RS Growth Funds
US > Multi-Cap > Growth
May 28, 2013
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Inception Date
Dec 31, 1969
Q: What is the history of the company and the fund?
A : RS Investments has four diversified growth funds: A small-cap fund, a SMID-cap fund, a mid-cap fund and a large-cap fund. The same team with the same philosophy, process and risk management control manages them all.
RS Investments’ first launch was the Small Cap Growth Fund in November 1987, a month after the stock market crashed.
Through the late 80s and early 90s we decided to start a number of new products that spanned the cap spectrum. The Large Cap Growth Fund started in May 1992. The Mid Cap Growth Fund was started in July 1995. Finally, the SMID Cap Growth Fund, or the RS Select Growth Fund as we now call it, was started in August 1996. These funds all did well in the late 90s and then as the new millennium started, technology stocks started to underperform and there was a lot of emphasis on that sector in all of these funds. The early 2000s were harder on the funds because we were massively overweight those sectors.
There are three co-portfolio managers that manage all these products. Melissa Chadwick-Dunn and I joined in 2001 while Steve Bishop had started in 1996. The three of us have been together about 12 years.
As we were coming out of that late 90s cycle, we decided that we needed to create a more diversified strategy that looks at all different sectors, not just focusing on technology, healthcare and consumer, which dominated the Russell benchmarks. As we grew up as analysts and ultimately got promoted in 2007, we decided to take a much more sector neutral approach.
We filled out our research coverage, building our analyst team underneath us. From 2007 onward we made sure that we had very good coverage across all the different sectors within the Russell. We now have seven investment professionals who are working on these funds and we are all sector specialists. We have all been working in our sectors for over 10 years.
This has provided a nice approach to be able to find great growth companies within any sector. We will not go more than one and a half times the benchmark weight. Nor will we go less than half weight, with 50% to 150% being our general guidelines for the benchmark weights. For example, if technology were 20% of the benchmark, we would go no more than 30% in that benchmark weighting, and no less than 10%. That helps us manage risk and create diversified portfolios, but most importantly tries to save us from the pitfalls we had in the late 90s of over-investing in certain sectors and hurting returns.
We spend all of our time doing fundamental research. We think our advantage is really in finding those great secular growth companies within any sector that can outperform their individual benchmarks. In May 2007 we took over the Select Growth Fund. As we progressed and started to turn around performance in 2007 and 2008, we took on more responsibility and moved up the cap spectrum. We started taking over the mid-cap fund in August 2008. In May 2009 we took over the large-cap fund.
The full migration from small-cap to large-cap was completed by 2009 and now we have very solid results in mid-cap and large-cap growth funds since inception, as well as the three-year numbers being very much intact for those two products.
The reason we organized ourselves into sector specialties was that we had over a dozen years of experience covering our individual sectors and we had built up a lot of expertise and core knowledge in our sectors. We developed long relationships with all the companies and contacts within our industries. We have a very strong system of performance attribution to make sure we are driving our alpha from stock selection and not from taking big sector bets.
Our largest franchise is the Small Cap Growth Fund. The assets are $1.3 billion; about $750 million of that is in mutual funds. In the Select Growth Fund we have roughly $750 million in the strategy and $500 million in the mutual fund. The mid-cap strategy is $70 million all in mutual funds. The large-cap is $200 million all in mutual funds. The biggest parts of our overall franchise, which totals $2.5 billion today, are in the small and the select growth strategies.
Q: What is your investment philosophy?
A : We believe that sustainable earnings growth drives long-term stock price appreciation. We are looking for companies that can grow sustainably over a multi-year period. We take a three-to-five year outlook for the companies we invest in. We are not looking for companies that can beat numbers for a quarter or two. We prefer to find those companies that can grow consistently over time.
We would much rather find a company that can grow 18% this year and 22% the next, and maybe fall back to 19% for the following, averaging the 20% range, than one that might grow 40% or 50% this year and then drop to 10% next year. The average rate of return maybe the same over the multi-year period but it is going to be much more difficult to invest in the latter stock and figure out what the right price to pay is when earnings are rapidly accelerating and then rapidly decelerating.
