Small gems

REVIEW SUMMARY
Company. RGM Capital
Industry. Money management
Key. Don't follow the crowds.

Tucked away in a small office complex next to King Richards Family Fun Park in Naples, Robert Moses and Edward Calkins have been quietly building a money management firm with impressive results.

Since 2004, shortly after Moses formed RGM Capital, the firm has posted annualized returns of 8.9% after fees, handily beating the 4.6% annualized returns of the Standard & Poor's 500-stock index of large U.S. companies and the 7% returns of the Russell 2000 index of small U.S. firms during the same period.

Over the most recent five-year period, one in which the markets were especially volatile, RGM exceeded the S&P 500 by 4.8 percentage points and the Russell 2000 by 3.9 percentage points on an annualized basis net of fees.

Most impressive, Moses and Calkins have achieved these results by forging a strategy that can't be easily replicated. Moses explains it this way: “Find a niche, put up good performance and you'll ultimately get a following.”

Moses, the firm's managing partner, and Calkins, chief operating officer, started RGM with $2 million of their own savings and money from friends and family. Today, they manage $175 million for about 40 institutions and high-net-worth individuals.

Moses and Calkins weren't neophytes to money management when they started RGM. Moses was managing director and portfolio manager at the legendary Naples-based investment firm Private Capital Management headed by Bruce Sherman from 1996 to 2002. Calkins was vice president in equity sales at Goldman Sachs offices in New York, Hong Kong and London from 1998 to 2003.

But both managers had an entrepreneurial streak. “Naples is actually a very good place to do business,” Moses says. It's away from money centers such as New York, where group thinking prevails. “It worked for Warren Buffett,” Moses quips, referring to the successful investor from Omaha, Neb.

Out-of-the-box style

It's hard to pigeonhole RGM's investment strategy, which is just the way Moses and Calkins like it. “We don't fit nicely in a box,” says Calkins.

To appeal to institutional investors, many investment managers adhere to a certain style of investing. For example, they might invest in stocks of large U.S. companies or fast-growing mid-sized firms. Others buy hundreds of stocks that mimic an index such as the S&P 500, deviating slightly to boost returns or minimize risk.

By contrast, RGM has its own distinct investment style.

Moses and Calkins start with this simple premise: “We're going to invest in the best industries,” Moses explains. These include software technology, health care and business services, which provide plenty of opportunities for growth and consolidation.

RGM avoids cyclical and mature industries, such as airlines and financials. The firm also doesn't invest in industries that are capital intensive or sensitive to volatile commodities.

Then, RGM scouts small companies with market capitalization of $100 million to $1.5 billion in those favored industries that trade at a discount to their value, have little or no debt and are well managed. Moses and Calkins meet extensively with the management of the companies they're considering so they can feel confident about the skills of the managers and the competency of the boards of directors. “You can't put that in a spreadsheet,” Moses says.

RGM looks for companies that make products that are critical to their customers. They ask: “If they disappeared tomorrow, would someone care?”

Moses and Calkins seek out companies with recurring revenues, such as royalties and maintenance agreements. They like companies that may have larger potential suitors who might pay a premium to acquire them.

Currently, RGM's universe of companies totals well over 300. But on average, RGM doesn't invest in more than 20 companies at a time; its current portfolio consists of 17 companies.

Because 90% of their liquid net worth is tied up in RGM, Moses and Calkins say they want to be certain of the financial health of the companies in which they invest. That wouldn't be possible if they invested in hundreds of companies, as many money managers do to diversify risk. “This is a high-conviction strategy,” Calkins says. Picking companies with no or little debt and a cash cushion takes a lot of the risk out of the investments, they say.

When they invest, Moses and Calkins buy a significant stake in the company so they have a voice in the affairs of the company. But both men are quick to say that they don't demand seats on the boards of the companies they invest in, and they prefer to make constructive suggestions rather than critique management.

Staying small

One of the challenges that successful managers who specialize in small-company stocks have is getting swamped with investor money because it gets harder to invest those funds as assets grow.

“Our intent is to stay small,” says Moses. He estimates the firm could manage up to $750 million and stick to its current strategy.

Currently, RGM has three employees: Moses, Calkins and Jason Krishnan, a research analyst. At most, Moses and Calkins say their firm will have six or seven employees.

The firm doesn't plan to invest in mid- or large-capitalization companies because analysts cover them widely and there are fewer opportunities to make big returns. Most of the companies RGM invests in have no analyst coverage from big brokerage firms.

While RGM buys and sells stocks of the companies it owns when opportunities arise, it's focused on being careful about generating taxes from selling. “We're not traders; we're investors,” Calkins says.

RGM's goal is to double investor money every five years, returning about 15% on an annualized basis over that period. It charges a 1% annual management fee and 20% performance fee based on achieving certain targets, lower than many hedge-fund competitors (RGM only accepts money from “accredited investors,” defined by securities regulators as individuals with at least $1 million of net worth, among other stringent requirements.)

But sometimes, RGM's cash position grows, especially when companies in the portfolio are acquired as occurred recently to four holdings. Currently, the portfolio contains 20% cash, but on average it has about 15%, Calkins says.

Moses acknowledges that the firm's small size and its unique strategy don't attract some bigger institutional investors. But he says that's what sets RGM apart from its competitors. “There's a lot of alternatives out there,” Moses says.

Focus: Accelrys

RGM's top holding at the end of 2010 was Accelrys, a San Diego-based developer of software that helps healthcare companies develop new drugs and materials.

RGM Capital Managing Partner Robert Moses says Accelrys (symbol, ACCL; recent price, $8) fits the firm's investment profile: no debt, a good cash cushion and it was undervalued when RGM started buying its stock.

What's more, Accelrys' managers have deep experience in the software industry and the board of directors actively oversees the company's management, Moses says.

Healthcare companies depend on Accelrys' software to manage and analyze vast amounts of scientific data.

Besides pharmaceutical and biotech customers, Accelrys also has clients in industries ranging from chemicals to aerospace, energy and consumer packaging.