T. Rowe Price’s (TROW) logo, a ram on a mountain, is an apt metaphor for the firm founded in 1937. Its namesake, Thomas Rowe Price Jr., was a pioneer in the mutual fund business when growth investing wasn’t mainstream. His definition of a growth stock—penned in the pages of Barron’s in 1950—has since become canon. And David Giroux, manager of the $35 billion T. Rowe Price Capital Appreciation fund (PRWCX), picks stocks in Price’s tradition.
Over the past 10-plus years, Giroux’s fund has crushed the competition, returning 11.5% a year on average, beating similar funds by four percentage points each year. Capital Appreciation holds a mix of stocks and bonds—60% of assets are in about 40 stocks, another 25% is in bonds, plus 13% in cash and 2% in convertibles—yet he has nearly matched the total return of the S&P 500 index (.SPX) over 10 years. Barron’s met with Giroux in his Baltimore office to chat about his approach to stock-picking and his views on big market trends.
Q: You’re also head of investment strategy and hold some other more big-picture roles. What issue are you working on now?
A: I spent 10 hours last week meeting with people who had worked with Elizabeth Warren and former Obama administration officials. Warren is rising in the polls, she’s the odds-on favorite, and we’re trying to understand her priorities. Presidents can’t get everything they want accomplished; they usually focus on two or three big things.
Q: What do you think Warren would focus on?
A: I’m not sure I’m allowed to say. We are trying to build an investment edge.
Q: OK, moving on: You talk about the big trend of disruption. What do you mean by that?
A: Disruption is a situation where new regulation or technology will significantly impact the trajectory of a company’s earnings growth. When I first became a portfolio manager in 2006, very few businesses were being disrupted. It came up in management meetings maybe 5% of the time. In recent years, the pace and frequency of business-model disruption has accelerated dramatically. We set out to understand how many businesses were being disrupted by new technologies or regulations. Two years ago, about 20% of the S&P 500 market cap was subject to disruption. Today the number is 30%.
Q: What’s being disrupted?
A: Cable networks are a good example. When I started, they were great businesses taking share of advertising dollars. Now, there is Amazon and Netflix, and people don’t want to watch commercials. Viacom (VIAB) isn’t a long-term viable franchise anymore.
Q: Utilities are a large overweight in your fund; you have a bigger stake than is in the index. But aren’t utilities being disrupted by solar?
A: There was a 15- or 20-year period when utilities didn’t grow earnings at all for a variety of cyclical and structural reasons. The only return was their dividend. In that environment, utilities traded with interest rates.
In the past 10 years, they’ve started growing earnings at a really healthy pace. The earnings growth for the market has decelerated, while utilities have accelerated. They’re no longer yield plays. Today, you’re getting S&P 500 returns with a lot less downside, a lot less cyclical risk.
This is a case where disruption is helping an industry. I’m going to close down the coal plant and put up a wind farm, or solar farm with some storage, and maybe do some grid modernization. All of that is allowing a lot of utilities to actually grow their rate base at a 5%, 6%, 7% rate—8% in some cases. And it’s not impacting customer bills, because half of a utility bill is the coal, or natural gas. As you close down gas and coal plants, that portion of the bill goes down. So, high-quality utilities are growing earnings 5-7%, and customer bills are only going up 2%. That’s a dramatic change from 20 years ago.
Q: Growing earnings without growing customer bills. Wow! What utilities do you like?
A: American Electric Power (AEP) is probably our favorite utility right now. It’s one of the cheapest regulated utilities, yet it is very high quality. They should grow earnings at a 7% clip. It [services] a lot of different states, which reduces the risk of any one state going in the wrong direction. It’s in the Midwest, which is really good for wind. They have a great transmission asset, and the stock trades at a discount to other utilities, despite the high-quality transmission business. So, AEP is probably our favorite utility right now, given the valuation and fundamental combination.
Q: What about some nonutility stocks?
A: We are bullish on General Electric (GE).
