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T. Rowe Price: An Undervalued Play for Long-Term Investors (TROW)

Financial analyst working on computer with multi-monitor workstation with real-time stocks, commodities and exchange market charts.  A businessman works at night in the downtown office of an investment bank.

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Since listing in 1986, T. Rowe Price Group, Inc. (NASDAQ:TRO) has grown more than 14,434%, compared to 3,687% for the S&P 500. Factoring in dividends, T. Rowe Price has amassed 16,432.5% of its wealth over that period, giving investors an annualized total of shares. About 20% return per annum. Over a 30-year period, the company has generated revenue of 135 per year, diluted GAAP earnings per share (EPS) by 17%, and increased dividends per share by 16% per year. Despite that stellar track record, year-to-date, the company is down 30% compared to about 11% for the S&P 500. The company is trading at very attractive valuations and the underlying economics of the company and industry suggest the company can continue to grow strongly.

Source: Google Finance

Source: Google Finance

What does T. Rowe Price do?

Founded in 1937 by T. Rowe Price, the company is an iconic name in finance. The company is the world’s eighteenth largest fund manager by assets under management (AUM) with $1.31 trillion in AUM, according to its Q2 2022 results. Over the past decade, AUM has grown at a compounded annual rate of 12%.

Source: Investor Day 2021

Source: Investor Day 2021

With offices in 16 countries around the world, T. Rowe’s Price services through its US mutual funds, subadvised funds, separately managed accounts, collective investment trusts and derivatives, according to its 2021 annual report. The Company also provides administrative services to certain clients. The company’s AUM is invested as follows: $700 billion in equities, $171 billion in fixed income, $396 billion in multi-asset strategies, and $43 billion in alternative products managed by recently acquired Oak Hill Advisors.

High performance funds

As a fund manager, AUM flows depend on market conditions and charges. Fees vary by product, but average around 0.45%. Fees across the industry are in secular decline. According to T. Rowe Price, fees have come under pressure as passive investing has taken market share away from traditional active strategies. It is still possible to grow investment advisory fees as a function of the growth of AUM, but active managers do not have the competitive advantages necessary to increase fee levels.

As a result, the success of T. Rowe Price and other fund managers increasingly depends on their ability to generate high returns from passive investments. This has the effect of increasing fund inflows, increasing fee income and retaining existing funds.

It is encouraging that the company’s products are outperforming their benchmarks, bucking the trend of large funds experiencing declining returns.

Source: Investor Day 2021

Source: Investor Day 2021

Source: Investor Day 2021

Source: Investor Day 2021

Long-term AUM rises

Although stock markets are subject to boom-and-bust cycles, as Jeremy Siegel’s work shows, over the long term, stock markets tend to rise in value. Of course, this assumes that the fund’s strategy doesn’t blow the fund. A look at the chart of the S&P 500 makes this clear.

Source: Robert Schiller

Source: Robert Schiller

We can believe this fact because of three factors:

  1. Governments have created more of a floor for stock market prices and have shown that they are ready to step in and support the market when they feel prices are too low. This increases the liquidity of the markets, as each investor is assured that there will always be someone to sell their shares to.

  2. Moreover, over the past eight centuries, interest rates have been in secular decline and this has made equity markets more attractive and investing in them more attainable.

  3. Although demand for equities is increasing, supply for equities is highly volatile and this puts further upward pressure on equity market prices.

A combination of these factors means that a discretionary managed fund like T. Rowe Price does not have to experience inflow growth to grow AUM, because over the long term, market prices tend to rise.

Emphasis should be placed on the fund’s ability to stay in the game, ie not blow up.

T. Rowe Price is able to maintain a high foundation for their AUM and income. This is because its customers face switching costs as they seek alternatives to T. Rowe Price. Getting a new partner means undergoing new rounds of due diligence, assuming the risk of not working with a new partner, and possibly going for a period without an investment partner. As long as the company delivers modest performance, it has room to turn around, especially when it comes to pension funds.

Although passive investment vehicles have wiped the ground with active managers, there are still clients who want to earn returns beyond what passive investment vehicles offer. Moreover, the market is not always right. Although the market is in equilibrium most of the time, there are times when it is far from equilibrium and active managers exist to exploit those opportunities. Active managers are not headed for Armageddon.

In terms of risk management, the company’s portfolio is diversified across different strategies and its value investing philosophy ensures that the company has a minimum margin of safety while purchasing assets. Furthermore, the company believes that conditions are changing in favor of value stocks, and I agree. In a world of stagnation, I think the outperformance of the post-growth 2008 period has come to an end.

evaluation

The company generated free cash flows (FCF) of about $3.137 billion in trailing twelve months (TTM) and has an enterprise value of $27.94 billion, giving an FCF yield of about 11.23%. This is much higher than Treasury yields and indicates that the company’s underlying and stock performance will be higher in the future. The company’s FCF, which grew from around $826 million in 2012 to $3.137 billion during the TTM period, shows that it is on offer at a very attractive valuation.

Additionally, T. Rowe is trading at a price-to-earnings (P/E) ratio of 12.75, compared to a 5-year average of 15.07. According to Aswath Damodaran’s data, the industry has a P/E ratio of 72.9. In addition, the P/E ratio of the S&P 500 is 21.63. The company is clearly trading at a discount to its historical value, the industry average and the market.

Conclusion

T. Rowe Price is a storied name in the fund management industry. It has proven to be a compounding machine that can easily beat the results of any stock market index. Its products are similarly successful, giving the company a long-term advantage in building its AUM. Given secular trends, the company can tolerate stagnant AUM inflows, which should provide strong support for growth. The company is trading at a very attractive valuation and is a must-buy for long-term investors.

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