In the August 2012 issue of Investor Advisory Service, we reflected on the low rate of economic growth. We said the U.S. economy was failing to achieve “escape velocity.” Growth simply wasn’t strong enough to generate a self-sustaining virtuous cycle where growth begets more growth. Most of the key economic statistics seemed to be showing some improvement, but not enough to generate any real momentum.
The Federal Reserve’s response was to pump yet more money into the financial system. With bonds already paying near-zero yields, much of the new money seemed to find its way into stock prices. The result was a total disconnect between weak economic performance and strong stock market gains, proving, in our opinion, the futility of trying to time the stock market. We are not a market-timing newsletter. In any stock market, our focus will always be on trying to find the best growth companies trading at reasonable prices.
One of our three featured companies in the year-ago issue was T. Rowe Price (Ticker: TROW), an investment manager controlling over $500 billion in total capital, which is mainly invested through retail mutual funds. Trading at $61.85 per share with a forward P/E of 19, we modeled 14% future earnings growth and a 4.5 to 1 potential gain / loss ratio. The stock had a dividend yield of 2.2%, above-average for a growth company. Most growing companies consume their earnings to finance further growth. One of the attractive features of the investment management business is that earnings growth translates quickly into a similar amount of cash. Capital requirements are low, so cash flows can be directed toward acquisitions, share buybacks, or dividends.
About three quarters of TROW’s assets under management have exposure to the stock market. When the market goes up, those assets grow and produce higher fees. When the market falls, the reverse occurs. For investors, that means TROW shares tend to magnify the broader stock market’s fluctuations. If TROW were simply a market-cyclical stock, good for buying low and selling high, we probably wouldn’t be interested. However, we have followed this stock in the IAS for thirteen years. While the market’s gyrations have produced some ups and downs, T. Rowe Price has also produced an attractive record of underlying growth. Put another way, this company can grow nicely in a flat market environment.
One month after our August feature, we noted that T. Rowe Price’s second quarter results had been uncharacteristically weak. The company manages money for both retail investors and for institutions, such as pension funds and endowments, and institutional asset flows were particularly weak in the quarter. Still, revenue rose 3% in the quarter and EPS increased 4%.
A strong stock market gave the company a nice boost in Q3. EPS increased 23% and revenue increased 13%. The weakness in institutional “asset gathering” remained, but the overall market’s surge swamped any fissures in the growth story. After some choppiness, TROW shares started climbing in late 2012 and really popped in early 2013. Asset gathering weakness appears to have bottomed out during Q4 2012, turning positive again in Q1 2013. Looking back over the past twelve months, T. Rowe Price’s underlying growth has actually been a little weaker than we hoped, but strong markets have supported gains in the share price nonetheless. At a recent price of $77.44, plus $1.44 in dividends, TROW has produced a 28% total return during the past twelve months, slightly outperforming the broader S&P 500. When the current market rally eventually loses steam, TROW’s success will hinge on its ability to once again outgrow its industry.