Manager avoiding wild price swings

Investing in the commodities markets without actually buying commodities enables the managers of the RS Global Natural Resources Fund (RSNRX) to look beyond such basics as the fluctuating price of corn. The $2 billion mutual fund, offered by San Francisco-based RS Investment Management Co. LLC, is the primary responsibility of three portfolio managers: Mackenzie Davis, Kenneth Settles and Andrew Pilara. “We're value investors, and we maintain a rigorous focus on return on invested capital,” Mr. Davis said. The fundamental premise of the fund is to offer investors an opportunity to gain exposure to the commodities markets without dealing with the anxiety and uncertainty that often comes with wildly unpredictable commodity prices. “We would agree that investing strictly in a commodities index can be a benefit as commodities move up or down, but it is the companies that create value,” Mr. Davis said. The team's research has shown that in aggregate, over long periods of time, commodity producers rarely generate much value beyond the fluctuation in commodity prices. Their strategy involves a bottom-up approach toward finding companies that have an edge regardless of the direction of commodity prices. “We want to identify and own the companies that will earn excess returns above the cost of capital,” he said. “As opposed to just assuming natural-gas prices are going up and then buying natural-gas companies, let's find the companies with differentiated assets.” Mr. Settles explained that commodity prices are cyclical in nature, but the returns on invested capital within each company “are extremely different project by project, and that's what we're searching for.” Because the management team doesn't believe that specific commodities create an investment value, there is very little emphasis on the direction of commodity prices, which is a strategy that runs contrary to most investors in this sector. “On a commodity-by-commodity basis, we can see supply coming into the market, because the supply response happens, and commodities are still cyclical,” Mr. Davis said. “But we don't pretend to know or understand short-term price fluctuations.” If RS Investment Management does focus on commodity prices, it will involve a conservative analysis of what a specific commodity price needs to be in order for a company's project to make economic sense, according to Mr. Settle. The all-cap global portfolio, launched in 1995, is typically concentrated in fewer than 40 positions with a notably low annual turnover rate of around 25%. The low turnover rate underscores the value-based research process, which involves spending a lot of time visiting with companies in pursuit of stocks that can be held for between three and five years. “We're like private-equity in-vestors in the public markets, and we believe he who knows the most over the long-term wins,” Mr. Davis said. One of the positions in the fund that illustrates the advantages of looking at a company independent from the commodity it produces is Fort Worth, Texas-based XTO Energy Inc. (XTO). While the price of natural gas has moved virtually in tandem with the American Stock Exchange Natural Gas Index over the past 12 years, mostly experiencing negligible cyclical movement, both XTO's return on invested capital and its stock price have continued to test new highs. This year through last Thursday, XTO's stock had gained more than 33.4%, which compares with an 8.78% gain by the Standard & Poor's 500 stock index over the same period. In order to ensure a focus on preserving capital, one stress test every stock must pass involves showing a potential for $3 to $5 worth of upside for every $1 worth of downside risk. “We think the key to guaranteeing returns is losing less during cyclical downturns,” Mr. Settle said. The portfolio's current largest sector weighting is a 30% allocation to oil and gas companies, followed by a 25% weighting in metals and mining stocks. Energy service, coal, utilities and chemical-industrial sectors each have 10% weightings. The management team also favors keeping between 5% and 10% of the portfolio in cash, which helps defend against investor emotions, Mr. Davis said. The fund, which has a three-star rating from Chicago-based Morningstar Inc., had gained 25.16% for the year-to-date period ended last Wednesday. That compares with a 27.66% gain for the average fund in its Morningstar category and an 8.55% gain for the S&P 500 over the same period. Questions? Observations? Stock tips? E-mail Jeff Benjamin at -jbenjamin@crain.com.