Q: What is the history and mission of the fund?
Although the T. Rowe Price Diversified Mid-Cap Growth Fund was launched on December 31, 2003, the strategy itself dates back further and still continues today. Its name, Structured Active Mid-Cap Growth, remains an accurate description of our process and what we aim to do with this fund. Assets under management for the fund are currently about $740 million.
The mid-cap growth asset class provides a fertile field of companies we’d like to own long term. There is data that actually shows over time, mid-cap growth has higher returns per unit of risk relative to other asset classes. We believe strongly that it remains an area where thoughtful active management can add value. We seek to provide a consistent, risk-adjusted alpha by investing in high quality mid-cap growth stocks.
We try to stay within the bounds of our benchmark, the Russell Midcap Growth Index, where market caps range between $2 billion and $30 billion. The portfolio’s investment-weighted median market cap is around $11.5 billion.
Another hallmark of the fund is its low turnover, which tends to be 20% to 25%. To us, long term means three to five years or longer; we want to own companies through a full cycle. Instead of being overly worried about what might happen in the next quarter or even the next year, we’re patient and give companies time to evolve.
Q: What core beliefs guide your investment philosophy?
Our firm has a bottom-up, fundamental focus. To us, an attractive company is a market leader in a rational industry with high-quality management and strong returns on capital. We pay a lot of attention to free cash flow and how companies allocate capital, and like it when they buy back stock and reduce shares outstanding – over time, these are indicators of good management. Building in this quality bias is important to our philosophy.
A quantitative overlay compares how the fund does versus the benchmark. If anything looks particularly out of line, we won’t necessarily change the portfolio, but want to be aware of implicit bets we might be making. Typically, we don’t make big, unintended bets on macro factors like interest rates or oil prices. Our preference is to isolate that out and focus just on stock selection, which adds to our consistency over time.
Q: Would you describe your investment process?
T. Rowe has a strong central research effort with about 50 analysts domestically, and we rely on them heavily for our content and idea generation. We read everything that comes from the research team and constantly interact with them. As their recommendations come in, we sit with the analyst and talk through why an idea may or may not make sense for the portfolio.
With our rating system, a “2” is a buy, a “3” is a hold, and a “4” is a sell. But because holds can be good over the long term, it’s important that we discuss with analysts how they see their space evolving beyond the next quarter or year.
Also, we typically meet with management teams at least annually to really dig into their businesses. Many of them regularly come through Baltimore, Maryland to meet us here, or we get together at their headquarters or at a conference.
From time to time, we’ll also use the sell side to generate ideas, or source ideas from the screen, or do the work ourselves and hope an analyst will pick up coverage. However, we’re willing to own unrated names because risk can be managed through position size.
Q: How do you evaluate growth and what kind of growth is attractive to you?
We like companies that show a consistent path of earnings and free cash flow per share growth. Also, we watch whether shares outstanding are going up or down, and have found success with companies that buy back their own stock. Regarding growth rate, we like to see at least low double-digit growth in earnings per share, although we don’t require it.
Our analysis considers a company’s free cash flow per share and its reported earnings per share. Earnings quality is a good guiding principle; sometimes when companies are in a growthier stage, their free cash flow might lag earnings, and we monitor the balance sheet. Also, because companies that are overly levered can have a lot of downside, we tend to avoid them.
Q: What do you focus on when screening for earnings quality?
We want to find companies that produce free cash flow in line with earnings over time. A number of things might cause that number to be depressed – perhaps timing differences or heavy investments in capital expenditure – but if a company’s free cash flow is significantly lagging earnings, it’s something to think about.
Q: Can you highlight your research process with a few examples?
Sherwin-Williams Co, the paint business, is a good example of the kind of company we look for. We bought Sherwin in the downturn when housing was quite depressed and the stock was in the $60s. Even though its market cap is above $30 billion now, we still own some.
