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Portfolio > Economy & Markets > Stocks

For the Long Term

By Bob Keane

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When it comes to mutual fund management, Bob Smith’s approach could easily be summed up as “Slow and steady wins the race.” Disdainful of those funds that frantically chase after gains, Smith has steadily steered the T. Rowe Price Growth Stock Fund, relying on solid research, a highly diversified portfolio, and a deep understanding of what’s taking place in the market to deliver consistent returns to shareholders.

Last year, the fund was up 31.23%, outperforming the S&P 500 Index, which returned 28.7%. For the one-year period ended March 31, 2004, its return was 35.41%, while its style peers returned 31.23%, the S&P 500/BARRA Growth Index 26.74%, and the S&P 500 Composite Index 35.11%. Currently, holdings in large companies in the consumer discretionary, financial, and information technology sectors (pretty evenly split) make up about 60% of the fund’s assets, while healthcare accounts for another 14%.

The key to the fund’s performance may lie in the ability of Smith and his research team to identify companies with consistent growth and stable earnings streams regardless of overall economic conditions.

The financial ratings community seems to agree that Smith is on the right track. S&P recently upgraded the fund from three stars to five, matching its Morningstar rating, while Lipper gives it high marks for overall returns and expenses.

How would you describe your investment philosophy? It starts with the underlying assumption we have, which is that, over time, stocks have cash flow and earnings growth, and the stock’s price will go up. That’s a pretty basic assumption.

What we then try to do is find those companies that have double-digit growth in earnings and cash flow over a three- or five-year base–in the 12% to 15% range. We sometimes find companies that are higher. United Healthcare, for instance, over time has been better than 15%, but a lot of our companies are in the 12% to 15% range. And we think that if we can pay a fair price, a fair price being somewhere near market multiples, then even if the multiples remain flat you can compound your earnings and cash flow. That’s pretty much what we’re trying to do.

We have a pretty deep research staff whose goal is to find those companies. On average, the market tends to expect earnings to compound at a 12% to 13% rate, though on average they compound at about 7%. So the [market] analysts are wrong.

I see it as an absolute return type of investing. If we find companies that can [grow that way], and pay a reasonable price on an absolute basis, we should offer pretty good returns.

How is what you are doing different than a fund that’s based on an index like the S&P 500? The S&P, if you think about it, represents the average company. So if you’re buying the S&P on average, you would think that the S&P should put your gross earnings at 7%, and that over time it should be that type of return plus whatever dividends you have.

What we’re doing is trying to find companies that have been 300 to 500 basis points higher in growth over time.

How big is the fund and how big would you like to see it? It’s about $6.5 billion now. We hope it gets to $50 billion.

Is this a team-managed fund? We have a lot of analysts, but I’m the one that makes all the investment decisions.

How would you describe your role with the fund? My job is to find ideas, to find companies that can grow earnings at a double-digit rate.

What makes this fund work? I think the first thing is that we have a pretty good research staff. We’ve done a reasonable job of actually finding companies that can grow. Second, we take a longer-term approach. I think one of the issues that has plagued a lot of other funds is that they tend to react. They tend to be like stock investors where they chase (the market) and buy things that have already gone up. We try to take a longer-term approach. Rather than trade stocks, we try to buy companies that can grow over time.

Does the size of the fund restrict you in any way? It is a large-cap growth fund, so it is restricted somewhat by the nature of what it looks at. At the very lower end of the market-cap range it can, at times, be restrictive, but only slightly. With the majority of our companies, it really doesn’t restrict us at all. In some ways it helps us. It helps us to be longer-term investors. So while the volume might be restrictive at the lower end of the market cap, I think it helps us to stick to our philosophy of long-term investing, because when you’ve got a big ship you can’t turn it in a few minutes.

Can you talk about your screening process? We’re looking at companies with over $4 billion in market capital. We’re trying to find companies that we think can have 10% plus-inflation-type growth, so [we're back to that] 12% to 13% growth. On occasion we’ll find something that’s a little less, but we’re looking for those companies that the research shows can have that growth.

Then we look into value, and the nature of what’s happening in terms of market share. We try to find companies that are taking market share, that have cultures that are enduring and prosperous, that are trying to improve, and that have very good information systems and capital allocation systems.

Since the end of the year you’ve made some shifts in your largest holdings, adding Dell, GE, and WellPoint Health into your top 10 while moving away from First Data, Cisco, and Comcast. What caused those moves? In terms of Wellpoint going up, it was a combination of the fact that I really like the Wellpoint/Anthem combination and that the stock had done well.

