RULE MAKER PORTFOLIO

Rule Maker Portfolio
T. Rowe's Matador Management
Using the Cloak to Confuse the Bull

By Bill Mann (TMF Otter)

ALEXANDRIA, VA (Oct. 4, 1999) -- It's Monday. I'm about 5 cups of coffee short of where I'd like to be. Not even my pick me up staple of a good James Brown jam helped balance my humors. You know you are in trouble when lines like "I don't know karate, but I know Ca-razy" fail to get your funk moving in the right direction.

Sometimes a good kvetch is the best thing going. So, with that in mind, I'm going to talk about my least favorite Rule Maker company -- the one which I would be most apt to sell -- T. Rowe Price (Nasdaq: TROW). Why? Well, for one because as a Fool I have a difficult time with the concept of investing in an equity management company, since my raison d'�tre is the antithesis of that of the T. Rowes of the world.

But that's just cranky, isn't it? After all, my hero Warren Buffett once stated that in investing the accumulation of wealth is in and of itself a moral imperative, a sentiment that I do not buy into 100%. I still can't get my indignant hackles up too much about a financial management company from a morality standpoint. Mutual Funds ain't pornography, after all.

That said, I do think that there is a valid reason that T. Rowe Price has underperformed the S&P by more than 30% over the last three years. To preface the point of my article, I'll quote from another of my investing idols, Phillip Fisher, who wrote in Common Stocks, Uncommon Profits:

"Probably most costly of all to the investor is the abuse by insiders of their power of issuing stock options. They can pervert this legitimate method of compensating able management by issuing to themselves amounts of stock far beyond what an unbiased outsider might judge to represent a fair reward for services performed."

The last time the Rule Maker delved into T. Rowe Price, back in August, Matt Richey and Zeke Ashton very capably analyzed the business case for the company, including some very prescient points about the economy of scale of asset management companies. Rather than reinvent that horse, I'll bullet point some of the highlights. I would highly recommend reviewing that article, even if it helps you, as an independent thinking Fool, come to the conclusion that I'm full of hot air. (As inconceivable as it seems�)

The highlights:

  • Cash on hand has increased from $283.8 million to $361.6 million in the six months from December 31 to June 30 of this year;
  • Revenues for the quarter, consisting mostly of investment advisory fees, grew 10.5% over the year-ago quarter, from $222.3 million to $245.8 million;
  • Net income rose 19.7% quarter over quarter, and 24.3% year over year & Net margin was 21.8% for the six-month period and 20.5% for the latest quarter;
  • Total assets under management grew from $147.8 billion to $159.2 billion over the six-month period, which translates into 15% yearly growth.
Impressive stuff, and a well-researched analysis by my colleagues. So why has T. Rowe Price, with a history of gross revenue and net profit gains, seen such an anemic share price performance over the last three years?

Well, I believe that there are two reasons. One comes from page 30 in the 1998 Annual Report, discussing the company's stock option plan. To quote:

At December 31, 1998, the Company had reserved 36,425,304 shares of its unissued common stock for issuance upon the exercise of stock options�"

Every company has stock options. Options are a valuable tool for aligning the interests of management up with those of the shareholders. But the devil is in the details, because, as Phillip Fisher warns, options provide a simple way for a company's management to grab a disproportionate amount of the wealth derived from a company's operations.

T. Rowe Price offers us an object lesson in the danger to shareholder return subjected by an overly generous options program. In this case, the company has allocated more than 21% of the current share float for issuance of options. This is, unfortunately, not nearly the highest among American companies. According to a study conducted by The Economist using the Black-Scholes accounting method for options, Merrill Lynch (NYSE: MER) has retained more than 57% of the current value of the company for the granting of employee options. But Fools have never been too kind to Merrill, so let's focus on a company to which we have entrusted our investment dollars.

Why Options Should be Treated Like Mutual Fund Fees

What if I were to tell you that over the next 10 years your portion of the revenues of a company were guaranteed to drop to only 79% of what they currently are? This means that a company must earn a minimum of 21% more than it does right now just for you to break even, which breaks down to a growth rate of 1.9% per year.

1.9% of assets is not too much to pay for competent management, correct? But The Motley Fool rails against paying such a premium to mutual fund managers, so why should our treatment of options programs be any different? In both cases, a company is taking a portion of our risk and converting it into their gain, either in the form of revenues or the form of off-book executive compensation.

And think about this -- in the past decade T. Rowe has enacted three Employee Option Plans and two Director Option Plans, which means that the chances are very good that the 21% currently allocated is going to be followed up by still further option grants. All at a time in which the company's share price performance trails the S&P 500 over the past three years. I could be really base here and make a comparison between the price performance of its shares and its mutual funds, but I'll save that for a later rant.

THAT is what makes me unhappy. Well, that and the aforementioned dearth of coffee in my bloodstream. You see, options are not counted on the balance sheet against revenues. They are executive compensation that are not treated as an offset to corporate profits, and as such provide the company a legal way to overstate its net earnings.

