The Father of Growth Investing: T. Rowe Price Screen

Summary

A GARP investing approach based on identifying companies with long-term prospects in their early stages before they become quot;glamourquot; stocks.

Background

Considered by some to be quot;the father of growth investing”, T Rowe Price started investing in the 1920s. He founded T. Rowe Price Associates in 1937, a firm which has subsequently grown to manage assets of over $300 billion. His innovation was to depart from the then conventional wisdom that all stocks were cyclical, argung instead that most companies passed through a life-cycle (growth, maturity and decline). He advised looking for “fertile fields for growth” and then holding for a long time.

He defined a growth company as one which:

“has demonstrated long-term growth of earnings, reaching a new high level per share at the peak of each subsequent major business cycle and which, after careful research, gives indications of continuing growth from one business cycle to the next at a rate faster than the cost of livingquot;. 

He also felt that growth companies need to be in growing industries such as new industries, divisions of old industries experiencing growth as a result of new products or new uses for old products, and specialty industries with expanding products and markets. 

According to John Train of quot;The Money Mastersquot;, Price looked for these characteristics in growth companies:

• Superior research to develop products and markets.
• A lack of cutthroat competition.
• A comparative immunity from government regulation.
• Low total labor costs, but well-paid employees.
• At least a 10%  return on invested capital, sustained high profit margins, and a superior growth of earnings per share.

“In short, invest money in a business that must cope with the minimum of consumer, labor, and government interference, that is managed by men with vision who understand the significance of the social and economic trends, and who are preparing for the future through intelligent research and development”.

Criteria

It is not easy to screen mechanically (given the long time series of data required) for one of Rowe's main criteria - he looked for companies with EPS increasing at the peak of each successive major business cycle, in order to rule out non-growth “cyclicals. Nevertheless, here are some other quantitative criteria for an indicative T. Rowe Price Screen:

• Earnings growth: Price also specified that earnings per share should be increasing faster than inflation but, given current inflation levels, this is not particularly demanding. As an arguably imperfect alternative, one set of screen criteria might be to specify that the 3 Year, 5 Year and 7 Year EPS growth be above a minimum level of, say 5% and also be rated above average vs. the database median.
• Reasonable price: While looking for growth, he looked for stocks quoting at a PE ratio lower than the historical average, so it might make sense to stipulate that i) the PE ratio is less than the five-year average and ii) the average PE ratio for the last 5 years is less than 40 (each year and on average)
• Size: He placed no restrictions on size as such, although smaller capitalization stocks were viewed as particularly attractive.
• Secure Financial Position: Cash flow for the last 12 months is greater than zero.
• Return on Capital - RoIC gt; 10% and above the industry's media for the last 12 months. 
• Favourable and rising profit margins: Operating Margins and Net Margin above the industry's medians for last 12 months and above the 5 year average.
• Management support:  Insiders own gt; 20% of the outstanding shares. On a more qualitative note, Price wanted to know are directors and officers pro-active, are they planning for the future growth of the company through intelligent research and do they have the good will of their employees?

Does it work?

Since inception, the AAII implementation on a Rowe Price screen has seen a 9.7% return since inception (vs. 2.4% for the Samp;P 500). More anecdotally,  Price and his firm were extremely successful employing the growth stock approach to buying stocks. Merck, the pharmaceuticals firm which grew at an average rate of 18.6% per annum over 32 years, not including dividends, was one of his early finds.

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From the Source:

Rowe Price died in 1983 and did not summarise his thinking in a book, unfortunately.  He did however write various articles for financial publications such as Barron's amp; Forbes and as well as pamphlets for clients describing the investment philosophy of his firm such as “Change—The Investor's Only Certainty” (1937) and quot;The New Era for Investorsquot; (1968). However, neither of these sources are easy to access. However, there are a couple of books worth reading on Price's life and approach, firstly Forbes' greatest investing stories (available online) and secondly,  John Train's Money Masters.

Watch Out for

Price believed in a long-term buy-and-hold strategy. For example, in the early 1970s, Price had accumulated gains of 6184% in Xerox (XRX), held for 12 years, and gains of over 23000% in Merck (MRK) over the course of 31 years as mentioned above (see Lessons from the Legends of Wall Street).According to Price, the time to sell was when a company no longer appeared to have favorable future growth prospects. If it still met the criteria, significant price declines offered an opportunity to add to a holding.  Nevertheless, he constantly emphasised the importance of looking out for change:

quot; A forward-looking investor must be able to reasonably assess and evaluate the currents and the tides and be prepared to reckon with winds or storms, which are unpredictable. He must be constantly alert. He must stick to the basic concepts which have proven sound over a period of centuries, be flexible of mind and be willing to change opinions, change tactics, and not stubbornly stick to old opinions and buck new trends, or try to swim against the tides.quot;

In terms of diversification, AAII note that Price felt that as many as 60 stocks could be necessary, with this level of exposure allowing an investor to participate in a wide range of basic industries and to hedge against almost any conceivable crisis. 

Other Sources:

• Investopedia on Rowe Price
• AAII on Rowe Price
• ValuPickr on Rowe Price
• Daily Reckoning: The Investment Secrets of T Rowe Price
• The Intelligent Investor on Price

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