February 28, 2005

John Wallace and Jay Sherwood of RS MidCap Opportunities Fund

S&P Rank: 4 StarsBeyond Traditional Growth Fare

Quick Take: With a handful of exceptions, the companies owned by RS Investment Trust:MidCap Opportunities (RSMOX) are profitable, say John Wallace and Jay Sherwood, who oversee the portfolio. However, the managers are not opposed to investing in a business that's in the red if they see it on the cusp of moving into the black.

Their willingness to buy stocks others don't see as growth-oriented investments sets them apart from other money managers who hunt for growing companies, Sherwood says. The two managers scan for mid-sized firms that consistently increase earnings and sales. They look to scoop up shares that appear attractively priced compared to their history and the overall market.

The pair guided the $584-million fund to a return of 12.4% last year. That kept it within walking distance of the average mid-cap growth fund, which was up 12.8%. The fund has topped its peers over longer periods. For the three years ended January 31, it registerd an annualized return of 7.6%, versus a gain of 3.8% for its peers. Over the five years, it edged up 0.02%, versus a loss of 2.3% for similar funds.

Wallace is also the lead manager of the RS Investment Trust:Growth Fund (RSVPX), which he runs with Sherwood. In addition, Wallace, a former Oppenheimer Funds portfolio manager, helps pilot RS Investment Trust:Diversified Growth (RSDGX). Though the fund's investment advisor recently settled charges with the SEC that it allowed rapid-fire trading, RS MidCap Opportunities fund was not implicated in the scandal.

The Full Interview:

Because of their bias towards growth, you would expect John Wallace and Jay Sherwood to look for companies whose top and bottom lines are expanding.

Most of the time the two stock pickers, who run the RS Mid-Cap Opportunities Fund, do just that. But not always.

"We may own some names that the typical growth fund manager wouldn't own," Sherwood said. "John and I look at things a little bit differently than, maybe, the traditional growth manager, which we think actually gives us a bit of an advantage."

Wallace and Sherwood explain that they're willing to bet on companies that aren't earning money if they think that situation is about to change.

Take Gemstar-TV Guide Intl (GMST), for instance. The television listing company, one of the fund's top stocks, isn't profitable now, but it's generating cash, Sherwood said. He expects its revenue to increase "quite dramatically" as more companies use Gemstar's service to advertise. Given Gemstar's leading position in its field, "it's only a matter of time" before it starts generating "a lot" in earnings, he added.

Wallace believes that Gemstar's stock, which has been trading for around $5.50 lately, can reach $8-$11 within the next one to three years.

As an example of an atypical growth stock that RS Mid Cap Opportunities owns, Wallace cites Vulcan Materials (VMC), which makes crushed stone, gravel and sand that's used in construction. He envisions the company, another of the fund's major holdings, benefitting from the strengthening U.S. economy, as well as increased spending on highway building by Washington and state governments. Wallace sees Vulcan's profits growing 15%-18% this year.

A stock that illustrates what the managers usually look for in an investment, Sherwood said, is Cytyc Corp (CYTC), a medical device maker he and Wallace like because of its leading position in the pap smear test market. Cytyc got to the top there on the strength of its ThinPrep System for screening for cervical cancer, he said. Labs that use ThinPrep get better reimbursement from insurers and the government, and Cytyc collects a fee each time it the product is used, so both win, Sherwood said.

Sherwood expects Cytyc's earnings to increase 20% this year. Its stock is trading at 25 times projected 2005 earnings, which, compared to similar companies, "isn't totally unreasonable," he said.

In stocking their portfolio, the managers as a rule look for consistent improvement in earnings and sales, and they want to see a catalyst, like a new product or management, that can drive profits higher. They prefer to buy shares that are trading at a discount to their historical prices and to the market.

The fund, which usually holds 75-100 stocks, currently draws investments from a pool of companies with market capitalizations of $1.5 billion to about $18 billion, Sherwood said. The maximum size of companies eligible to enter the fund is tied to the caps of those in the Russell Midcap index.

Although the managers base their buying and selling decisions on the merits of individual companies, they also keep an eye on broader economic factors, like the direction of interest rates and the strength of the U.S. dollar, Wallace said. "We try to keep it simple: Is the economy going up, down, or sideways," he said.

When it comes to selling Wallace and Sherwood will start trimming when a stock drops 15% below what they paid for it. Stocks that reach the price targets they set for each of their holdings are sold, too, as are companies whose financial fundamentals head south, or those that the managers think can be replaced by a more promising investment.

Earlier this year, the managers reduced their position in online broker AmeriTrade Holding (AMTD) when its shares dipped 15%, and they sold the remainder because they saw the company's electronic trading volume slipping, Sherwood said.

Although Wallace and Sherwood plan to hold investments for at least a year, stocks tend to move in and out of the fund rapidly. It sported a turnover rate of 253% last year, compared to its peers' 140.6%.

Wallace said the turnover rate has been decreasing over the last couple of years. Still, "we try to cut our losses quickly," he said.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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