Paint is a strong business, but it’s fairly oligopolistic with only a few players – Sherwin recently bought The Valspar Corp, a coatings company that was also in our portfolio. It’s a heavily contractor-based business where contractors buy the paint they need from a Sherwin-Williams store. As a result, the company has a lot of pricing power; as commodities go up or down, Sherwin can usually pass along any price increases to contractors.
As housing picked up, so did Sherwin’s same-store sales; we saw a lot of leverage to the bottom line and people realized what a great business it was. The best part, though, was Sherwin was buying back stock all along and reduced its share count significantly. Companies that do this can enhance the growth of their earnings per share well above their operating income growth.
During this period, Sherwin was putting up consistent double-digit earnings growth and continues to do so, and we think the purchase of Valspar is going to be quite accretive to earnings. Currently, Sherwin is trading in the mid-$300s, so it’s been a great holding for us.
Another example is Ross Stores, Inc., the off-price retailer. We’ve owned it since the fund’s inception and it’s been a solid compounder without a lot of volatility since.
The company buys department-store-quality merchandise at exceptionally cheap prices to sell in its retail locations, which provide a sort of “treasure hunt” experience for shoppers who get brand names for 60% to 70% less than at a department store.
Ross and TJX Companies Inc have taken advantage of the current struggles faced by department stores. Their same-store sales have consistently been in the mid-single digits, their earnings have been growing in the double-digits, and they’re reducing shares outstanding.
Even though we’ve owned Ross for over a decade, it’s still one of the larger positions in the portfolio because we find the company so attractive.
Q: What is your portfolio construction process?
With 275 to 300 names, the portfolio is quite diversified. Position sizes are small and rarely exceed 1%. Starting positions are typically around 20 basis points and may increase as we gain conviction or a stock becomes cheaper. When a position hits 1%, or 100 basis points, we’ll likely start paring it back.
Really, our portfolio construction process centers on making a series of relatively modest bets and trying to skew toward companies we like a lot. This limits our risk through a cycle, but over time, our goal is to add significant value just by being consistent.
Because we want most of our alpha to come from stock selection, we tend to not take big sector bets, typically staying within a few hundred basis points of the benchmark. Because we don’t make market timing calls, the fund is always nearly 100% invested in mid-cap growth stocks and our cash reserves less than 1%.
Although these factors govern portfolio construction, the way we actually put it together is based on somewhat idiosyncratic fundamental decisions regarding the names we want to own and those we don’t.
Our goal is to construct a portfolio of high-quality names and outperform the Russell through a full cycle. Ultimately, we hope to get up to 200 basis points of alpha versus the Russell but want to do so in a way that’s quite structured.
Q: What is your sell discipline?
A few things could trigger a sell decision. One is fundamental deterioration: perhaps we feel our thesis has broken or a company has gotten too big for mid cap. Another reason is that the company is acquired, which is something that happens quite often in the mid-cap space as there are many attractively growing, smaller companies – we benefit from this. Finally, should a company become so expensive we believe it’s overvalued, we’ll reduce or eliminate our position.
Q: What does risk mean to you? How do you control it?
Risk control is embedded in our process. The nature of what we are trying to do helps us manage risk better than other approaches that are more concentrated with big alpha and higher tracking error. Our approach is iterative and we’re willing to make modest changes: we’re constantly analyzing where we are, which factors we’re betting on, and any unintended bets.
Ultimately, the success or failure of this product comes back to stock selection – to whether the companies we own are the right ones. We never want to be in the position where we have the right companies but have unintentionally made a huge bet on a macro factor that goes against us. To preclude this, we’re vigilant and rely on many reports and processes created for this purpose.
In terms of risk control, our tracking error is typically between 150 and 200 basis points. Historically, the fund has tended to outperform in choppier markets as a result of our quality bias.
Our portfolio construction process has sufficient guardrails which allow us to manage risk effectively. We look at statistics like earnings variability, where we skew toward companies with lower-than-average variability, and risk parameters like beta and volatility, which protect us on the downside.