Q: GE is a controversial name lately.
A: We didn’t own it until recently. I’ve known [new CEO] Larry Culp for about 19 years, from when he ran Danaher (DHR). I don’t think Larry has ever failed at anything, and we’re confident he will turn around GE. I don’t own GE for the upcoming quarter or the upcoming year; I’m looking at free cash flow in 2023 or 2024, and think this stock can double or triple over three to five years. It’s hard to find situations like that in the marketplace.
Q: GE’s power business is suffering from some of that disruption, isn’t it?
A: True, but it’s only 15% to 20% of [GE’s] enterprise value. Don’t forget, GE sells renewables. Health care is a good business, not really subject to disruption.
The crown jewel at GE is the aerospace division. That’s where most of the value is. It starts with more people on planes. There are about 5% more people on planes around the world each year. It’s pretty consistent. And there isn’t going to be a gig-economy company building a jet engine.
The average industrial asset trades for 12 times earnings before interest, taxes, depreciation, and amortization. This is an A+ asset. Aerospace generates most of its profits in the aftermarket; they are a market-share taker. The military business can double over a five-year period. [Aerospace] makes up most of the enterprise value of GE, and people aren’t valuing it adequately. Aerospace free cash flow will grow in the high-single digits for years to come.
Q: Its financing arm, GE Capital, has been a source of big losses.
A: Low-quality reports from shorts can have a disproportionate impact on stock. Gecas [GE’s aircraft-leasing division] is a fine financial asset, probably worth a little more or less than book value. The long-term care liability is manageable and won’t disrupt the turnaround. Five years from now, GE Capital will be a much simpler business to understand.
Look, GE is very complicated, but we love complexity. That’s a chance for us to dive in and arbitrage the difference between what we think and everyone else thinks.
Q: What are other examples of disruption hurting or helping a business?
A: Payment software— Fiserv (FISV) merged with First Data in July. I’ve owned Fiserv for a long time. There are large parts of it that aren’t subject to disruption. First Data was losing market share for years, with little growth in its North American payment business. But that has turned in the past 18 months. An important part was the success it had with Clover, its Square (SQ) competitor. We think Clover will be bigger than Square. The merger will generate a lot of synergies; the company has mid-teens earning growth the next three or four years almost locked in. It doesn’t trade at an expensive price on free cash flow. And you’ve got an exceptional CEO in Jeff Yabuki.
Q: What other stocks do you like?
A: Another attractive one is PerkinElmer (PKI). It’s a life-science tool and diagnostic company located in Boston. They have—through acquisitions, divestitures, and operational excellence—reimagined their company from what was originally a 3% to 4% organic growth company into more of a mid- or high-single digit growth company with [profit] margin expansion. That is a well run company that trades for less than 20 times free cash. A low- to mid-teens earnings growth rate—with a lot of new product optionality—could drive the stock multiple higher. So, yeah, we like PerkinElmer quite a bit.
We also like Fortive (FTV) quite a lot. What you really want in an industrials conglomerate is good management that deploys capital at high returns, with good operational excellence. That’s what Fortive has. It has transformed its portfolio, buying $1.7 billion of revenue since it got spun off from Danaher. Those assets are growing in a mid- to high-single digit rate. They’re more software-ish—faster growth, more reoccurring revenue. But the market really cares about the cyclical aspect of Fortive right now. I care less about the cyclical aspect; I want to own Fortive for the next five years, not for the next quarter.
Q: Let’s spend a moment on the fixed-income portion of your fund. What do you look for there?
A: Fixed-income is a combination of top-down and bottom-ups analysis. On the top-down analysis, we do a matrix, with bond spreads on one axis and risk-free interest rates on the other. The magic quadrant is where is you are getting at or above-normal spreads and risk-free rates that are above our long-term projections. Today, we are in the “ugly” quadrant. That is why we have reduced our fixed income exposure from 30% of assets last year to 25% today and have added to cash reserves.
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