Thursday, March 19, 2015

Why I bought shares of T. Rowe Price Group Inc.(TROW)

I’ve invested fresh capital in high-quality dividend growth stocks just about every single month for almost five consecutive years now and I can’t quite remember a time when I felt that value was so hard to come by. That’s not to say that attractively valued stocks are extinct, but rather that they’re a rarer breed than they were even just one year ago.
Some would prefer to just hold cash right now. But I’ve always been of the opinion that cash flow is far better than cash. After all, the major reason to be a dividend growth investor is to turn $1 into a steady stream of nickels, quarters, and eventually dollars. As such, I continue to put cash to work in order to turn it into cash flow.
Besides, nobody has any idea as to when the eventual market correction will come. I’ve been hearing for years now that it’s been a bad time to buy stocks due to a variety of concerns. If I would have held cash all that time, I would have missed out on a number of fantastic opportunities and the chance to build as much cash flow (and wealth) as I have now. Instead, I’ll be ready for cheaper stocks – when they come – with a steady flow of cash that will constantly reload my BB gun. Cash is gone once spent. Cash flow, however, tends to not only keep flowing, but growing.
With that perspective, I put fresh cash to work once more.
I purchased 20 shares of T. Rowe Price Group Inc. (TROW) on 3/3/2015 for $82.77 per share.

Overview

T. Rowe Price Group Inc. is a global investment manager that provides asset management services for institutional and individual investors.
As of December 31, 2014, the company had a record $746.8 billion in assets under management.
Approximately 64% of the company’s managed assets are held in sponsored US mutual funds. And the vast majority of the AUM are held in retirement accounts and variable-annuity portfolios.

Fundamentals

TROW sports some of the more impressive fundamentals I’ve come across, especially as it concerns growth across the top and bottom lines. However, it’s also important to remember that their AUM, and the fees they can collect, have been positively impacted by the unprecedented stock market run coming off of the financial crisis lows.
So let’s take a look and see what we’re working with here.
Revenue was $1.512 billion in fiscal year 2005. That increased to $3.982 billion in FY 2014, which is a compound annual growth rate of 11.36%. It’s not particularly often that I run across companies with double-digit top-line growth.
Earnings per share, meanwhile, grew from $1.58 to $4.55. That’s a CAGR of 12.47%. I don’t know how investors could be anything but delighted with that.
S&P Capital IQ is predicting that EPS will compound at a 5% annual rate over the next three years, anticipating slower AUM growth due to particularly strong equity market performance as well as the possibility of rising rates which could impact fixed-income portfolios.
What’s interesting is that TROW kind of flies under the radar even though they have a fantastic dividend growth record.
They’ve increased their dividend to shareholders for the past 29 consecutive years. That’s almost three straight decades which includes more than one major stock market crash, multiple wars, and the Great Depression. Not bad.
And the dividend growth rate is pretty incredible – over the last decade, the company has increased its dividend at an annual rate of 16.6%. And it’s not slowing. The company just announced last month an increase in the quarterly dividend from $0.44 to $0.52 per share, which is an 18.19% raise. Even more spectacular, the company is also paying a $2.00 special dividend in April with an ex-dividend date of April 7, 2015.
Now, the dividend growth rate is higher than the rate at which earnings per share has grown over the last decade. However, the payout ratio is still moderate, at 45.7%. So they could theoretically continue to grow the dividend slightly faster than EPS growth for the foreseeable future.
The stock yields a fairly attractive 2.51% here. Factoring in the special dividend, the yield is temporarily boosted to 4.93% this year.
Another quantitative aspect about this company that shows its high quality is its balance sheet. The company has no long-term corporate debt. Zilch. And they have $3.4 billion in cash and fund investment holdings as of the end of 2014. So they’re in excellent financial condition with a flawless balance sheet. I love investing in companies with low debt, but it’s somewhat rare to find a company with no debt.
The firm’s profitability metrics across the board are robust. The company has posted net margin that’s averaged 29.24% over the last five years, and return on equity has averaged 23.39%. These numbers compare extremely favorably to other large asset managers.
Assets under management have increased from $269.5 billion to $746.8 billion over the last ten fiscal years. While global equity markets have positively impacted the company’s AUM in a large way, net cash inflows have also substantially increased total AUM. Net cash inflows have averaged $17.1 billion over the last decade with only FY 2013 seeing net cash outflows.