General Electric is a stock that we haven’t really owned that long. We had some for the long term, but it was a pretty significant underweight. I think that all GE’s issues are behind it by the second quarter of this year, and that after that you’re going to have a solid double-digit growth for the next five. I’ve become much more bullish on GE and I’ve been buying, but it’s not really going to show up in the numbers until ’05. So gradually we’ve been adding to General Electric. I think it will be a very good catch from the $30 to $31 level [as of April 19, GE was trading at $31.07]. It’s going to be a very good stock over the next three years.

With Dell, from looking at its numbers we’ve confirmed that the company is continuing to take share in many different segments. The stock hasn’t done much for the last couple of years, yet the company has continued to grow. So on a free-cash-flow basis, the stock has become much cheaper. And we do think there will be a corporate spend cycle on the back half of this year and next year, and Dell should be a beneficiary.

On the down side, with First Data, the internal metrics seem to be weakening a little bit. I think if you look at the company’s growth prospects, it’s somewhat less than we thought. It’s been an okay stock, but its growth is moderating.

If you look at Comcast, it’s because of [the offer to acquire] Disney–I didn’t think that made any sense. I like the Comcast assets. It’s a very good price for the stock, but I think it made a mistake: I don’t think it’s going to get [Disney]. I’ve held onto where I am.

With Cisco, when the stock hit 28 to 30, I sold some because I thought it was ahead of itself.

Are there any bargain stocks out there? How do you find them? Take a look at what I call some of the megacaps. GE would fit into that. Microsoft would fit. Citigroup and Pfizer would fit, as would AIG.

Over the last five years there’s been no absolute money made in these stocks. Forgetting relativity, these companies all pretty much doubled earnings. They’ve all come somewhere between growing earnings 80% and 120% over that five-year period. So that says that the wall has come down a lot, which is a combination of the fact that the price was too high in 1998 and 1999. But I think also that the cost is too low now for the types of growth that these companies have shown.

Look at those five as a basket. They all trade at about a market multiple, yet they are all dominant at what they do; they all have very good businesses. Does that make them cheap? I think if you buy them, you can get double-digit returns for the next several years without a ton of risk.

Lipper gives this fund its highest rating on overall return and expenses and its lowest on tax efficiency. Do you think those assessments are fair and accurate? Tax efficiency. That really gets me. One of the reasons it’s not been tax-efficient is because this is a very old fund and there’s a really low cost basis on a lot of these names. Then you go through a period like 1999-2000 where you tend to be shifting names because you get more conservative because the economy’s weakening. You get a little more aggressive in 2002, so there’s a little bit more turnover, even though it’s below average within the sector, and you create a lot of gains. [Lipper] looks at [tax efficiency] on a going backward basis, but going forward it should have much better tax efficiency.

When I took over the fund in 1997 the cost basis was 40 cents on the dollar. So I tend to take offense to that comment: it’s a backward-looking statistic.

I’ve seen this described as a conservative fund. Is that how you would describe it? It’s conservative in that we think the best risk-adjusted returns are in what we would call conservative growth companies. Historically, if you look at companies that are expected to grow 10% to 15%, those stocks tend to outperform the stocks of very fast-growing companies.

If the fast-growing company can maintain, it tends to be much better, but very, very few of them actually do it. What we try to do is give people very good risk-adjusted returns, so it is conservative growth. We’re not there because we want to be conservative. We’re there because we want to give the best return to shareholders over time.

Is this fund a core holding? Yes. Compare it to core volatile funds, such as any technology fund. Say our fund is up 12% over time and a tech fund is up 12%. If you ask which one is a better holding, I’d argue that it’s ours, for two reasons. First, we have less volatility for that return. Second, you are much less likely to make a bad investment decision. The problem with a volatile fund is that it’s apt to buy in after a stock has gone up, and apt to sell it after the stock has done poorly. It’s the nature of how people are. Because our fund is not as volatile, I think people are more apt to hold it.

What’s your turnover rate? It’s usually between 35% and 50%.

How does that compare with similar funds? It’s about half to a third. Every year we are less than half the average turnover, because of our philosophy of trying to buy over the long haul. That’s the better thing to do.

How important is the advisor channel in selling this fund? It’s become more important. I think it’s a good channel because people in that capacity are trying to make people money over time. They’ve realized that trying to make people fast money is not a good way to make a living. I think having a fund that can lead the market and do it with low risk is very good for us in terms of managing money, and it’s very good for them in terms of servicing their clients.

It’s an election year and the campaign has started early. What kind of an effect will this have on the economy and on investors? On the economy, I’m not sure, but from an investor’s point of view, it can be negative if it stays close. Uncertainty is always a negative.

What more can be done to put investor fears to rest after all the negative attention given to mutual fund companies? I think the time horizon for all people’s investing needs to get longer. Investing shouldn’t be approached like you’re at the casino looking for a quick score. And we all have to be more accountable.

Staff Editor Robert F. Keane can be reached at [email protected].

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