We are looking for secular growth companies that have organic growth. We think organic growth is much more sustainable than acquisition driven growth. If that organic revenue growth is sustainable, it really does lead to the compounding of earnings growth over that multi-year period. That is the key to driving stocks higher.
Q: What is your investment strategy and process?
A : We do work on several hundred names per year in the top two quintiles of our investment universe as scored in our quantitative screening process. But, we also develop a farm team of about 200 stocks that we then populate the portfolios with. These are stocks that we like. We forecast earnings and price targets for these companies, and we are simply waiting for the right price.
A really important part of our process is our valuation discipline. We require $2 of upside for every $1 of downside for a new stock to enter the portfolio. A lot of the great growth companies are not always great growth stocks. We think it is really important to buy the stocks right, particularly in small-cap where there is a ton of volatility and you really have to pick your spots well, especially on the buy side.
The upside is based on our earnings model and our projection for what the company can earn. We use a fair multiple on our earnings target, which is always higher than where the street is. We are trying to find ideas that are undervalued and underestimated by the street. We are going to look out a couple of years beyond where the analysts are and develop an earnings model and apply a fair multiple. This would be an average multiple that the stock has reached over the last five years. For example, if it is a financial company and the average P/E for the last five years has been in the range of 12 to 18, I would use 15 and apply that to my earnings target.
We are not relying on multiple expansion to make money in the stock for our upside case, we are relying on getting the earnings right. If our earnings are right and we use a fair multiple, we think that we will get paid well on the stock.
For the $1 downside, relative to $2 of upside, we use the low end of that 12 to 18 range. We would use 12 and apply that to the current street estimate, so what people think the company can earn right now. It is a nice framework that works for all industries. We use the same framework across all the funds all the way from small-cap to large-cap and across all industries.
The statistics on our funds show that we generally have a little bit higher P/E than that of the benchmark, but significantly higher growth. We do think that as far as valuation is concerned we are very prudent in picking our entry points and making sure we have the $2 of upside and $1 of downside. Even if it might be a bit more expensive, we still have that really strict valuation discipline. We use a five-year average multiple for the two-to-one criteria. It is a historical multiple.
Because we are focused on the companies themselves and doing fundamental research and uncovering those great growth ideas, it is really our task to find companies that can sustain that growth. If we do not think they can, we will not invest in that company. Ultimately the onus is on the analyst to find those companies, uncover the competitive advantage and ultimately the thing that is going to drive those stocks higher. In some cases it might be a new product that came out that they think will enable them to take market share.
As an example, MarketAxess Holdings Inc. is a little more expensive stock than some other financial services names. In this case, they are just starting to embrace European fixed-income trading and they are essentially going to try and replicate what they have done in the U.S. in Europe. It could be a whole new layer of growth for them and a real driver of continued topline growth. They have already done well for the last four years, the price is elevated and the P/E is elevated, but we still think they can continue to grow fast because they have created a whole new market for themselves.
We have a very strict sell discipline. We do not get caught up in the game of stocks reaching our price target and we are going to increase our price target by increasing the multiple. We will only increase the price target due to the earnings being better than expected or if something has changed in our model that creates a higher earnings number.
The reason we sell some of our companies after 18 months is partly the law of averages. We have a lot of companies that we have owned for three or four years. We have owned Core Laboratories (Ticker: CLB) for eight years and it graduated from small-cap. We still own it in mid-cap and large-cap because it is a $6 billion plus cap. We do have places that we can continue to own the stocks. That is one of the nice things about having the full spectrum of asset classes from small to large. There are some great mid-cap and even large-cap names like Starbucks, Priceline and Whole Foods; companies we have owned for over a decade. They started out as small- or SMID-cap companies and have elevated themselves to mid- or large-caps.
