Online Extra: Mavericks in the Growth Corral

RS MidCap Opportunities' John Wallace and Jay Sherwood have earned good returns buying names that the typical growth manager wouldn't
The BusinessWeek 50

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 aren't 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 perceive as growth-oriented investments sets them apart from other money managers who hunt for growing companies, Sherwood says. The two managers scan for midsize outfits 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% in 2004. That kept it within walking distance of the average midcap growth fund, which was up 12.8%. The fund has topped its peers over longer periods. For the three years ended Jan. 31, it registered an annualized return of 7.6%, vs. a gain of 3.8% for its peers. Over the five years, it edged up 0.02%, compared with a loss of 2.3% for similar funds. Based on risk-and-return characteristics over the last three years, Standard & Poor's gives the fund a rank of 4 Stars.


  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 RS Invesment Trust adviser recently settled charges with the Securities & Exchange Commission that it allowed rapid-fire trading, the Sherwood- and Wallace-run funds weren't implicated.

Because of the bias Sherwood and Wallace have toward growth, you would expect them to seek companies whose top and bottom lines are expanding. Most of the time, the two stock-pickers do just that -- but not always.

"We may own some names that the typical growth fund manager wouldn't own," Sherwood says. "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 the situation is about to change.


  Take Gemstar-TV Guide (GMST ). The TV-program-guide company, one of the fund's top stocks, isn't profitable now, but it's generating cash, Sherwood says. 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 adds.

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

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


  Cytyc (CYTC ) illustrates a stock that the managers usually look for, Sherwood says. It's a medical-device maker he and Wallace like because of its leading position in the market for pap smear tests. Cytyc vaulted over competitors on the strength of its ThinPrep System for screening for cervical cancer, he says. Labs that use ThinPrep get better reimbursement from insurers and the government, and Cytyc collects a fee each time the product is used, Sherwood says.

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 notes.

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 trading at a discount to their historical prices and to the market.


  The fund, which usually holds 75 to 100 stocks, currently draws investments from a pool of companies with market capitalizations of $1.5 billion to about $18 billion, Sherwood says. 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 buying and selling decisions on the merits of individual companies, they also keep an eye on broader economic factors, such as the direction of interest rates and the dollar's relative strength, Wallace says. "We try to keep it simple: Is the economy going up, down, or sideways," he adds.

Concerning 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 the managers think can be replaced by a more promising investment.


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

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

By Richard Diennor, of Standard & Poor's Fund Advisor

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