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Portfolio > Portfolio Construction

Passing the Baton

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What’s the secret strategy for a fund that holds the distinction of 15 consecutive years of positive total returns? “We think like financial planners,” says Stephen Boesel, portfolio manager of the $8 billion no-load T. Rowe Price Capital Appreciation Fund (PRWCX) with colleagues Jeff Arricale and David Giroux. “We start with an investment objective, take a long-term investment horizon, we’re patient, we diversify, we rebalance tactically, we understand that costs are important so our overall costs and trading costs are low, and last but not least, we try to think of dollars, rather than percents,” says Boesel.

Boesel, who announced his retirement about a year ago, will hand over primary responsibility of managing the fund’s portfolio at the end of June to Arricale and Giroux. Boesel has been the primary manager of the fund since August 2001, and will remain on the investment committee at least through the end of 2006.

This asset allocation fund’s consistently positive returns have helped it earn Standard & Poor’s five-star ranking overall, and in each of the one-, three-, five- and 10-year periods. The fund earned an average annual 12.03% total return for the 10 years ended May 31, versus 7.01% for its S&P Hybrid U.S. Equity peer group; 9.72% versus 3.42% for five years; and 14.03% versus 8.79% for the three-year period.

How different will the day-to-day management of the portfolio be once [the changeover] occurs?

Arricale: Our shareholders shouldn’t notice any difference. We view the world from a reasonably similar perch: a focus on valuation; contrarian, out-of-favor stocks and sectors; a curiosity about bonds and convertible bonds; thinking beyond equities; and finding the most attractive part of the capital structure.

Boesel: The fund will have a 20-year anniversary at the end of this June, and there have been three portfolio managers [over that whole time.] The philosophy has always been the same, always drawing on the T. Rowe Price research department.

How long have you worked together on this fund?

Boesel: They’ve been members of the advisory committee, in David’s case, I think at least three years, I believe, and in Jeff’s case, the last year-and-a-half or so.

You’ve had a remarkable 15 consecutive years of positive returns for the fund. How have you been able to do that?

Boesel: I think there are three elements that have to fall into place for us to be successful. Flexible portfolio management–we have the flexibility to own various asset classes so that gives you the potential to be right, and enhance your return in other areas when the equity market isn’t doing well. We have quality research input, [and we] rely heavily on credit analysts in addition to our equity analysts; and third, rigorous evaluation work. It’s the combination of the three of those things that have let us be successful.

What’s your investment process for the fund?

Boesel: By charter we [must] have a minimum of 50% of the portfolio in common stocks. That’s why it has an equity orientation, but what makes this portfolio unique is [getting] our fixed-income exposure through convertible bonds and high-yield securities.

Giroux: We have, between fixed-income, international, and domestic equities, 118 analysts that are constantly generating ideas for us. We have 50 different quantitative screens–everything from the standard low P/E, high dividend yield, and some others that are free-cash-flow or earnings-quality focused, [to] things that can help identify securities before they blow up. Jeff and I travel; we have met with almost every single company in the portfolio; last year we met with over 200 companies internally, and we saw over 200 companies at conferences.

Arricale: Within T. Rowe Price, this product is the most total-return focused. If the stock market was down 15% and we were down 13%, you might think that’s a success; we would not think that’s a success–we’re really trying to make money.

In a negative market how do you generate a positive return?

Giroux: Over time this product is probably going to have a larger cash position than the average mutual fund. That will allow us to pounce when the market crumbles, and that cash will not go down if the market goes down. We have a convertible exposure that is somewhere in the high teens as a percentage of assets today–that convertible exposure does limit the downside because a convertible is essentially a bond with a call option. Our convertible exposure should buffer our downside.

Do you think of the fund as an asset allocation fund?

Boesel: Yes. We think that’s an important component to it. In this last market cycle, we say it was stress-tested during the bear market in which the S&P 500 from its peak to its trough had close to a 50% decline. How did we get through that? In order of importance, the value sector of the marketplace had been such a laggard in the late ’90s that it was really priced for opportunity; [we did not own] one single technology stock, and the rest of the market was doing actually pretty well. But the equity exposure of the portfolio was right down along the minimum, 50%, and that exposure turned out to be reasonably safe. Secondly, we had close to the rest of the portfolio in converts and conventional fixed-income; when the stock market was getting hammered, the bond market turned out three consecutive years of double-digit gains. So we had that half of the portfolio hitting positive returns.

