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RS Value Fund - Fourth Quarter 2012 Mutual Fund Commentary

January 22, 2013 | About:
Holly LaFon

Holly LaFon

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As investors, we are trained to look forward. We know that the market is a discounting mechanism, that an asset's value is the present value of future free cash flows, and that we should be seeking "catalysts", earnings revisions or, in the case of the RS Value team, future value creation opportunities. While developing opinions about what may happen in the months and years ahead is fundamental to investing, it also can impact one's ability to learn from the past, deconstruct what has gone well and, more importantly, what has not. In our prior letters, we have discussed specific investments — some good, some less so — as a means to highlight our research process. In this letter, we would like to step back even further, and more directly address the three pillars of our investment framework and the steps we took in 2012 to reinforce our capabilities.

Philosophy

Our investment philosophy is a simple one, and has remained unchanged over the 17 years that we have managed client portfolios. First, we believe that, over time, stock prices must reflect the value of the businesses that they represent. Second, we believe that we can understand a company's ability to create economic value for its owners by analyzing unit level economics, changes in cashon- cash returns on capital and future reinvestment opportunities. Finally, we believe that capital preservation is the key to long-term wealth creation. As such, we define "risk" not as stock price volatility, but rather the permanent impairment of our shareholders' capital. These three tenets form the core of our philosophy, and we come to work every day seeking to exploit investment opportunities that are consistent with this mindset. We do not believe that the market is particularly efficient at first identifying and then pricing future value creation, and the proliferation of ETFs and compensation schemes that incent a focus on short-term relative returns only serve to perpetuate this inefficiency. The result is periodic disconnects between price and value, which allow us to deploy our clients' capital with the appropriate relationship between risk and return potential.

Team and Structure

Any investment framework starts with people, and the RS Value team has invested significant time and effort over the past ten years building a group that shares a passion for deep company-specific research, is willing to subject ideas and conclusions to rigorous, iterative debate and enjoys a collaborative, team-based culture. In addition, we have created a high level of redundancy, so that our investors can be confident that portfolio returns are not driven by any particular individual, but rather reflect the consistent application of a well-defined investment process.

As is true of most endeavors, the appetite for introspection and reassessment is rarely whetted by success and, while we don't expect to outperform every year, our 2011 results suggested that some refinements were in order. Thus, the team reviewed the data, reaffirmed its core philosophy and made some nuanced enhancements to the process and structure such that our core capabilities could be brought to bear more consistently. To date, we are encouraged by the outcomes. During 2012, we formalized a role that we refer to as a portfolio administrator. Looking back at our investment results over the past several years, it became apparent to us that the tension that we have successfully created for analyzing specific business opportunities was not being appropriately replicated at the portfolio level. In our prior structure, the Pod Leader addressed portfolio construction and risk assessment from a sector standpoint. We determined, however, that this

structure wasn't providing sufficient transparency into competition for capital between individual investments across the portfolio and that we needed to manage portfolio risks more pro-actively. As a result, we introduced the portfolio administrator role in the spring of 2012 to address the same questions from the overall portfolio perspective. Because we believe in the benefits of peer to peer debate and have invested heavily in creating a deep, talented team, we now have two to three portfolio administrators dedicated to each RS Value product.

Thus far, we are pleased with the improvement in risk transparency, position size management and overall portfolio balance. It is worth noting that we chose the term "administrator" carefully, as the primary emphasis in our process continues to be company-specific research, as opposed to the macro-focused inclinations of an individual who happens to carry the title of Portfolio Manager. We believe that by vetting ideas consistently across the entire economy, and having those ideas compete for a limited pool of capital, we can allow our expertise — the ability to identify companyspecific value creation that is not being discounted in the stock price — drive alpha, while actively managing the risks inherent in any investment or portfolio of investments. The role of portfolio administrator allows us to more effectively strike this balance.

Process

As the team has grown, we have more formally codified the steps of our investment process. The intent is to have a simple framework with inputs sufficiently flexible to adapt to specific business and industry dynamics, yet with outputs that allow us to objectively and unemotionally manage both risks and opportunities. The framework is straightforward — for each investment we quantify both the business opportunity and the value opportunity. We define a business opportunity as the magnitude of potential economic value creation and our conviction in the ability for that value creation to be realized. This involves in-depth analysis of unit-level economics, cash-on-cash returns and reinvestment opportunities, combined with our assessment of both management and the balance sheet. In effect, we are trying to find business plans that we are excited to underwrite. Value opportunities are simply a function of a conservative assessment of the business as it exists today, the magnitude of future value creation, and current stock prices. We are all investments analysts and our job is to identify the business opportunities in our areas of responsibility, price those businesses appropriately and then build portfolios based on the opportunities provided by the market. Investment analysts work in teams of two, vetting and valuing ideas. Analysts work in conjunction with portfolio administrators to establish maximum capital allocations and capital consumption schedules, and portfolio administrators work in teams of two or three to ensure that the best ideas at the best prices are well represented in the portfolio, that portfolio risks are identified, and that unwanted risks are appropriately mitigated. We believe that our value-add lies in our business analysis framework and capabilities, such that our simple portfolio construction mantra is "do no harm". By combining rigorous company-specific research, a common sense approach to portfolio construction and a conscious effort to minimize the impact of ownership bias and emotion, we believe we can continue to provide our investors with the opportunity to generate excess riskadjusted returns over a reasonable investment horizon.

