 3-5 years, we remain of the view that Southwestern Energy will continue to generate very strong rates of return which should support double-digit growth in net asset value (NAV) annually, even in a low commodity price environment. In addition, with a strong balance sheet and multi-year drilling inventory, we believe Southwestern is well-positioned to benefit from any potential improvement in natural gas fundamentals over the next few years.
Over the past six months, we have established several new positions such that the net number of names in our portfolio increased from 29 at the end of the first quarter to 40 today. This outcome was created by the opportunities provided by the market in conjunction with our team, which has grown meaningfully over the past five years and become more efficient at identifying and valuing business opportunities. Overall, we used market volatility to establish a more balanced portfolio, finding business-specific investments in areas such as staples and producer durables, which help reduce the cyclical exposure of the strategy. 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.
From a sector perspective, we continue to believe that our Energy exposures, particularly to North American natural gas, provide the basis for excess returns. We see changes in horizontal drilling technology, especially when combined with the existing energy infrastructure and geology in the U.S. and Canada, creating potentially significant value for cost-advantaged and returns-focused companies in North America for 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 capital-efficient oil and gas projects that will generate the most attractive returns longer-term combined with management teams that are capable of managing the temporary dislocations in the market.
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 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.
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 continues to marginally improve but, with many institutional portfolios approaching more normalized levels, this should not be a driver of significant value creation going forward. In addition, industry capital levels are near historical highs, home prices appear to have bottomed, 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, more disciplined underwriting standards, and a quelling of lower quality legacy loans. That said, persistently low interest rates, increased regulatory scrutiny, and a fragile economic environment continue to challenge returns for the group, which we do not view as being adequately discounted in valuations. 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 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.
Over the past several years, we have invested significant resources in building out our team and our core capabilities. To that end, we are pleased to announce that during the third quarter we hired James Bruce as an analyst on the Hard Assets Team. James spent the last ten years managing a global natural resources portfolio in Australia before joining RS. Prior to that, James spent eight years in the mining industry, managing both above and below-ground mines and conducting business development initiatives. He is a mining engineer by trade and adds a complementary skill set to our debate-oriented process, which is aimed at mitigating both financial and technical risks. We are excited to have James on our team and we look forward to sharing some of his work with you in future communications.
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 better capitalized local and regional banking industry, and continued improvement in the housing market. Moreover, our portfolio was trading at attractive downside risk relative to our assessment of warranted value. Nine 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 many of the best performing stocks this year have been low Return on Equity (ROE), non-earning 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 September 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 website: 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.
1 The Russell Midcap® Value Index is an unmanaged market-capitalization-weighted index that measures the performance of those companies in the Russell Midcap Index with lower price-to-book ratios and lower forecasted growth values. (The Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000® Index, which consists of the 1,000 largest U.S. companies based on total market capitalization). Index results assume the reinvestment of dividends paid on the stocks constituting the index. You may not invest in the index, and, unlike the Fund, the index does not incur fees or expenses.
2 The Fund's holdings are allocated to each sector based on their Russell classification. If a holding is not classified by Russell, it is assigned a Russell designation by RS Investments. Cash includes short-term investments and net other assets and liabilities.
3 Portfolio holdings are subject to change and should not be considered a recommendation to buy or sell individual securities.
4 Class A shares inception date June 30, 1993.
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