| RGM Capital
is based in Naples, Florida, in the United States.
The firm was founded by Robert G. Moses who is
also the Portfolio Manager and General Partner.
The company manages two US equity funds - the
RGM Value Opportunity Fund LP (US$4 million) and
the RGM Value Opportunity Fund II LP (US$34 million)
- with total assets under management of US$38
million. Both of these funds are absolute-return
oriented and aim to exploit valuation extremes
in the marketplace.
The RGM Value Opportunity Fund LP has returned
21% since inception (June 2003), with an annualised
return of 9% and annualised volatility of 12%.
The RGM Value Opportunity Fund II LP has returned
16% since inception (September 2003), with an
annualised return of 8% and annualised volatility
of 12%.
- With so many funds available in the
market, what makes your fund different from
the others? What's your definable edge in terms
of strategy and market ability?
We think our fund is different in a number of
ways. First and foremost, we invest in businesses;
we do not speculate on stocks. While we invest
entirely in publicly traded companies, our investment
philosophy is more private equity-like than
many traditional hedge funds or mutual funds.
With this private-equity mentality, we manage
a very concentrated portfolio (10-20 positions)
of companies that we have researched intensively
- this too is different from many funds that
have significantly more diversified portfolios.
We invest in high-conviction ideas and build
large positions in companies (both as a % of
our portfolio and as a % of their shares outstanding).
Admittedly, a concentrated portfolio can lead
to more volatile returns, but we believe that
volatility often creates opportunity.
Our investment discipline is focused on finding
businesses that we feel are trading at 50% of
their intrinsic value based on our analysis
of their financial and qualitative attributes.
We spend a lot of time on corporate governance
and adhere to what we term as "value-added"
activism by partnering with portfolio company
management teams to enact change if we believe
certain actions are necessary to realise intrinsic
value in a business. For example, we will typically
not invest in a great business with a bad management
with the goal of enacting a management change
through proxy battles or challenging letters.
Rather we focus on businesses where we feel
we can work with management by sharing ideas
such as our view on capital structure/capital
allocation decisions, value creation through
share repurchase programmes, etc. Ultimately,
we hold management teams accountable to creating
shareholder value and will not let them off
the hook to do so - but over much longer and
more strategic increments than quarterly earnings.
Tax efficiency is also an important focus for
us. Given the long-term investment horizon (3-5
years) with which we expect to hold our positions,
we expect to be more tax efficient than many
funds as we would expect most of our gains to
either be long-term or unrealised in any given
year. Ultimately, after-tax returns are really
what matter.
We believe that our edge lies in our concentrated
approach and our independence. We believe managing
a concentrated portfolio is the best way to
preserve capital and achieve superior returns
over the long term. Concentration allows us
to be highly selective about our investments,
perform the type of in-depth research we think
is necessary in order to truly understand a
business and its management team's motivations,
as well as the ability and time to partner closely
with those management teams and hold them accountable
to creating shareholder value.
Lastly, we pride ourselves on our independence
from the broader investment community, which
emboldens us to be true contrarians. We consider
ourselves both geographically and behaviourally
removed from Wall Street and understand the
vital importance of conviction and patience
to being a successful value investor.
- What about the personal and business
histories of the team members? Is there any
positive performance track record? What's the
length of common work experience of all core
members of the team?
I founded RGM Capital in June, 2003 and am the
Portfolio and Managing Partner of the firm.
I started my career in 1991 as a sell-side research
analyst at McDonald & Company in Cleveland,
Ohio. During my five years at McDonald I published
on industrial and consumer-related industries.
In 1996, I moved to Private Capital Management
here in Naples, Florida. PCM is a value-oriented
manager that has consistently been ranked as
one of Nelson's top money managers for the past
ten years, with compound annual returns in the
low 20% range. I spent six years there, most
recently as a portfolio manager and managing
director. In addition to focusing on industrials,
I also researched the technology and healthcare
industries at PCM. Throughout my 14 year career
I have researched a significant number of companies
and have built contacts in the industrial, healthcare,
technology, and consumer-related industries.
I received my bachelor's degree in finance and
real estate from The Ohio State University in
1991.
Ed Calkins is our Chief Operating Officer, and
oversees all non-investing business-related
functions at our firm including marketing, service-provider
relationships, and compliance. He spent nine
years with Goldman Sachs & Co in New York,
Hong Kong and London in Institutional Equity
Sales & Trading and Equity Capital Markets.
