RS Value Fund First Quarter 2013 Mutual Fund Commentary
We believe that company-specific value creation is frequently mispriced in the public markets. As a result, the RS Value Team employs an investment process that is driven by fundamental 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 toward 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 Recommended List. However, as value investors, we know that risk is not defined as share price volatility, but rather the permanent impairment of our clients' capital. As a result, Recommended List names only come into the portfolio when a) we can clearly quantify a downside or safety net value, b) the market provides us with an opportunity to purchase an interest in the company close to or, preferably, below that safety net price, and c) the investment augments the existing positions in the portfolio from both a risk and return perspective. While we expect, over time, that excess returns will be driven by superior stock selection, it is critical that we construct "all weather" portfolios—concentrated around our very best investment opportunities, but broadly diversified across the economy. 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 first quarter of 2013, RS Value Fund (Class A Shares) generated a return of 15.08% versus 14.21% for the benchmark Russell Midcap® Value Index.
Stock selection in technology and financial services were the largest relative contributors during the quarter. Activision Blizzard (publisher of electronic entertainment software; 2.49% position as of the end of the quarter) and Symantec Corp. (provider of security, storage and systems management solutions; 3.20% position) were the top performers within technology, while CBRE Group (the world's largest global real estate services business; 1.53% position) led Financial Services. Conversely, stock selection in producer durables and consumer discretionary were drags on relative results. Within producer durables, Waste Connections (a waste management company; 1.52% position) underperformed during the quarter, as did specialty retailer GameStop Corp. (which was sold during the quarter) within consumer discretionary. Importantly, the first quarter of 2013 marked the third consecutive quarter where the RS Value Fund outperformed its benchmark, which helped validate the process enhancements that were implemented last year and were discussed in our year-end 2012 letter.
Select Position Review
Below we review two investments, one that we exited during the first quarter (Life Technologies) and another that remains a core holding (Crown Holdings; 2.98% position), in an effort to use tangible examples to highlight our investment process.
Life Technologies (NASDAQ:LIFE) is a global life sciences company that manufactures and sells instruments, consumables, and services used in life science research as well as in commercial applications. The Company sells a broad range of products including cell cultures, sample preparations, DNA analysis and forensic products. Life has more than 75,000 customers in 160 countries and provides integrated and complete solutions that address researchers' workflow. End markets for Life's products are academic/government organizations (~45% of revenue), pharmaceuticals and biotech (~30%), and applied markets (~25%), which include forensics, diagnostics, and water and food safety. Importantly, 80% of Life's revenue is recurring (i.e., consumables and services) with the other 20% related to instrument sales.
We saw a compelling entry point to purchase the stock during the summer of 2011 as investors became increasingly concerned about potential National Institutes of Health ("NIH") funding cuts. In our opinion, these concerns were overstated given that a potential 8% cut to NIH funding would only translate to about a 1% headwind to Life's overall business, given that NIH funding only accounted for ~15% of Life's revenue. Importantly, NIH funding has doubled over the past 12 years to $30 billion and has historically received broad bipartisan support. Moreover, we felt that a reasonable cut to NIH funding would be more than offset by the increasing growth prospects from the emerging markets. At the time of our investment, emerging markets made up just 10% of Life's revenue but were growing at an annual rate of 25%. China alone was a $180 million revenue business growing at 25%, partially in response to the Chinese government's announcement that it was determined to invest $125 billion in health care and science over the coming years. Other growth opportunities that we felt were under-appreciated by the Street included sequencing product launches that exceeded expectations as well as applied markets in bio-production and forensics.
