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The Struggles of Success

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After more than 30 years in the business, portfolio manager Andy Pilara knows who he is and has strong ideas about what works for him and his shareholders. For the RS Value Fund (RSVAX), formerly the RS Contrarian Value Fund, that means doing his homework and finding companies with market capitalizations in the $3 billion to $18 billion range that are selling below their market or intrinsic value and buying them. He’s a realist who is more than willing to accept abnormally high returns, such as the fund has enjoyed recently, when they occur, but who knows that such conditions don’t happen very often.

His approach to the investment market is an understated one and unlike many mutual fund managers, he doesn’t talk much about the upside when the market is booming. “We focus on losing less, not making more,” he likes to say. “That’s more than a trite statement, because we are not going to take the risks to maximize returns. We believe that if you lose less, the law of compounding will take care of you as far as long-term appreciation is concerned.”

In some market environments, like that of the last three or four years, Pilara’s aim of losing less can translate into making more. In 2004 the fund’s performance (29.31%) dramatically outpaced its style peers (18.2%), its benchmark indexes, and the S&P 500, and unlike many funds, it didn’t generate all its returns in the fourth quarter. S&P gives the fund a five-star rating and ranks it first among 296 mid-cap value funds for the one-year period ended December 31, 2004, sixth out of 222 for the three-year period, and 24th of 141 for the five years.

Investors have certainly responded in a big way to the performance figures, leading to a dynamic infusion of new assets over the last two years. The fund had only $57 million at the end of 2002, but since then has grown more than tenfold and finished last year with $625 million in assets. According to S&P data, that puts it in the top 1% of all funds in growth of assets under management (see “The Big Growers” on page 66) over the last two years.

Although the huge capital inflow has given the fund a temporary excess of cash, Pilara has no intention of changing his style or methodology to conform to the expectations of investors who think that it’s possible to reap huge gains year after year. “I will not let shareholder expectations dictate what we do. I’m sure we have some investors who are chasing performance and that with the first sign of performance that is not number one in its category they will no longer own our fund.”

The last thing he seems to want is shareholders anticipating unrealistic returns. “Reasonable expectations in a normal market environment would be 10% to 12%. Sometimes we’ll do better and sometimes worse, but over the course of a five- to 10-year period, that’s the way you create shareholder value. We’re trying to optimize performance rather than shoot the lights out. Our performance in the last three years didn’t come because we hit a lot of home runs, it came because we didn’t strike out a lot. I think that baseball analogy is apt, because when you take those big risks, like what happened in technology, it takes you a long time to come back. The laws of compounding work really well when you don’t blow a hole in your portfolio.”

At a time when many observers are predicting single-digit returns for the major indexes, when Pilara speaks to shareholders he talks about annualized rates of return for the next five years in that 10% to 12% range. “I’m not saying that’s right or wrong, because I’m not a stock market pundit, I’m just a portfolio manager who tries to buy good companies at the right price for his shareholders.”

Pilara admits that the above statement reeks of motherhood and apple pie, but what’s wrong with that? It’s obviously an approach that has stood Pilara and the RS Value Fund in good stead and seems likely to continue to do so for years to come.

I noticed that the official name of the fund is no longer the RS “Contrarian” Value Fund. By dropping “contrarian” from the title, were you indicating that you’re now going to go along with everyone else? Hopefully, we’re still taking the road less traveled. The reason we dropped contrarian was not because we changed our investment philosophy or changed the way we look at the world. We dropped it because this was a fund that historically, before I took over, had shorted stocks. It’s a fund that had used options, and I wanted to send the signal that this is a plain vanilla value fund without the risky options or shorting associated with the old contrarian fund.

The literature on the fund lists, besides you, two co-managers. What role does each of you play? I set the portfolio strategy and portfolio policy and then we set the major investment sectors. Healthcare is under Joe Wolf’s watch; the financials under Dave Kelley; the resources, industrials, and staples are under my watch. Then Joe and Dave combined do the consumer discretionary and the more technology-oriented companies. That’s how we cover the universe, but I’m the portfolio manager, so at all times, because we have a small shop, I know which stocks the co-portfolio managers are looking at or going to start looking at.

How would you describe the investment philosophy behind this fund? The philosophy is one of cash flow and rates of return. We’re value investors, but we’re not the classic low P/E and low price-to-book value managers. We believe that value is derived from buying companies below their business or intrinsic value. The best way to do that is to analyze the capital deployment of a company. I guess we would be considered business analysts as well as stock analysts because we’re looking for the same things that companies look for in making acquisitions. That is, structural changes in the business [environment], the dynamics of a particular business, and the business model.

S&P calls this a mid-cap value fund and gives it five stars. Morningstar says it’s a mid-cap blend with a three-star rating. How do you define the fund and what benchmark do you use to gauge performance? I define it as a mid-cap value fund. Sometimes the boxes that we are placed in are somewhat arbitrary, although I know there are objective standards used in making those classifications. As an example, [take a] company that might not have earnings but has a lot of real estate and we’re buying it for less than the real estate is worth. Because it has no earnings, it would not be considered appropriate in a value fund.

As far as what we’re compared against, we look at the Russell Mid Cap Value Index, but we grade ourselves a little differently. Obviously we look at a value index, but grade our performance in down markets. We don’t have high expectations. We look at absolute returns. We don’t look at relative returns.