Why Foolishness Requires Uncompromised Integrity

Again, let me note that T. Rowe Price is doing nothing illegal. But just because it's allowed doesn't mean it's something we as shareholders should stand for. But here's my point, and I do have one: Shareholders can and should use their voice to express their displeasure with rich option programs for underperforming companies.

T. Rowe Price is eligible for criticism on both accounts: its options program is overly rich, and its share performance has been less than impressive. Couple these items with a share buyback program (the expense of which does get booked) having the net effect of maintaining the overall number of outstanding shares, and you have the ingredients for a significant asset grab by the executives.

Grrrr. We as Fools need to be as willing to be vigilant with executive compensation "friction" as we are with debt loads, mutual funds fees, and accounts receivable. All point to specific threats to our investments, whether they are booked as assets, liabilities, or, most damnedly, not at all. In my opinion, T. Rowe Price is counting upon the rules for treatment of options according to FASB and the tendency of most investors not to compute this cost themselves.

And that, my friends, is Wise.

A final note. We have received many excellent e-mails and message board posts in regard to the monthly $500 investment into a Rule Maker company, and on behalf of Tom, Matt, Phil and Rob, I'd like to express our appreciation for your input. We encourage the involvement of the Foolish Community and treat this as an integral component of out decision-making process.

For this month, we considered all pontifications, read tea leaves, and threw goat bones, determining that our monthly installment will be invested in Microsoft (Nasdaq: MSFT). As always, this transaction will take place sometime in the next five business days.

Thank you, and keep on Foolin'.

- Bill Mann, October 4, 1999


 




Rule Maker Portfolio

10/4/99 Closing Numbers
Ticker Company Dly Pr Chg Price
AXPAMER EXPRESS3/16$137.56
CHVCHEVRON CORP-2 3/16$86.00
CSCOCISCO SYSTEMS5/8$70.50
DPHDELPHI AUTOMOTIVE SYSTEMS3/16$15.44
EKEASTMAN KODAK11/16$76.94
GMGENL MOTORS15/16$64.19
GPSGAP INC5/8$36.63
INTCINTEL CORP1/16$77.00
KOCOCA-COLA CO-1 1/2$47.56
MSFTMICROSOFT CORP19/32$92.56
PFEPFIZER, INC5/16$37.63
SGPSCHERING-PLOUGH-3/4$46.75
TROWT.ROWE PRICE ASSOC25/32$28.22
XONEXXON CORP-1 5/8$73.00
YHOOYAHOO INC-4 1/4$171.19

  Day Week Month Year
To Date
Since
2/2/98
Annualized
Rule Maker 2.00% 2.00% 2.66% 11.09% 38.84% 21.71%
S&P 500 1.70% 1.70% 1.71% 6.13% 33.08% 18.67%
S&P 500(DA) 1.70% 1.70% 1.71% 6.71% 34.85% 19.61%
S&P 500(DCA) n/a n/a n/a n/a 20.25% 11.67%
NASDAQ 2.16% 2.16% 1.81% 27.51% 72.66% 38.68%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
6/23/9875CSCO32.865$70.50114.52%
2/3/9854MSFT45.135$92.56105.08%
2/13/9852INTC46.928$77.0064.08%
5/1/9882GPS22.708$36.6361.29%
2/3/9866PFE27.433$37.6337.15%
2/17/9916YHOO126.309$171.1935.53%
5/26/9818AXP104.067$137.5632.19%
3/12/9820EK63.148$76.9421.84%
3/12/9820XON64.335$73.0013.47%
3/12/9817GM60.400$64.196.27%
3/12/9815CHV83.343$86.003.19%
8/21/9844SGP47.993$46.75-2.59%
3/12/9811DPH17.190$15.44-10.19%
2/3/9856TROW33.673$28.22-16.20%
2/27/9827KO69.107$47.56-31.18%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
6/23/9875CSCO$2,464.86$5,287.50$2,822.64
2/3/9854MSFT$2,437.28$4,998.38$2,561.10
2/13/9852INTC$2,440.28$4,004.00$1,563.72
5/1/9882GPS$1,862.06$3,003.25$1,141.19
2/17/9916YHOO$2,020.95$2,739.00$718.05
2/3/9866PFE$1,810.58$2,483.25$672.68
5/26/9818AXP$1,873.20$2,476.13$602.93
3/12/9820EK$1,262.95$1,538.75$275.80
3/12/9820XON$1,286.70$1,460.00$173.30
3/12/9817GM$1,026.80$1,091.19$64.39
3/12/9815CHV$1,250.14$1,290.00$39.86
3/12/9811DPH$189.09$169.81($19.28)
8/21/9844SGP$2,111.70$2,057.00($54.70)
2/3/9856TROW$1,885.70$1,580.25($305.45)
2/27/9827KO$1,865.89$1,284.19($581.70)
  Cash: $635.47  
  Total: $36,098.16  


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.