In founding his firm, Thomas Rowe Price Jr. believed that investors could earn superior returns by buying well-managed companies in fertile fields whose earnings and dividends could be expected to grow at rates faster than those of inflation and the overall economy. Robert W. Smith, portfolio manager of the $9.6-billion T. Rowe Price Growth Stock Fund (PRGFX), follows the same principle.
Smith seeks companies that excel in cash generation, have well-structured business models, and possess the ability to re-invest capital at very good rates of return. Standard & Poor’s, Business Week Excellence in Fund Management Awards recently recognized Smith for his proven history of strong management, anchored by a track record of consistently sound returns.*
For the one-year period through April 29, 2005, the fund gained 3.64%, while the average large-cap growth fund rose 1.62%. For the three-year period, the fund gained 3.86% (annualized), beating the peer group, which edged up 0.83%. Similarly, for the five-year period, the fund dropped 2.11%, while the peer group plunged 8.43%.
Smith’s investment philosophy and stock-selection process have generally remained consistent: he buys companies with increasing market share, good management teams, and good use of cash flow, noting that such companies tend to prosper during difficult times. More importantly, Smith is interested in fairly priced companies that will grow in value over time, provide a favorable return-on-capital, and, in particular, generate at least 15% return-on-equity.
Smith’s research team focuses on individual sectors (most often in growth-oriented businesses) by analyzing their historical performance and outlook. Once the sector has been selected, individual securities are evaluated and chosen with long-term goals in mind.
As of April 30, 2005, the fund’s top sectors consisted of information technology, 24.4%; financials, 18.7%; consumer discretionary, 17.3%; healthcare, 13.1%; industrials and business services, 8.4%; consumer staples, 6.1%; and energy, 4.5%.
Prior to the dot-com implosion, Smith kept the portfolio underweight in technology stocks, adopting a more conservative approach. Now it ranks as the fund’s top sector. Despite the recent slide in technology equity prices, Smith believes sector fundamentals will begin to improve and achieve good growth, demand, and valuations for the first time in years. Within the tech sector, Smith feels his odds of owning Hewlett-Packard (HPQ) are slim to none, citing its lack of proprietary business and decreasing market share. On the other hand, Dell Inc. (DELL) is gaining ground; Smith feels the company is well-managed and uses capital favorably.
Smith attributes a significant portion of the fund’s outperformance to his energy holdings, which were boosted by record high oil prices. Additionally, the materials sector generated good returns largely due to strengthening global demand for commodities, especially from China.
While Smith presently has an overweight position in healthcare, including such names as UnitedHealth Group (UNH) and WellPoint Inc. (WLP), he is steering clear of the pharmaceutical industry.
Smith maintains a diverse portfolio of stocks with a long history of growth, thus mitigating each individual company’s risk. With respect to volatility, the fund features a Sharpe ratio of 0.16, versus the peer group average of -0.04.
As of March 31, 2005, the fund’s ten largest holdings comprised Citigroup Inc. (C), 3.26%; Microsoft Corp. (MSFT), 2.95%; General Electric (GE), 2.70%; UnitedHealth Group (UNH), 2.64%; American International Group (AIG), 2.33%; Wal-Mart Stores (WMT), 2.31%; WellPoint Inc. (WLP), 1.80%; Dell Inc. (DELL), 1.75%; Tyco International (TYC), 1.72%; and Danaher Corp. (DHR), 1.62%. The portfolio totalled 117 holdings.
Among the top holdings, Smith especially likes Citigroup for its favorable risk-reward ratio, in addition to an 11%-12% growth rate, 4% yield and strong management team.
Smith unloads stocks from his portfolio when double-digit earnings growth is no longer achievable. Moreover, he sells only when the stock bounces back to a set target price, thereby avoiding major losses. Smith also disposes of stocks when presented with better ideas, absorbing the new holding and shedding his most worrisome stock. During unfavorable market conditions, Smith takes on a more aggressive stance, tilting towards economic growth and risk — buying risk when the market is selling it, and selling it when the market is buying.
However, Smith trades far less often than other large-cap growth managers — his fund has a modest turnover rate of 30.70%, compared with a 87.55% peer group average.
Large-cap growth managers like Smith have been facing some challenges — funds in this category have gotten the cold shoulder from investors as a result of poor performance in the early part of the decade, while value portfolios have outperformed. Indeed, for the five-year period ended April 2005, as the average large-cap growth fund shed 8.43% and the average small-cap growth fund lost 4.16%, small- and large-cap value funds gained 11.99% and 2.97%, respectively.
Smith asserts that one of the major factors impacting the large-cap growth sector in recent years lies with the theory of “multiple compressions.” This occurs when a stock trades at a certain multiple and, while earnings may be strong, the equity price doesn’t move up (or even goes down). As a result, the given P/E multiple is reduced, even though nothing is fundamentally wrong with the company. Compression of a stock’s multiple can be interpreted as investors questioning its valuation. The multiple is based on many factors, but most importantly, the company’s future growth expectations. Generally, investors would only pay higher multiples on prospects that the company will grow significantly faster than its competitors or markets in general. When a company’s growth rate starts to slow, investors might start to doubt its prospects, and not pay an expensive premium.
Looking forward, Smith feels quite bullish about the economies of the U.S. and other developed markets, forecasting expansion for the remainder of the year, although at a slower pace than that of 2004. Economic growth in 2005, he believes, will likely be accompanied by slightly higher inflation and interest rates, resulting in positive, but not spectacular, stock market returns. He particularly expects the consumer discretionary sector to perform well.
*S&P’s methodology for the Excellence in Fund Management Awards is built upon funds that have received a BusinessWeek category ranking of “B+”. The BusinessWeek methodology uses the five-year total return of the Standard & Poor’s 500 Stock Index as the underlying benchmark. Using the BusinessWeek category fund rankings, the top 7.5% of the funds are assigned an “A” score.
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