Ed received his master's in business administration
from Cornell University in 1994 and his bachelor's
degree in history from Princeton University
in 1992.
Ben Brodkowitz is a research analyst at RGM
Capital. Ben was hired recently (April 2005)
to help me with all aspects of the investment
research process including financial modelling
and due diligence. Ben graduated from Emory
University with a bachelor's degree in business
administration in 1995 and became a CPA at Ernst
& Young. Ben completed his master's in business
administration at Cornell University in 2002,
where he was involved in that school's student-managed
hedge fund - The Cayuga Fund. Most recently
Ben was employed as a trader and analyst at
John Henry & Company.
- Is there any reason to have two funds
especially when your investment mandate, strategy
and base currency are exactly the same for both
of them?
We currently have 2 funds, The RGM Value Opportunity
Fund which is a 3c1 fund and the RGM Value Opportunity
Fund II which is a 3c7 fund. As we manage both
high net worth and institutional money, we have
two funds because of the legal and structural
issues associated with 3c1 and 3c7 classification.
Therefore limited partners in the 3c1 fund are
generally high net worth individuals, while
the majority of limited partners in the 3c7
fund are institutions.
- You tend to focus on healthcare,
technology, business services, industrials and
consumer products etc. With only one research
analyst on your team, how strong is your in-house
research? Do you rely on other independent sources
too?
We acknowledge that we are fishing in a pretty
large pond when we say our focus is on industrials,
healthcare, technology and consumer-related
businesses, but we tend to focus predominantly
on market caps of US$100 million to US$1 billion,
so the universe of companies we look at is more
targeted than one may initially believe. In
addition, because we run a concentrated portfolio
of 10-20 positions we do not need a "stock
of the day" or for that matter a "stock
of the week." We can be extremely selective
about what goes into our portfolio, and ultimately
we would rather know an enormous amount about
a few companies and industries than know a little
about a lot of companies and industries. With
this type of approach we think that our research
effort is appropriately staffed. Admittedly
though, our idea generation still involves a
lot of heavy lifting, so it is worth talking
about it in some detail…
Most importantly, we have very few contacts
in the buy-side community and therefore do not
consider ourselves in the flow of the idea-sharing
networks that many hedge funds use (ie instant
messaging, idea dinners, etc). In addition,
we do not use Wall Street research. We think
that level of independence is an edge - it allows
us to be true contrarians by filtering out the
noise or buzz in certain ideas while avoiding
"group think."
At any given time we may be looking at 10-15
companies for potential investment, and usually
end up selecting one or maybe two for the portfolio
after several months of research. The challenge
we face is finding those original 10-15 ideas.
There are quantitative and qualitative elements
that going into finding our ideas. We like to
find businesses that would not show up on traditional
value investor screens because the company's
valuation based on recent results may not tell
the whole story. For example, a company may
have a money losing segment that is masking
their income statement, where if they sold the
segment or shut it down, the true earnings power
of the company would be revealed. Or perhaps
it is something as simple as seeing insiders
buying stock in their own company.
We tend to focus on companies in the market-cap
range of US$100 million to US$1 billion for
a number of reasons. First, because of their
size many of these companies are orphaned by
the sell-side and therefore have very little,
if any, analyst coverage. This means there is
probably less understanding about the value
creation potential of the companies we research.
Second, we like the micro/small-cap segment
because of the potential for privatisation or
acquisition. Sarbanes-Oxley and the overall
costs of being a public company in the US are
much more of a burden for small businesses than
for large businesses. Going private to eliminate
those costs, or selling out to financial or
strategic buyers, are trends that we think will
continue for small public companies and are
very viable alternatives for value creation.
While on the topic of consolidation, it is worth
noting that the industries we follow have historically
been areas where there is a lot of M&A.
Therefore researching and understanding the
reasons certain companies are acquired and the
reasons the buyers pay what they do is relevant.
It is a good starting point for identifying
which companies in an industry are still independent,
what they might be worth to an acquirer, and
if they are a suitable investment opportunity
for us.
Ultimately there are qualitative and quantitative
elements that go into our sourcing ideas, and
the vast majority of the time our research process
results in us NOT making an investment.
- Do you do company visits?
Company visits are generally a prerequisite
for our building a position in a company. We
can glean a lot from talking to management on
the phone, as well as to their competitors,
suppliers, clients, etc. But until you spend
time with a management face-to-face and see
how they react to difficult questions as well
as see their corporate headquarters to get a
feel for the culture you don't really know a
company and what is motivating management. The
time that we spend on a company's turf is invaluable.