One of the reasons the 18 month holding period comes into play is if our investment thesis is successful and it reaches our price target sooner than the three-to-five years, that is a great outcome for everyone and we will sell stocks before that investment horizon has been achieved. There are also a lot of times that companies misstep and we only own them for six or nine months.
The small-cap range is $200 million to $3 billion, SMID-cap range is $500 million to $10 billion, mid-cap range is $1.5 billion to $25 billion and large-cap range is over $5 billion. Roughly 50% of the names have an overlap. All of our funds are smaller or average market cap than the index.
Q: What is your research process and how do you look for opportunities?
A : The universe of stocks from small to large is almost 3,000 names. We start doing our research on the top two quintiles of about 500 or 600 stocks. Then the team of seven analysts, each roughly having 75 to 80 stocks to look at, does all the fundamental research. We are looking at 10-Qs and 10-Ks, interviewing management teams, visiting companies at their headquarters and going to trade shows and industry conferences. Ultimately we talk to people in the industry to find out about their competitive position. We get our feet on the street. We actually have over 2,000 company meetings a year. This could be individual companies or the same company contact multiple times; at least 100 would be at their headquarters.
We build our own proprietary models for each one of the companies in earnings, cash flow and balance sheet. We create a farm team of about 200 stocks that are really ready to put into the portfolio. Our portfolios are quite concentrated. The small-cap fund has 70 to 90 names, the SMID-cap portfolio has 45 to 60 and the mid-cap portfolio has 60-80 names. The large-cap fund has 40 to 60 names.
We find these companies by being organized around our sector specialties, and we are really looking for companies that have a competitive advantage that can help them sustain that growth over a multi-year period. These are companies with an innovative product or service that is helping them take market share in their respective industries. They are typically industry leaders and their competitive advantage has helped them have superior margins. Companies with strong returns on equity and invested capital are companies we look for. Those returns and margins are really a validation of the competitive advantage.
Over the last three or four years we have developed a great proprietary system to screen for companies. It is integrated in our process. It is a front-end proprietary model that we use to screen for companies that have attributes we would look for in great growth companies. It is a five-factor model with five key areas that we screen for companies.
The first area is sustainable growth. The screen looks for companies that can sustainably grow in the mid-teens or greater year in, year out with not a lot of variability in both earnings and revenue.
The next factor is company quality. Very strong margins are a validation of the competitive advantage. We look for companies with strong operating margins, returns on equity and invested capital, as well as low levels of leverage. We do not want our companies to be generating returns from leverage. We would rather they generate that with a good strong balance sheet, superior earnings and cash flow.
The third criteria are estimate revisions. These are companies that are doing well in their respective industry and perhaps have a tail wind and are often underestimated by analysts on the street. We look out multi-year beyond where most others on Wall Street are looking, but in the case of getting from point A to point B, a company that is executing and beating numbers, those tend to outperform over time.
The fourth category is relative valuation. We are looking for companies that are trading at a discount to their peer group as well as to the market. This would be on a P/E price-to-EBITDA, price-to-sales, or price-to-book, depending on the industry. Generally speaking we are looking for those companies that trade at a good relative value to their peer group.
The fifth criteria is companies with strong price action. Relative strength and price momentum are typically good indicators for future stock price performance.
We have a concept we call anchor points, which are metrics that we put on every company. These are metrics that really anchor our conviction in a long-term thesis. A simple example would be a retailer that has 100 stores today that we think over the next four or five years can get to 400 stores. We will monitor the progress over that period towards that anchor point. That anchor point is going to ultimately drive sales per square foot and EBITDA margin for the company and is ultimately an earnings target for the company. That would be our very high level estimate of what the company can do. Then we will discount that back to 18 months out because we derive our price targets from 18 months forward earnings projections.
An example that highlights our process is a mid-cap company called Core Laboratories. They do core sampling of reservoirs for energy companies before they start drilling. They are doing fluid analysis for those core samples. They provide an invaluable service to companies that used to be done in-house and now it is outsourced. As Core Labs grew they were able to attract a lot of the engineers to join their services company, to ultimately be an expert in core sampling and fluid analysis.
