Rule Maker To Buy
February 03, 1998
**When Rule Maker announces an intention to trade, that trade will be made within the next five business days, as opposed to the very next day. For more detail on how buys are determined and how this portfolio originated, please read the "11 Steps to Rule Maker Investing" section of the Rule Maker Portfolio.**
Rule Maker Portfolio Buy Report
Announcement: Purchasing $1,875 in T. Rowe Price stock.
An Overview of the Company
Yep, hard to believe, eh? Gee whiz... we're buying a mutual-fund company! In this case, though, we believe we have something much more valuable than the standard fare in the industry. So, read on, and tell us what you think.
T. Rowe Price Associates and its subsidiaries serve as investment adviser to the T. Rowe Price Mutual Funds (the Price Funds), other sponsored investment products, and private accounts of other institutional and individual investors. T. Rowe Price also gives investment advice to defined-benefit and defined-contribution retirement plans, endowments, foundations, trusts, and other mutual funds.
At the close of 1997, the company's assets under management (AUM) totaled $124.3 billion, including $81.1 billion in the Price funds (65% of the total AUM). Equity investments comprise approximately 62% of the total AUM, and international holdings account for nearly 30% of the firms assets under management.
The Basic Financials
T. Rowe Price was founded by Thomas Rowe Price, Jr., in 1937 and is headquartered in Baltimore, Maryland, less than a hundred miles from Fool Global HQ. Historically, the company has methodically grown its assets under management, closing out 1997 with 25% asset growth for the year.
The company has a number of market-beating funds and has been somewhat uniquely engaged (relative to its industry) in trying to educate individuals and retirement plan administrators about everything from the new Roth IRA, to the power of compounding, to the myriad benefits of stock market buying-and-holding for the long haul.
We know we'll be justifying and explaining this investment decision for weeks ahead in the Rule Maker message folder ("You guys... a mutual-fund company?! A danged mutual-fund company?!"), but for now, let's take a look at the financial performance.
Year-End 1997 Revenue: $755 mil. Net Profit: $144 mil. Net Profit Margin: 19.1% EPS: $2.25
Trailing earnings: $2.25
Calendar 1998 Estimated Earnings: $2.73
P/E on Trailing Earnings: 31.5
P/E on 1998 Estimate: 23.8
Basic Rule Maker Criteria*
Market Capitalization: $4.2 billion
Cash (and short-term securities): $181 million
Long-Term Debt: $0
Cash as % of Debt: n/a
Flow Ratio: 0.70
*all balance sheet data as of Sept. 28, 1997
Consensus 5-Year Growth Rate: 18.4%
Debt as % of equity: n/a
Debt as % of revenues: n/a
Dividend Yield: 1.10%
Return on Equity: 38%
Return on Invested Capital: 30%
*all balance sheet data as of Sept. 28, 1997
A Concentrated Look at the Business
T. Rowe offers its Price Funds shareholders and private accounts a broad range of investment products with varying investment objectives. Shareholders are allowed to exchange funds among mutual-fund products as market conditions and/or investor needs change. T. Rowe frequently introduces new mutual funds, which are designed to complement and expand existing offerings. The company also provides various administrative services to the Price Funds and other clients. These services include:
- mutual fund transfer agent
- accounting and shareholder services
- participant recordkeeping and transfer agent services for defined contribution retirement plans
- discount brokerage services
- trust services
T. Rowe's base of assets under management (AUM) consists of a broad range of domestic and international stock, bond, and money-market mutual funds and other investment products. In recent years, there have been significant net-cash inflows to the stock mutual funds, particularly the international funds in 1994 and the domestic funds in 1995 and 1996. Investment advisory fees earned on assets under management and related expenses are generally higher for stock and international investment products.
As of December 31, 1996, retirement accounts made up about 49% of all AUM. 44% of Retirement AUM was in 401(k) and other defined contribution plans; 33% was in private accounts; and 23% was in IRAs.
The investment strategies used by T. Rowe Price accommodate a variety of client investment objectives. Management of investments in stocks include active approaches emphasizing established growth, mid-cap growth, New America growth (companies that participate in the growth of the service sector of the U.S. economy), small cap, science and technology, equity income, capital appreciation, and natural resources as well as systematic and balanced portfolio strategies.
Approaches for investing in fixed income securities portfolios include active and index management strategies, along with management of high-yield securities and cash reserves. T. Rowe has also developed several specialized investment management services including:
- private company investing
- investing in debt securities and creditor claims of financially troubled companies
- the efficient disposition of equity distributions from venture capital investments
T. Rowe Price's expense ratios are among the lowest in the industry and that's one of the reasons we think the company will continue to succeed. All of its funds are 100% no-load, with no 12b-1 marketing fees. To minimize costs, there are minimum balances to open funds and small account charges. However, some or all of these minimums are waived for customers who agree to have money regularly taken out of their checking accounts for automatic deposit into the T. Rowe fund -- a meaningful incentive.