What about some of your largest holdings?

Boesel: One of our largest holdings is General Motors. We actually own three GM securities and we have a profit in all of them because there are unique features to them. David was also a General Motors analyst.

Giroux: The security with the largest exposure for us is the GXM convert. This is a convert that does not mature until around 2030 or so–it’s a very long-dated convert, and it’s very far out of the money–so it’s really a bond more than anything else. The equity value of this security is very limited. This security has a put feature. [In] March 2007, we can put this instrument back to General Motors for $25, so this really isn’t 30-year paper. It had a 4.5% coupon yield. In the [event] of bankruptcy, most converts are junior to other forms of debt; this convertible was equal in the capital structure to all other forms of debt. We saw $20 billion of cash on [GM's] balance sheet, $10 billion of additional VEBA Trust assets, (that they can use over the next three or four years to pay down their healthcare costs); they’re selling half of their credit subsidiary and they’ll get another $10 billion plus in the door over time for that. So we saw a company with close to $40 billion of liquidity potential, which is not going to be that negative in terms of free-cash-flow this year.

What about one you liked that just didn’t work out so well?

Boesel: Usually we’re correct in identifying a good price level, but it often takes a lot longer for the market to reward it than we expect. One of our other large holdings is Marsh & McLennan (MMC), a security that Jeff follows.

Arricale: It’s been a very frustrating investment. It’s probably our second- or third-largest position. Marsh & McLennan is a collection of four businesses: the largest insurance broker in the world; Putnam [Investments], one of the largest asset management companies in the world; Mercer [Inc.], a global consulting firm; and recently it acquired Kroll [Inc.], an investigative firm and consultant. We owned the stock in a number of our growth portfolios and value portfolios for a number of years, it was trading in the $40s, and looked attractively valued; we had bought it because Putnam was having a tough time after the mutual fund scandals and the bubble. Here you have the biggest and best insurance brokerage, a world-class consulting firm, and a broken asset manager that can be fixed. Our evaluation work suggested [that] in the low $40s or high $30s you were getting Putnam for free.

Then the Eliot Spitzer investigation hit and Marsh, it turned out, was engaged in unethical and illegal behavior in the form of bid rigging. Obviously, that wasn’t part of our investment thesis; the stock promptly dropped into the $20s in a matter of days. It was a very dicey situation and it was unclear what the company’s earnings power would be. Our work suggested that Marsh was going to be a less profitable insurance broker going forward, but they were still one of the only global, go-to insurance brokers out there, and they still had power in the marketplace. That was our thesis, along with the belief that new management at Putnam would turn the company around and that the consulting businesses would continue to do okay. Underpinning all this we thought we had a solid balance sheet, and these businesses kick off a lot of cash; there’s a good amount of leverage on the balance sheet now, but it’ll be quickly paid down.

The market is unwilling to pay up for earnings power that might not manifest itself until the second half of 2007 or even 2008. The company has had to cut the dividend. We’re stubborn investors, we’ve continued to add to the position as time has gone by. As the stock has fluctuated between, say, $28 and $32, we tend to buy a bit more when it dips into the $20s. We think over time we are going to get paid…in a number of ways. We think that if the company broke itself up, you could completely eliminate the corporate overhead and sell these three or four businesses off–there’s really no need for all these businesses to be together–and we think we’d see something with a four in front of it rather than 28 now. Or they sell off just one or two pieces of their business–Putnam would make a great LBO candidate–or they get it together and the businesses start clicking and produce some decent double-digit earnings growth that is sustainable.

Where does this fund fit in an individual’s portfolio?

Boesel: It seems to appeal to investors that are relatively new to the investment game, and they aren’t sure what to do, they don’t want to take a lot of risk, and they seem to find their way to this fund.

Giroux: Jeff and I have all of our 401(k) money is in this product. We’re both very risk averse; we thought it made sense to put our money where our mouth is.

Staff Editor Kate McBride can be reached at [email protected].

For a longer and more detailed version of this interview, as well as, “In The Running,” a list of the other funds we considered for this month’s profile and that you may find of interest, go to “Web Extras” at


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