Could you talk a little bit more about your screening process and how often you go through it? We use screens, but the companies that have historically been our best investments don’t come from them–the big stocks are not coming from a minor change in valuation parameters that would be pulled off a screen. They’re coming from larger structural changes within a business. Changes in a business that we would look for if you and I were to go out and buy that business don’t come from screens. When we do screen, and obviously we do, we look for changes in a company’s return on capital. We assign a cost of capital to the stock market and then we look for companies that are earning returns above that cost of capital. So we have two primary screens: companies earning above the cost of capital, and companies whose returns on capital are improving.

How big is the universe of companies that you are looking at? We start with probably a couple of thousand, but we try fundamentally to look at between 200 and 300 companies. Then we try to narrow to about half that many, say a range of around 100. Our expectation is that we’ll find approximately 50 companies that meet our objectives and then there will be companies that have a business model that we like but don’t have a valuation that meets our discipline. So we carry a farm team, to use a baseball analogy, of approximately 50 to 75 companies where we like the business, we like the people, but the time isn’t right [to buy] because the price isn’t right on a valuation basis.

How did you do in the fourth quarter of last year? We accept good quarters, and the bottom line is we did very well. (The RS Value Fund returned 17.39% in the fourth quarter of 2004, while the Russell Mid Cap Value Index returned 13.46% and the S&P 500 9.22%.–Ed.) I’m more concerned with how we’re going to be doing in the first part of this year when the market is down.

What are you going to do this year? We’re planning to do nothing differently than we did ending the year. We look at the stock market valuations the way we look at company valuations, with a discounted cash flow model. If we look at that in a very simple way, the numerator in this equation is the net cash receipts of a company. When we look at the stock market and the S&P 500 it’s the net cash receipts of the 500 companies in the aggregate. Then we use the discount rate to come up with a value for the stock or the stock market. When you’re looking at the stock market, what goes into a discount rate? It’s obviously risk. It’s also inflation, interest rates, and the country’s tax policies. So as we proceeded through 2004, we had a conservative outlook for the stock market. Even though we had good increases for net cash receipts and corporate profits as a proxy, we believed that we were seeing the best of times in interest rates, inflation, and tax policies. We did not believe that we would get much help from the discount rate, or the denominator in this case, and that’s what really propels markets. We have maintained a very cautious stance in how we invest with the fund.

Some of the reports I’ve seen on the fund showed cash at about 16% of assets. Is that a normal level or a little high? Right now we’re at about 15% but I’m not sure there is a normal for us. Let me explain. Cash for us is a residual of the valuations that we’re seeing. So we don’t walk into a research meeting and say we want to be at 15% cash. We are primarily bottom-up stock pickers. So when we see values, we certainly will be investing. The cash position, if you’re using parameters, is probably going to range between 5% and 20%.

In comparison with its peers, turnover on the fund is somewhat high. Why is that? It’s been a problem for us. I anticipate that turnover will decline in the next one to three years. I say that because we have a discipline that when we go into a security we look for a 50% rate of return in a three-year period of time. We have been very fortunate in encountering companies that have met our objective in a very short period of time. If it is up 50% we sit down and ask, “Have the fundamentals changed in this business to justify this 50% rate of return over this period of time?” If not, our discipline requires us to sell it. We also have a discipline on the down side. If a company declines 15% in price, then we have to decide if the fundamentals have changed. If it’s a negative change, the stock must be sold. We have pretty strict parameters as far as our buy/sell decisions are concerned, but I would anticipate that if we have a normal market environment–one where the stock market has a single-digit increase–then the volatility of performance will be less and the turnover in the portfolio will be lower.

Will 2005 be a normal market year? Yes. Normal from the standpoint that we’ve had abnormal returns in the last couple of years and I look for a market environment of mid-single-digit returns. I’m not a stock market prognosticator, but we have to acknowledge the kind of market we’re investing in.

Talk about a few of the fund’s larger holdings and what you found attractive about those companies. One of the larger holdings in the fund is Peabody Energy (BTU), an investment that we’ve had for a couple of years now. On commodities we try to use a price stack that is not a peak or a trough assumption. We’re trying to use a life of the cycle price. In this case it was coal, primarily Powder River Coal [a subsidiary of Peabody Energy]. This was a company that had a great business model, was generating free cash flow, and was generating returns on capital above its cost of capital. It had a management team that we would grade A. So they met all of our ingredients from a valuation standpoint when we entered and they continue to meet our valuation criteria. This company is up 47% for the fund at the present time.

A company that represents a larger percent of the assets is Alcan Aluminum (AL).What we see here are structural changes in the business. The major structural change is what is happening on the demand side from China. On the supply side the structural change is in terms of increased energy costs. Alcan is very attractive [since it's] 50% self-sufficient in its energy requirements, and 85% of that 50% is represented by hydroelectric power, which is one of the cheapest sources of energy. There are also structural changes within the company. It’s splitting up, effective today [January 19, 2005]. It’s trading on the New York Stock Exchange as Alcan on the one side, which is the primary aluminum company, and as Novelis, which is going to be the fabricated part of their business. So we think Alcan is making itself a higher-return company by spinning off the lower-return parts of its business. We like the dynamics of the industry and the company. We expect that the company will be throwing off free cash and we expect that the returns on invested capital will be increasing. We don’t believe those expectations are embedded in the current price of the stock.

Staff Editor Robert F. Keane can be reached at [email protected].


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