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Interview with Robert G. Moses, Portfolio Manager and General Partner of RGM Capital
Eurekahedge
September 2005

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%.

  1. 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.

  2. 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.

  3. 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.

  4. 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.

  5. 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.

  6. 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.

  7. 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.

  8. 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.

  9. 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
ECalkins@RGMCapital.com

 
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