When you get right down to it, this portfolio is a miniature investment club where all decisions are democratic, and we don't all agree with each other much -- or even most -- of the time. The big learning opportunity of having an online, real-money portfolio is that readers and writers see how we resolve issues such as how many stocks to hold, which stock to buy next, when to sell an existing holding, and how to learn from our mistakes.
Tom Gardner, our fearless Rule Maker leader -- and one of People's 100 most eligible bachelors (it must have been a dry year) -- recently wrote a public apology in this space for three of our underperforming picks: Coca-Cola (NYSE: KO), Schering-Plough (NYSE: SGP), and T. Rowe Price (Nasdaq: TROW).
While I feel that it's a little early in a very long game to be calling any of these choices mistakes, the company I feel is closest to the edge is T. Rowe Price. This has little to do with the company's stock performance since the Rule Maker Portfolio has owned its shares. Investing isn't always about immediate gratification, although the amazing (and historically uncharacteristic) investment returns of the past several years might make it seem so.
My concern also has little to do with the company's business performance, which has been quasi-spectacular for a long, long time. The real concern I have is that it isn't the big dog in the big back yard of the mutual fund industry. That honor goes to Janus, the high-octane subsidiary of railroad company Kansas City Southern (NYSE: KSU). Over the past year, Janus has been sucking up assets like a giant Hoover.
As of the first quarter last year, T. Rowe Price had $149.2 billion in assets under management (AUM), and Janus had $136.8 billion. Since then, T. Rowe has grown the asset base to $185.2 billion, an excellent 24% growth rate. And Janus? It's grown AUM to $315.3 billion, meaning in one year Janus grew AUM nearly $179 billion, almost as much as T. Rowe Price accumulated in its entire history! That's a mind-blowing statistic. So, should we sell T. Rowe Price and buy shares of Kansas City Southern?
Bill Mann's recent article, When to Sell a Rule Maker, presents six criteria for selling a Rule Maker. Number five is to sell when the company is no longer a top dog, but Bill doesn't really go into a lot of detail on what that might entail. I'm going to plagiarize the entire paragraph right here. (English teachers, please cover your eyes and pull the kids away from the screen!)
Selling a Rule Maker Criteria #5: Company No Longer a Top Dog
"Some companies respond well to competition, others fail to do so. A former Rule Maker is just that, a has-been. Most has-beens do not make it back to the top, though there are exceptions, such as reborn Texas Instruments (NYSE: TXN) . On the other hand, Bethlehem Steel (NYSE: BS) and Venator (NYSE: Z), the holding company for Woolworth, are great examples of former greats that have dimmed. They are yesterday's news, former kings of the hill. Those who hold such declining companies should not let avoidance of capital gains taxes drive their decisions. Avoiding taxes on an appreciated asset that now lacks potential for further growth is, in my mind, cutting off the nose to spite the face."
Bill's point is well taken, but it doesn't help us a heck of lot with T. Rowe Price. It may have been the top dog in the mutual fund industry when the Rule Maker bought it, but it definitely isn't now. On the other hand, T. Rowe has been shooting nothing but net since our purchase. Let's look at the direction of our company's financials -- a before and after snapshot, if you will.
Q1 1998 Q1 2000 %Change Sales 210,434 316,331 49.6% Gross margin* 66.5% 70.6% 6.2% Net Income 41,290 75,034 81.7% Net margin 19.6% 23.7% 20.9% Flow Ratio 0.80 0.73 -8.8% Cash/Debt 215/0 438/0 NA Cash King 23.7% 27.4% 15.6%*Mutual fund companies don't really have gross margins. As a proxy, I used compensation and related costs expenses to represent the cost of goods sold.
As you can see, T. Rowe Price improved across the board at an impressive rate. So our problem here isn't T. Rowe, it's Janus.
If the mutual fund industry were more of a zero-sum game, I'd be very concerned. Luckily, the mutual fund industry is much more fragmented than, say, the carbonated beverage industry. Whereas PepsiCo (NYSE: PEP) and Coca-Cola account for the lion's share of soft drink sales, about 40 mutual fund companies or asset managers account for about 80% of the mutual fund pie. In addition, I'd guess Janus investors have a different investor profile than T. Rowe Price investors. While there is no doubt that Janus is doing a better job of accumulating assets than T. Rowe, this is an industry where Rule Makers can peacefully coexist. It's not the same as some technology sectors where a shift in consumer preferences or rapid change can put a good company out of business.
I don't buy Tom's rationale that T. Rowe Price was a mistake because of the "havoc the Internet has wrought on pricing in the financial services industry." Would that be the havoc that has caused T. Rowe's profit margins to expand from an already impressive 19.6% to an excellent 23.7%? Or maybe the havoc that caused its net income to increase 81.7% in two years? If that's havoc, I'll have another helping, please. No, I think the real reason for Tom's mea culpa is that T. Rowe's stock has simply underperformed both the business fundamentals (as measured by our criteria) and the S&P 500. This doesn't make it a mistake in my book. Stock prices can go nowhere for long periods of time despite fabulous business performance.
Returning to Bill's six reasons to sell, T. Rowe isn't THE top dog in its industry anymore, if it ever was. But it is still A TOP DOG, and even better, it's been rapidly improving according to the Rule Maker criteria, just not as fast as Janus. If we were starting the portfolio today, would T. Rowe Price be in a 10-stock Rule Maker Portfolio? I'm not sure it would. Maybe today we'd choose Charles Schwab (NYSE: SCH) or Citigroup (NYSE: C). Maybe we'd look at buying Janus, which will soon be spun off from Kansas City Southern in the form of Stillwell Financial. (Why don't those folks come to their senses and call the new company Janus?) And if we're truly trying to collect only the absolute top-tier companies in the industry, maybe we should consider selling T. Rowe Price to make room for something better, assuming we find a better company.
On the other hand, if it's our aim to buy great companies and hold them as long as they remain Rule Makers, then T. Rowe Price has earned its spot in this portfolio. If that's the case, we need to recognize that failing to beat the market indices over a short period doesn't make those decisions mistakes.
What's your take? Should T. Rowe stay or should it go? Should we only be interested in the number one player in a given industry? If you've got an opinion, and something to back it up, let's hear it on the Rule Maker Strategy board.
Related Links:
When to Sell a Rule Maker, Rule Maker Report, 6/6/00
Fools at the Confessional, Rule Maker Report, 5/22/00