Because T. Rowe has matched low annual fees with a nice blend of market-beating performance, and because the fund family has been able to retain key fund managers, we're positive on the business' ability to survive and thrive through the natural fluctuations in the market and the wildcard introduction of Internet-trained, saavy individual investors (dare we call them Fools here?).
A Look at Historical Stock Performance
Over the five years ending December 31, 1997, fully diluted earnings per share have grown sequentially by 33%, 67%, 24%, 28%, and most recently by 42%. The annual compound rate of earnings increase was 30% during that period. The stock price has done even better, growing sequentially by 27%, 32%, 64%, 77%, and most recently by 45%. This equates to an annual rate of stock price increase of 41% for the five-year period.
The company's net margins are substantially above their average value over the past five years (the companys business does not lend itself to a calculation of gross margins). The same is true for return on equity and return on invested capital. The company has achieved this while consistently outpacing the growth of its competition.
T. Rowe's performance has been outstanding over the last five years, and current business conditions suggest to us that the company can continue to grow faster than its competitors and faster than the general market.
Concerns Going Forward
There are certainly a few.
First, T. Rowe Price's revenues are largely dependent on the total value and composition of assets under management. Thus, fluctuations in financial markets and in the composition of assets under management impact revenues and results of operations.
Second, the general U.S. stock market performance over the past three years has been greater than ever before. There will be periods in the next decade when the market's overall performance is mediocre or worse. During that time, T. Rowe Price may experience a shift away from stock funds to lower-revenue and lower-margin fixed income and money-market funds.
Third, there has been considerable turmoil in foreign markets, particularly those in East Asia. T. Rowe's assets in these foreign-market funds may decline substantially, both due to market losses and fund redemptions. These funds produce some of the highest fees in the business, and shifts out of them may result in significant reductions in T Rowe's income.
Next up... more than 20% of all of T. Rowe Price's assets under management are in defined contribution retirement plans of one form or another. These plans must comply with a wide variety of government regulations, and there could be pressure in the future to limit fees (or at least those fees that are passed on to plan participants). Such limits could materially affect T. Rowe's revenues.
Finally, the company's revenues could also decline if independent directors of one or more of the Price Funds were to terminate or materially renegotiate the term of one or more management agreements.
Prospects Going Forward
We think, however, that there are more opportunities than risks in the decade ahead for T. Rowe Price.
Defined contribution retirement plans, particularly 401(k) plans, are currently very popular. And why shouldn't they be when the benefits of long-term, tax-deferred growth are gaining exposure!? T. Rowe has profited greatly from the general move toward the direct deposit of salary savings into investment accounts. The size of the 401(k) market is expected to continue to grow, and T. Rowe Price should remain a key player on that field.
T. Rowe has also created funds that are quite competitive with the S&P 500, while maintaining industry-low management fees. The business has been built on method and patience, which has seen it expand services from discount brokering to fund management to trust planning to education. It has developed a host of interactive products to assist both shareholders and plan administrators. These products provide clients with quicker access to the information they seek. We believe that the long-term consequences of this approach to financial services will reap substantial rewards for the company in the decade to come.
But we could be wrong. An important reminder!
Finally, the Price Funds have received national recognition from the financial media and associations of benefit administrators, for good reason. They've also been recognized and celebrated by Morningstar and other mutual-fund rating institutions.
Why TROW is a Rule Maker Stock
T. Rowe passes most of the Rule Maker financial tests easily. At $4.2 billion in market cap and with $755 million in trailing sales, the company is a little smaller than most Rule Makers. But we don't view this as a problem. Cash on the books is also on the low side, but that $180 million in savings strikes us as more than sufficient given that there isn't a lick of debt on its balance sheet. (We understand that some of these generalizations about the relationship between cash-and-debt seem oversimple, but hey, we're more than willing to discuss the merits of cash-driven growth in the Rule Maker message folder).
Beyond the numbers, as you know (you have read through the 11 Steps to Rule Maker Investing, right?), we're looking for a global consumer brand in a repeat-purchase business. The Price Funds, especially the $11 billion International Stock fund and the $12 billion Equity Income fund, are clearly strong brand names. Loads of people purchase these funds each time they invest either individually or through their 401(k) plans. In many cases, individuals are repeatedly buying into a fund through their retirement plan, and the company gains marketing exposure from those regular deposits.
Finally, as you know, we're also looking for strong historical performance. The 40% compounded annual increase in stock price since 1992 fits that bill nicely. We do believe that future prospects are compelling, inasmuch as T. Rowe gives us a chance to share in its profits from providing investment services to 401(k) plans. We grant that the stock market probably isn't about to grow 30% annually for the next three years, or the three after that. But over the next 10-20 year period, we expect the stock market to compete favorably with other investment options, and we're putting some of our moola down on T. Rowe Price's ability to capitalize on that growth.
Yes, it'll come as a surprise to a number of Fools that we're purchasing a mutual-fund company in the Rule Maker portfolio. But exposure to what seems the creme de la creme of an extremely profitable consumer industry makes good sense to us. Float by the Rule Maker folder and tell us what you think.