Qualitative Aspects

T. Rowe Price derives the vast majority of its revenue and net income via investment advisory service fees. And these fees are largely based on total AUM. As such, it’s imperative that the company maintains a healthy and growing source of manageable assets.
The great news about the business model – this gives it an economic moat – is that once someone is invested with TROW in some capacity, the odds are good that they’ll stick with them due to the inherent ease of just staying in place and the uncertainty of any benefits of switching. That stickiness tends to provide them durable advantages. As long as they’re performing as they should, odds are that current clients will largely stick with them and these metrics will attract inflows down the road, which will also be sticky.
One area of particularly strong growth for cash inflows and growth in AUM has been target-date retirement funds. These are funds that offer one-stop shopping for retirement planning. They automatically adjust a client’s asset allocation mix as they get closer to retirement and attempt to ensure enough income to last for a lengthy retirement. So instead of a worker having to choose five or six funds they may or may not understand, TROW makes it easy by offering one fund that’s based on a client’s age and expected retirement year.
I’ve long been hesitant to invest in asset managers because I’m a DIY investor and see successful long-term investing as something that’s not that difficult. However, I’ve been guilty of bias by assuming my perspective is shared by a healthy chunk of the general population. Hint: it’s not. I think it’s fair to say that most people lack the time and/or inclination to manage their own investments, which is probably a good reason why major asset managers continue to grow.
In addition, defined contribution plans such as 401(k)s offered through prospective clients’ workplaces often don’t offer individual stocks as an available asset class for investment. These DC plans are still dominated by funds, which, I believe, is why TROW’s target-date funds have been so appealing. I think back to when I knew nothing about investing and a fund that did all the planning and work for me based on my age and planned retirement year would have been a great solution.
As pensions continue to disappear and people become more responsible for their own retirement income, it makes sense that asset managers like TROW will continue to grow AUM. Moreover, there’s continued pressure on Social Security as a viable income source for many due to an influx of baby boomers and the potential for reduced income for future generations. These are long-term tailwinds for the company and the industry in general.
While the growth of passive investing through low-cost index funds remains a potential headwind for the company, the fact that their active management record remains one of the brightest in the industry bodes well for the firm. Over the last decade, 88% of the company’s mutual fund offerings outperformed their peers. And 100% of the target-date retirement funds outperformed peers on a total return basis over the last five years. Moreover, passive index funds have been around for quite a while, yet TROW’s growth over the last decade remains robust.
One last point is that TROW’s massive AUM gives them scale in an industry where scale matters. Larger AUM generates the kind of revenue and net income necessary to grow the business, attract quality managers, and continue developing the brand. And that size and scale also tends to speak for itself, as one is more likely to trust a large and established player than they are a smaller company.

Risks

I see the primary risk for the company as the rising prominence of index funds. Some recent large outflows have been apparently due to some clients interested in saving fees, and thus moving assets to index funds. T. Rowe Price’s issue here is that if it decides to offer low-fee index funds to appease clients and retain AUM, it would sacrifice significant fees. And I’d be willing to venture a guess that management feels it deserves the fees its charging due to consistent outperformance.
Another risk is the fact that the domestic stock market has risen so much so fast over the last five years that any correction could cause a reduction in AUM that may be compounded by the possibility of outflows as an emotional response by clients. While cash inflows have significantly contributed to the positive change in AUM over the last decade, market appreciation has accounted for much more. And TROW remains heavily exposed to equities.
Lastly, a more mild risk is the fact that TROW calculates its investment advisory fees on a daily AUM calculation, so any increased volatility could affect their revenue and net income.

Valuation

The stock’s P/E ratio of 18.19 is fairly attractive in this market, considering the quality and growth. And this compares well to the five-year average P/E ratio of 21.6. So whereas the market has typically valued this stock at a premium, it’s now valued at a discount. Furthermore, TROW’s yield has averaged only 2% over the last five years, and it’s now about 25% higher than that, even before factoring in the special dividend.
I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term growth rate. That growth rate is on the higher end of what I usually use, but it seems to be warranted here. TROW’s long-term dividend growth rate is substantially higher and the most recent raise just announced less than a month ago was almost twice that. And the payout ratio is moderate. There’s a chance that upcoming dividend raises could be lower if the market corrects significantly, but I believe that would be somewhat short term in nature like it was during the financial crisis. The DDM analysis gives me a fair value of $112.32.

Conclusion

Overall, this appears to be a very high-quality company. Fundamentally, it just doesn’t get much better. 30 consecutive years of dividend raises is mighty impressive by itself, but even more impressive is the rate at which the dividend has been growing over the last decade. And that even includes the major stock market correction during the financial crisis. No debt, robust profitability, a well-known brand name cultivated on outperformance, and long-term trends toward more DC business bodes well for them.
Passive index funds present the possibility of a long-term headwind while a stock market correction presents the possibility of a short-term headwind. However, index funds aren’t exactly new and the company has done well through previous market volatility. And these headwinds seem to be somewhat priced in as the stock appears to be undervalued based on numerous metrics.
Overall, I think this is an attractively valued high-quality stock, which is somewhat rare in today’s domestic stock market. The business model is easy to understand, they remain an entrenched player in their industry, and the metrics across the board are impressive.
This purchase adds $41.60 to my annual dividend income, based on the current $0.52 quarterly dividend per share. That doesn’t factor in the special dividend which will add $40 this year.
I’m going to include two current analysts’ valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar rates TROW as a 3/5 star value, with a fair value estimate of $89.00.
S&P Capital IQ rates TROW as a 4/5 star buy, with a fair value estimate of $96.80.
I’ll update my Freedom Fund in early April to reflect this recent purchase.
Full Disclosure: Long TROW.
What do you think of this stock here? An attractive investment candidate? What are you buying? 
Thanks for reading.

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1 comment:

  1. This is the second time I heard T Rowe mentioned as a stock pick this year. I am always a bit hesitant to invest in financial companies, as they are the first ones to bail on dividend shareholders. But time will tell if this is a good bet. Thanks for the info.

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