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A Small-Cap Alternative

Sometimes you have to look past the obvious to find what you want. With slim pickings remaining among small-cap funds, RS Value -- a first-class mid-cap fund -- looks like the next best choice.

One by one, the best small-cap funds have closed to new investors. Third Avenue Small-Cap Value and Masters' Select Smaller Companies are just the two most recent.

What's an investor to do? If you aren't already invested in a terrific small cap fund, consider RS Value (RSVAX). The kicker: It's not a fund that invests primarily in small-capitalization stocks. Indeed, only about 5% of assets are in small caps.

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Rather, RS Value is an all-cap fund, meaning it invests in companies of all sizes. About two-thirds of the fund is invested in mid caps. The average weighted market cap is about $5.5 billion -- putting the fund firmly in mid-cap territory.

In today's market, when the most-gifted small-cap managers are essentially saying, "I can't put anymore money to work," I think a first-class mid-cap fund is a better bet than a second-rate small-cap fund.

And RS Value is a first-class fund. Manager Andy Pilara, 64, has been managing money for more than 30 years. And he seems to keep getting better at it. Over the past three and five years, RS Value ranks in the top 5% among all mid-cap funds. During those periods, the fund has returned an annualized 33% and 17%, respectively.

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Pilara and his six analysts manage $6.8 billion in this and other RS value funds, including small-cap RS Partners, which is closed to new investors. "The common denominator across the funds is that we're value investors, and we pay particular attention to free cash flow."

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Many fund managers regard free cash flow as a better measure of how a company is doing than earnings per share. Managements have more discretion in how they compute earnings than they do free cash flow. Free cash flow is essentially a company's reported earnings plus depreciation and other noncash charges, minus the capital expenditures needed to maintain the business.

Like most value managers, Pilara tries to figure how much a business is really worth, then tries to buy it at 30% to 50% below that price. But because he insists on companies that have solid franchises, his fund is more accurately labeled a mid-cap blend offering.

Pilara has been bullish the past few years on energy and basic materials, and he's not backing off yet. "Many energy companies are still selling at four or five times cash flow," he says. What's more, demand from China and India shows no signs of cooling, he says. Favorites include Talisman Energy (TLM) and Peabody Energy (BTU).

Pilara's biggest holding is Corrections Corporation of America (CXW), the nation's biggest private prison firm. A turnaround play, new management has cleaned up the company, Pilara says. "It was a mess." Of prisons, he adds, "Unfortunately, the long-term trend looks quite positive."

Is the long small-cap run close to an end? Small caps have beaten large caps six years in a row -- and are ahead again this year. That's the longest winning streak ever for small caps, except for a period of outperformance in the late 1970s and early 1980s.

Despite the possibility that the small-cap advantage may be due to reverse, I would suggest a terrific small-cap fund -- if I could find one worth recommending. Because I can't, RS Value looks like the next best choice.

Opinions expressed in this column are those of the author.

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