Fund Focus: RS Small Cap Growth Returns From the Depths of 2008

Every now and then, I come across a portfolio manager who has an interesting take on investing -- and just happens to be recovering from some kind of nightmare. The retelling of it can be instructive in unraveling one of the great mysteries of life on Wall Street. That is, how to pick a great mutual fund -- or how to spot a bad one.

It's too early to decide which of those two labels fits the 13-year-old fund RS Small Cap Growth Fund (RSEGX). But its astute and experienced portfolio manager, Alison Thacker, who started running the fund in January 2007 with three co-managers in San Francisco, appears to be in the process of dragging it out of the worst-in-class category. That's where the fund landed in 2008. Now, Thacker is elevating it to a more appealing status.

Thacker's investment theme is compelling enough. She likes small-cap stocks because a small company tends to earn almost all of its revenue from a single product line. That gives the company more of an incentive to expand its market share than a large, diversified competitor that has multiple product lines. The large-cap company might just take a foot off one pedal to step on another at different points in various product cycles. "A small-cap company is truly able to participate in a product or service, almost as a pure growth play," she says.

Her methods also look sensible. She uses quantitative screens to distill the small-cap universe of about 3,000 stocks. Those that don't meet her criteria for long-term revenue growth, free cash flow, operating margin and other metrics get filtered out. That leaves a few hundred stocks to start doing fundamental research on -- visiting their offices, meeting their executives and so on. From that pool, she and her co-managers pick the approximately 80 stocks that the fund owns at any given time.

It Was a Very Bad Year

Thacker's first real test as portfolio manager came in 2008, the year the Standard & Poor's 500 Index fell 37%. This fund's performance was bad not only in absolute terms, but in relative terms as well. RS Small Cap fell 45.6%, not only worse than the S&P but also worse than 82% of the small-cap growth funds in the database of Morningstar, the Chicago-based firm that ranks mutual funds.

Thacker blames the underperformance on one of the smallest segments of the portfolio: "Somewhere between zero to 10% of the fund we invest in promising early-stage growth companies. Those can include IPOs and biotech. But I would say, in general, those were the types of companies in 2008 that investors did not want to own."

Ryan Leggio, a Morningstar analyst who covers this fund, has a simpler take on what went wrong. "It was just bad stock-picking," he says. "They were tested in a crisis, and they have to be retested in another." That, he says, could take years.

A Change for the Better

As the dust settled on the market crash, Thacker replaced some of the largest stocks in the fund. She says one that went was PROS Holdings (PRO), which sells predictive-analytics software suites to corporations to help them determine prices for their own products. But the financial crisis and a competing product cast a pall over PROS's future revenue growth. The stock fell 81% from $19.62 in December 2007 to $3.79 in March 2009, and closed at $9.93 on April 1.

A new company in the portfolio is Align Technology (ALGN), a dental-appliance maker that sells aligners, which are a clear plastic alternative to metal braces. The fund bought the stock for $17 to $18 between December last year and February this year, Align closed at $19.58 on April 1. It's now one of the 10 largest holdings. Melissa Chadwick-Dunn, one of Thacker's two co-managers, says Align could see its market share multiply.

From the fund's performance over the last 15 months, it's pretty obvious that Thacker and her two co-managers picked better stocks than they ones they threw out. In 2009, the fund grew by 47.7%. That was a better total return than 89% of the small-cap growth funds Morningstar covers. From Jan. 1 to March 31 this year, the fund is up 8.27%, beating 78% of its peers.

But RS Investment Management, which employs the portfolio managers, still hasn't found it easy to get people to invest in this $499 million fund. Investment flows have been flat for the last couple of years, meaning that investors are depositing no more than they're withdrawing. Apart from the underperformance in 2008, one reason could be that the minimum investment is $2,500, while some other funds require only $1,000. Or it could be the management fee, which was unusually high at 1.51% until January, when it was reduced to a below-average 1.35%.

Look Around Before Commiting

Statistically speaking, small is the right cap-size to invest in. Small-cap stocks outperformed large caps by more than three percentage points during the last 10 years, according to the American Association of Institutional Investors. But it's not clear that growth is the right style. Remember the Internet craze of the late 1990s? Startups that didn't even have profits saw their market cap grow rapidly. Thacker, who was an intern at Putnam Investments when she was studying for her MBA at Harvard Business School, recalls hearing "specious measures like eyeball count" being used to value Internet companies.

But if you've got your heart set on small-cap growth -- whatever the reason -- you might want to look at a few other mutual funds that claim to follow a similar strategy before you actually make a commitment. The more attractive ones, according to Morningstar, are Bridgeway Small-Cap Growth (BRSGX), Masters' Select Smaller Companies (MSSFX), Vanguard Explorer (VEXPX) and Wasatch Small Cap Growth (WAAEX). But do take care. These funds all did worse than the S&P 500 in 2008 and are now in the process of what looks like a long climb back up -- though not necessarily with the same extreme degrees of pain and euphoria as the RS fund.