Performance

For the fourth quarter of 2012, RS Value Fund (Class A Shares) generated a return of 4.49% versus 3.93% for the benchmark Russell Midcap® Value Index. (1) Stock selection in Consumer Discretionary and Materials & Processing were the largest relative positive contributors during the quarter. Specialty retailer GameStop (2.77% position as of the end of the year) and aggregates producer Martin Marietta Materials (2.48%) were the top contributors during the quarter within Consumer Discretionary and Materials & Processing, respectively. Conversely, stock selection in Energy and Producer Durables were drags on relative results. Within Energy, Concho Resources (3.41%) performed poorly during the quarter, as did Pall Corp. (1.45%) in Producer Durables.

For the full year, the RS Value Fund (Class A Shares) generated a return of 13.83% versus 18.51% for the benchmark. Stock selection in Materials & Processing and Health Care, and an underweight position in electric utilities, generated positive results for the full-year 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. (2.31% position as of year-end) in Materials & Processing, while Life Technologies (2.97%) and Covance Inc. (1.82%) drove outsized results within Health Care. Conversely, stock selection in Energy and Technology off-set those positive returns during the year. Within Energy, Peabody Energy Corp. (a position that was fully exited during the fourth quarter) was the largest detractor, while Atmel (also exited during the fourth quarter) led the underperformance within Technology.

During 2012, we established several new positions such that the number of names in the portfolio increased from 30 at the beginning of the year to 43 by year's end. Similarly, cash balances, which started the year at 10.10%, declined to 4.09% by the end of 2012. This outcome was created both by the process enhancements described above and by the fact that our team, which has grown meaningfully over the past five years, became more efficient at identifying and valuing business opportunities. Overall, we used market volatility during the year to establish a more balanced portfolio, finding business-specific investments in areas such as producer durables, as well as in companies with staple-like returns, which helped reduce the cyclical exposure of the strategy. We remain underweight 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.

We see early signs that the recent process enhancements are translating into improved results, as evidenced by the fact that Fund performance was much improved during the second half of 2012, increasing 11.08% vs. 9.95% for the benchmark. Moreover, we look forward to continuing to provide our investors with a well-defined, differentiated source of alpha because, as discussed below, we believe the outlook for company-specific returns over the next three to five years is quite attractive.

Outlook

We entered 2012 cautiously optimistic and despite double-digit stock market returns, we remain incrementally more positive coming into 2013. Perhaps more accurately, we are incrementally more confident in our cautious optimism. While the public sector struggles to balance budgets and deleverage, the private sector in the United States continues its slow and uneven emergence from the economic and financial imbalances of 2007–2008. The housing market continues to improve, and more certainty from the government regarding tax policies will allow companies to commit to capital budgets and hiring plans that were delayed during the last six months of 2012. Our financial institutions are much better capitalized and are essentially awaiting a recovery in demand. The benefits of low cost energy provided to US consumers and manufacturers as a function of low-cost natural gas reservoirs, and the ability to extend related technologies into oil and liquids, is in the early stages of being recognized and should positively impact the domestic economy over the intermediate and long-term. Outside the United States, the early data out of China appears to be improving, and it is difficult to imagine the situation in Europe deteriorating much further from here. From a valuation perspective, cyclical industries (where we tend to find more interesting companyspecific opportunities) appear attractive relative to defensive sectors, while equity risk premia remain elevated relative to historical levels. From a fund flows standpoint, the equity markets continue to witness unprecedented attrition — $150 billion withdrawn in 2012, second only to the $225 billion taken out in 2008. In fact, over the past five years, active US equity funds have had net redemptions of $400 billion, while passive domestic funds and ETF's have gathered $240 billion according to Strategic Insight. As contrarians, we like the fact that retail investors have fled the stock markets and large institutions have massive unfunded liabilities, which we believe are unlikely to be met via the returns offered by the fixed income markets. In addition, short-term stock correlations remain elevated, impacted by the 14-fold increase in ETF assets to $1.5 trillion over the past decade, according to research from BlackRock. High correlations and short holding periods are consistent with our contention that most market participants are solving for short-term returns and that, in such an environment, investors focused on long-term value creation and fundamental price/value disconnects should be able to generate reasonable risk-adjusted returns.

Summary

2012 marked a year of transition for the RS Value team where we focused on strengthening our fundamental capabilities, prompting a normalization of investment results. We are confident that both the reaffirmation of our philosophy and the minor enhancements we have made to our structure and process will allow us to compete effectively in a market that we contend will be well suited to our private-equity-like approach to business analysis and valuation. We thank you, as always, for your patience and support.

Sincerely,

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 December 31, 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.


Rating: 3.0/5 (2 votes)

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