Throughout their history they have been very innovative and have a strong competitive advantage. There is nobody that does what they do on a pure basis. They have grown very nicely over the years but what really attracted us to the name is that they had really great anchor points. The company was targeting 1,000 of the 4,000 largest oil fields around the world. They were in 400 of those. Every year they expected that they could add another 30-50 to that total. The anchor point was going from 400 to 1,000 fields over a five-year period.
Fast-forward about four years later and they actually reached that target. Along the way they introduced several new products that expanded their total adjustable market such that they thought they could get into 2,000 largest fields.
This is an example of very strong revenue growth; they are growing their revenues three to four percentage points faster than the CAPEX budgets of the oil producers, which on average over history has been in the 10% to 11% range. This was a mid-double-digit revenue grower that had very strong margins and ultimately EBITDA and operating margins in the 30% range, return on equity well in excess of that and better than all of the peers in the oil services group.
What excited us and kept us in the name for many years was the idea of the anchor points and how they could expand their presence and penetrate the world’s large body of oilfields. While they were doing that they introduced several new products that allowed them to increase their revenue per field. When we first bought the stock they were doing about $450,000 per field on an annual basis. They increased that to $850,000 over that timeframe. They were expanding the number of fields they were going into and through new product development and innovation they were expanding the amount of revenues per field.
Coming out of 2008 into 2009, when crude oil went from $140 to $40, Core Labs revenues only went down 11%. It went down a lot less and it rebounded much stronger. This is a validation that the energy producers could not live without this product.
Another example that highlights our research process is MarketAxess. This is an electronic trading venue for a fixed income. It is one of a kind; it is the only public company that does this. There are two competitors, Bloomberg and Tradeweb, both being private, but they do not have nearly the market share position. MarketAxess is the leading market share gainer within the fixed income market.
We were really attracted to MarketAxess when we first bought it because they only had 8% market share. The market was very under-penetrated. We felt they had a great technology solution and a good management team who could execute against this long-term vision, 30% is not out of the question for MarketAxess over time. It was going to be a fairly slow and steady increase in market share, so our anchor point for this company was 15%. We spent a lot of time in due diligence, talking to people who use the product and they really could not live without the service they offered.
Our anchor point for the company was that they could go from 8% market share to 15%. Ultimately, over a very long period, they can get to that 30%, but the anchor point in this investable horizon over four or five years was 15%. Every year since 2009 they have very methodically increased their market share and grown very fast as a result. This has been driven a lot by the strength in the fixed-income markets and people becoming more embracing of their technology. There has been almost a five-fold increase over a five-year period.
One of the reasons for this rapid growth is that MarketAxess is open. They can trade dealer-to-dealer, dealer-to-customer or customer-to-customer. There are a lot of different ways to create liquidity for traders. This industry is still dominated by voice brokerage so if you are trying to move a big piece of fixed-income you are going to call five different players to get quotes. That is the way that equities were maybe 15 or 20 years ago. We are still in the early innings of that transition and I think that is why the market share is only where it is at 12%-13%.
One of their competitors that has come into the market, Bloomberg, is trying to control the desktop across many asset classes. I think customers like to have alternatives to Bloomberg and not have over focused on one vendor. They really have not innovated and created products people want to use in a meaningful way.
Another is Tradeweb, which is a division of Reuters that has not got much traction. Reuters has gone through a lot of transitions with merging with Thomson and they have just made a couple of other acquisitions, including FX Alliance, which was another portfolio holding we had on the currency trading side. They have got their hands full with all the integration so they have not focused on Tradeweb meaningfully.
Q: What is your portfolio construction process?
A : We have the 200 stocks on the farm team and ultimately we are populating each of the portfolios with stocks from the farm team. But they do not just go into the portfolio when they reach that two to one, which is what we are waiting for, that great entry point. We look at our sector allocations. We are sector neutral. We look at the portfolios over the last six years. Our portfolio names are created from the bottom up, idea by idea. All the ideas have to stack up against other ideas of the portfolio.