- RGM funds have witnessed a lot
of volatility since inception, most of which
is bad (downside deviation). This has put the
Sharpe ratio in the range of 0.6-0.7 for both
the funds. With such high volatility how do
you think RGM Capital could be made sustainable
and scalable at the same time going forward?
Unlike most funds today we do not manage ours
to mitigate volatility. To some that is nonsensical
in today's environment where low volatility
returns are one of the keys to winning large
institutional mandates. But as a value investor
with a long-term approach to our investments,
downward volatility creates opportunity to add
to positions at cheaper valuations - and that
is exactly what we have done during every drawdown
that we have been through. In addition we will
not stop-loss ourselves out of a position. From
a value investor standpoint that is counterintuitive
- why sell a stock that is getting cheaper when
you have an enormous amount of conviction in
the research you have done on it? Ultimately
we firmly believe in and practice the adage
that we would rather have a lumpy 15% return
than a smooth 12% return. That philosophy was
coined by one of the greatest investors of the
modern era - Warren Buffet - but it does not
appeal to everyone.
With respect to our overall performance since
inception there are a few things worth noting.
First, our typical holding period for an investment
is 3-5 years. As we have been in operation for
a little over 2 years we feel we are still in
the early/middle stages of our overall portfolio
reaching fair value. We buy businesses that
are significantly undervalued because other
investors have given up on them and sold their
stock down to very compelling levels from a
risk/reward standpoint - or we buy businesses
that are in some sort of transition that at
some point in the future will reveal their true
value. Under both scenarios it takes time for
the market to recognise and reward these companies
with higher valuations. We are very willing
to play that waiting game with the companies
in our portfolio - most of which we have held
since starting our funds. In addition, because
of our research process we were very methodical
about investing up our initial capital. Therefore
we did not become what we consider to be fully
invested (ie 85% of capital) until June, 2004.
Accordingly our returns in the second half of
2003 and the first half of 2004 were diluted
by our high cash balance. Our unaudited compound
gross return on invested capital since inception
works out to +101% for RGM I and +53% for RGM
II, which hopefully give additional credence
to our stock picking capabilities.
We believe our philosophy and business are highly
scalable. With a concentrated portfolio we do
not need an army of research analysts and there
are more than enough stocks in the industries
and market cap ranges that we tend to focus
on. Moreover it is easier to manage a business
from a budgeting/overhead perspective in Naples,
FL than it is in a major city. Our breakeven
point is much lower than it is for most funds
that reside in higher cost centres.
Lastly, I suspect your reference to scale infers
asset growth. With the strategy we employ we
know we need to be very smart about the types
of limited partners we admit to the fund and
their appetite for volatility as well as their
own track record of dealing with it. Understanding
things such as their track record/behaviour
of dealing with managers during a drawdown,
how long have they been invested in strategies
like ours, and asking for a list of managers
they are invested with as potential references
are all critically important to building out
the correct limited partnership base. Given
we focus predominantly on small-cap names, which
we think is very fertile territory given our
style of investing and value-added activist
approach, we fully recognise that there is a
limit to the amount of assets we can manage
before we would need to start investing in larger
companies. That threshold amount is much larger
than where we are today in AUM, but growing
correctly to get to that level is what is most
important.
- What is your focus on risk management?
Our risk management tends to be more qualitative
than quantitative, and we believe it is ultimately
derived from the types of companies we invest
in. They tend to be very high quality businesses
with defendable market niches, so the risk of
a competitor blind-siding them with a new technology
or an ability to under price them is somewhat
limited. In addition, we tend to invest only
in companies that have limited debt or more
often net cash on their balance sheet, and are
generating consistent free cash flow. With all
our investments we seek to quantify downside
protection which we would define as a level
where a company's valuation is unsustainably
low. Cash on the balance sheet, or a large installed
base that generates a recurring royalty stream
that we can apply a net present value to, can
give us the downside protection we look for
in our investments. Certainly some companies
with those attributes have traded below net
cash - this occurred in Q3 2002, for example
- but those types of valuations tend to be unsustainable
and often represent the best opportunities for
significant returns on investment. In addition,
we enter every idea with a belief that there
are multiple ways to make money on the investment:
ether management will fix their business and
realise value, or they will make some sort of
transformation to unlock value (ie shutting
down or selling a loss-making business), or
a competitor will unlock the value themselves
by acquiring the company. Ultimately we believe
the best risk management is our research. Truly
understanding a business both on a stand-alone
basis, as well as in the context of its industry
can be a very effective risk management tool.