Having completed several large acquisitions in the past, management was increasingly focused on maximizing returns on its existing asset base, and return on invested capital ("ROIC") was added as a performance metric for the senior management team. We saw several positive signs that the company was more disciplined in its capital allocation strategy and remained keenly focused on improving ROIC. In fact, the company began publishing its ROIC metric and publicly set an ROIC target of 10% for 2012 (compared with just 7.7% in 2008). Margin expansion opportunities of 50−75 basis points a year were identified and could be realized by improving efficiencies and leveraging fixed assets. In fact, the company improved its efficiency and productivity by shutting down six manufacturing facilities in 2010, while moving 50% of its purchase transactions online. After successfully rationalizing the Company's cost structure and discontinuing unprofitable product lines, Life announced plans to use its free cash flow to aggressively repurchase stock and deleverage the Company. While we like its long-term prospects, when Life announced that it had hired consultants to help the Company pursue strategic alternatives, the stock price reacted by increasing by roughly 20%. As such, at this more aggressive valuation, we felt that we lost sufficient downside protection that we decided to exit our position in the company during the first quarter of 2013.
Crown Holdings (NYSE:CCK) manufactures steel and aluminum cans for the food and beverage industry. We were first attracted to Crown as an investment because of the stable end-demand for its products given that, even in recessions, purchases of canned goods do not materially change. In addition, the can industry has become increasingly consolidated in the more developed markets, resulting in disciplined behavior around both pricing and volumes. The result has been steady returns on capital and a business that produces a consistent and healthy stream of free cash flow.
Crown historically has returned its excess cash flow to shareholders through share repurchases. However, growth in emerging markets, particularly Asia and South America, provided Crown with the opportunity to recently deploy some of its excess capital into new projects with high returns. As such, Crown provides us with an opportunity to own a business with both very attractive underlying characteristics and additional growth opportunities. While the pace of growth has slowed and there are fewer potentially attractive new capital projects since we first purchased the stock, the company now has more free cash flow to allocate to share repurchases.
Crown has been a steady performer since we initiated our investment. We see this as a business that is resilient in most economic environments, while continuing to provide investors with significant cash flow, trading at a very reasonable valuation.
As discussed in our last letter, we have made a conscious decision to create more balanced portfolios, allowing alpha2 to be driven more consistently by stock selection and reducing potential macro and index risks at the portfolio level. Thus, the number of positions in the strategy has increased from 29 a year ago to 48 today, with an associated reduction in both cash levels and exaggerated portfolio bets. This evolution effort has been supported by the enhancements we made to the portfolio construction process last year and our deep and experienced team, which is increasingly 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 producer durables, which help reduce the cyclical exposure of the strategy. We remain underweight interest rate sensitive areas such as REITs (Real Estate Investment Trust) 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. 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.
We remain cautious about consumer-facing businesses, especially in light of higher payroll taxes and challenging year-over-year comparables. As such, within the consumer sector, we are allocating capital to companies that have more defensive demand profiles (e.g., dollar stores) 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.
Within financials, credit continues to improve and we are now 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. While persistently low interest rates, increased regulatory scrutiny, and a fragile economic environment continue to challenge the regional banks, in many cases these concerns are more than adequately discounted in valuations. As such, we have used the market's focus on near-term net interest margin (NIM) pressures as an opportunity to evaluate our regional bank exposure. 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.
We entered 2012 cautiously optimistic and despite double-digit stock market returns, we remain incrementally more positive in 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 2012. Our financial institutions are much better capitalized and are essentially awaiting a recovery in demand. The benefits of low-cost energy provided to U.S. consumers and manufacturers as a function of low-cost natural gas reservoirs, and the ability to extend related technologies into oil and liquids, are in the early stages of being recognized and should positively impact the domestic economy over the intermediate and long term. From a valuation perspective, cyclical industries (where we tend to find more interesting company-specific opportunities) appear attractive relative to defensive sectors, while equity risk premia remain elevated relative to historical levels. As contrarians, we like the fact that retail investors have fled the stock markets and large institutions have massive unfunded liabilities, which are unlikely to be met via the returns offered by the fixed income markets. Increasingly shorter 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.
We remain confident that our philosophy, 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.
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, are as of March 31, 2013.
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.