We constantly monitor the bets we are taking. Ultimately these products have, since inception, delivered the performance that would deliver a much lower than market beta. We do not want to take a lot of beta risk. We do not want to take any unintended bets. We make sure our product is true to its style.
As we go up in the market cap the beta has been a little closer to one in mid-cap and large-cap; that is just the makeup of the portfolio relative to the benchmark. In general these are low beta portfolios and trying to get our alpha from stock selection.
The reasons to sell stock are that there is a better idea on the farm team that has that two-to-one upside-to-downside. The other is very opportunistic; if the price target in the intermediate term is reached we will take profits. The third is if the anchor points deteriorate - something has happened to the competitive position, whether it is a new entrant into their market that is disrupting their competitive advantage and eroding our long-term thesis, or something happens and those anchor points are not going to be achieved in the manner or timeframe that we would like them.
Q: How do you define and manage risk?
A : The first step in our risk management process is something we call the radar. This is a quantitative system we have that looks at all the stocks in our portfolio and observes how they are acting relative to their peers and benchmark. It looks at volume trends, short interest and the chain of stock relative to moving average lines. It is a very technical indicator that looks at some of the market internals to give us a clue that there might be something going on with the company.
The second phase is what we call our early warning system. This is an attribution-based system that looks at rolling one-month performance. We look at the top ten and bottom ten performers over a one-month basis in the portfolio. These are stocks that have made it into the portfolio. Some of them have done fabulously well and as part of our risk management process you might want to sell some of those and take some profits if they are reaching price targets, but we are focusing our efforts on the bottom ten.
We have feedback that requires us to come back to the group the following Tuesday, after the risk management meeting, which is held every Friday. We then present the investment thesis to the group again and see if the investment still has merit, if that one-month underperformance is the start of some longer trend. We may trim the stock back or sell it outright. Most of the time this is just a way to let the team know what is going on with the stock and make sure it does not become a bigger problem.
The perfect example would be using that system to say this has hurt us in the short run, we know why we are sticking to our investment thesis and we are adding to it and getting a great opportunity. But there are cases where stock hurts you by 20 or 30 basis points and you want to make sure it does not hurt you by 50, 70 or 100 basis points and put a hole in the portfolio and its returns. It is a great early warning to examine the fundamentals and present the investment case as well as the anchor points to the group again to make sure the stock and the company are on track.
This third is what we call the gauntlet. We run the ideas that show up in this third step through the team. If I have a stock on the gauntlet, then I have to get one of the other two co-portfolio managers to buy-in if I want to add more to the name. It safeguards against one of the portfolio managers doubling down on a name because their stock is down and out and they just want to add more capital to it. We want to protect against that to make sure the rest of the group has bought into it.
We make sure that no analyst has more than two stocks on the gauntlet at any one time. These are really problem stocks that have hurt us from a performance standpoint and also are showing poor relative strength. Our quantitative screening process has identified them as ones that are not likely to outperform anytime soon because of the fundamentals. To defend them you really have to do a rigorous defense and write up an eight-to-ten page report on why you think that the stock will start to outperform again. We max the amount of stocks that are on the gauntlet in the portfolio to 10%. You just do not want to have that many problems in the portfolio.
We have many safeguards within the portfolio from a technical and fundamental, as well as a quantitative process standpoint, to make sure we manage risk on a name-by-name basis. Then as we think about risk overall in the portfolio, we run diversified growth portfolios since we want to have exposure to all sectors of the benchmark and find those great growth stocks within each sector and get great performance from picking the best stocks that will beat those benchmarks.
Ultimately we combine that risk management process with a sector neutral approach and it creates a predictable and consistent return pattern for our investors.
Annual Return
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2024 | 2023 | 2022 | 2021 | 2020 | 2019 | 2018 | 2017 | 2016 | 2015 | 2014 |
RSEGX |
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2.6 |
19.8 |
-40.6 |
-24.3 |
26.2 |
26.3 |
-9.3 |
36.3 |
1.3 |
0.1 |
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in percentage