But also knowing what drives a company's management
team and its board is vitally important. Is
management simply working for what we might
consider an overly-indulgent salary? Are they
flush with options and therefore more apt to
take risks that might not be in the interests
of shareholders in an effort to grow their company?
Are they empire builders? When was the last
time they bought stock in the open market? These
are questions that we attempt to answer before
buying share one of a company.
- How much capital do you intend to raise
this year? Is their any pre-defined plan?
We currently manage just under US$40 million
and we certainly want to increase our assets
under management before doing a soft close,
but that goal is driven largely by our desire
to increase our positions in certain of our
portfolio companies and becoming more influential
shareholders to them. Thus far we have filed
one 13D as a 5% shareholder in one of our company's.
With additional capital and larger position
sizes (as a % of a company's shares outstanding),
we would absolutely expect to make additional
public filings and feel that is a very effective
mechanism for raising our profile with management,
making our views known, and holding them accountable
to making decisions that are in the interest
of shareholders. That is not to say that 13Ds
are the only mechanism for creating value, in
fact, most of the situations we have been involved
in since inception of the funds where value
has been created have been without public filings;
but it is another tool that plays into our belief
of having multiple scenarios from which we can
make money on an investment.
It is worth noting that we do not have any misperceptions
about the capital raising market - given our
concentrated approach and the inherent volatility
that goes along with it, the number of investors
that have an appetite for what we do is a small
subset of the community that invests in alternative
assets. We therefore try to be as smart and
as targeted as possible about talking to potential
investors by understanding their track record
of investing in concentrated managers and their
stomach for it. It is very refreshing when we
find them because we find we talk the same language
- cash flow yields, after-tax returns, corporate
governance, etc.
- Finally, what are your views on the
North American markets for the rest of the year?
We try to steer clear of making market calls,
largely because (1) our portfolio companies
tend to beat to their own drums regardless of
market conditions, and (2) our prognostication
will invariably prove wrong - no one really
knows. That said, the valuation of the overall
market looks reasonable to us. The S&P 500
currently trades at about 16x forward earnings,
or a 6.25% earnings yield. That is not bad considering
the US 10-year treasury bond yield is below
4.5%.
Given our focus on free cash flow, earnings
yields are less relevant. Historically, we would
have argued that for the majority of companies,
GAAP earnings were overstating the true free
cash flow of the entities due to under depreciated
assets, unrecognised options expense, and pension
accounting. We would argue, however, that the
spread between GAAP earnings yields and FCF
yields have narrowed a bit, as phantom pension
income (courtesy of the bull market of the late
90's and overzealous pension return assumptions
made by management) has switched to pension
expense on the income statements of many companies.
Also, corporate capital spending has been subdued
over the last several years. That has resulted
in many companies with lower capital expenditures
than book depreciation and amortisation. And
while no one has figured out a perfect approach
to account for options expense, there has been
a concerted effort to at least realise it is
a big cost that needs to be addressed. We are
not saying that companies are now understating
earnings, but at a minimum, earnings are perhaps
a better proxy for free cash flow than they
have been in the recent past.
Importantly, we believe there is always value
to be found, regardless of the broader market
levels. Traditional value stocks (industrials,
conglomerates, etc) were very cheap during the
tech bubble at the end of the decade. Few investors
wanted to talk about slow growth, cash generative
businesses at that point. In late 2002, there
were a lot of "busted" technology
companies that were interesting as many traded
below net working capital and often below net
cash. The investors that couldn't own enough
of these companies in 1999 couldn't get out
fast enough three years later.
Currently, we are finding very interesting companies
that have often been viewed as "growth"
businesses. For example, we are currently invested
in several software companies. Software is interesting
to us for several reasons. First, many software
companies have large installed bases and significant
customer mind share, which makes it very difficult
for customers to rip them out of there workflow
and therefore allows software companies to extract
profitable maintenance dollars. Second, there
is a lot of M&A activity in the software
industry. Financial buyers are sniffing around,
attempting to latch on to consistent maintenance
revenue streams, while strategic buyers are
looking for growth. Lastly, and most important,
we have found several software companies that
are trading at 10% free cash flow yields. It
is very intriguing when you can get a double-digit
cash yield on a better-than-average business.
Contact Details
Edward T. Calkins
RGM Capital LLC
1 239 649 0878
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