Thu, 17 Apr 2014
We're always willing to go where we see long-term value, but the market may not, says T. Rowe Price Capital Appreciation manager David Giroux.
Jason Stipp: I'm Jason Stipp for Morningstar. It's Beat the Market Week on Morningstar.com, and today we are checking in with T. Rowe Price manager David Giroux, who is the manager of T. Rowe Price Capital Appreciation Fund. That's a Gold-rated fund by Morningstar analysts, and David is also a prior Morningstar Fund Manager of the Year.
David, thanks so much for calling in today.
David Giroux: Jason, it's my pleasure.
Stipp: I want to talk to you about your process and how you run the fund. Can you talk a little bit about your primary approach to selecting investments, and then also your approach to managing the balance in the fund? You do own stocks and bonds, so how do you figure out the balance between those two asset classes?
Giroux: We spend a lot of time thinking about marketing efficiency. Over the last five, six, seven years, we've developed seven or eight areas where we think the equity market is inefficient; two or three areas where we think the fixed-income market is inefficient. We really try to exploit those inefficiencies on a daily basis, if you will.
One example of that would be the market, which is so focused on the short term, as opposed to the longer term. People are seeking stocks that are working now. We want to find stocks that may be under some stress right now, but if you take a two-, three-year time horizon, have significant upside and very good risk-adjusted returns.
In terms of your question, Jason, about how we manage equities versus fixed income, we're always doing risk-adjusted return profiles of a BB-rated bond versus a utility stock, and trying to judge the volatility of the return profile and the expected return we see from those investments. So, we are always making those kind of internal rate of return analyses across asset classes.
Stipp: Is the balance between the stocks and the bonds determined by the levels of opportunity that you see? How much of a shift might investors in your fund see between the two asset classes?
Giroux: You will see over time, our equity exposure will usually range between the mid-50s to low 70s for equities, and our fixed-income exposure will go from maybe 15% to probably as high as 40%, given the interest rate environment or equity valuations.
Right now we are on the lower end of our equity weight given that the market is somewhat expensive on a beta-adjusted basis, and our fixed-income exposure has actually gone up a little bit, partially because rates have risen a little bit, which makes bonds a little bit more attractive for a longer-term investor.
Stipp: When you are thinking about the risks of your process and the risks that you control for, what is your process? What are the risks inherent in the way that you invest and how do you manage them?
Giroux: First of all, if the market goes up 50% a year, we are not going to keep up with that equity market. I think most of our clients, our investors, understand that. We are trying to generate really strong risk-adjusted performance year-in and year-out, and really return a certain return stream that's consistent with the risks and objectives of our clients.
From an equity perspective, we tend to have a little bit of a quality bias, and we tend not to pay high multiple for stocks. So, if you have a momentum market, where high-multiple stocks are driving the equity market returns, that's probably a little bit of a challenge. Likewise, if you've got a really low-quality rally in the equity market, where companies that have some secular challenges were driving returns in the stock market, that would also be a little bit of a challenge to us.
Stipp: David, your fund has had success for the long term. It's been a great performer over long periods of time. Some investment approaches work for a while, and then they are arbitraged away, or others recognize that there is a way to make some extra money, and so it no longer becomes a great investment strategy anymore.
Why do you think the way that you invest has been able to continue to work for so long? Why is it durable?
Giroux: We are not purely a quantitative strategy. While we use quantitative analytics as complementary to our good fundamental analysis, I think what really sets us apart is we're always willing to go somewhere where we see value that the market doesn't. And usually where the market sees value is things that have already run. We're typically buying into areas where the market has already corrected. So, all the pain has already been felt.
An example of that would be, we went into last year having a very low weight in utilities because utilities were very, very highly valued. Utilities performed very, very poorly last year relative to the equity market, because their valuation at the start of the year was so expensive. At the end of the year, we saw utilities as being pretty attractive on a risk-adjusted basis, and we took it from our biggest underweight to our biggest overweight.
This year, in a surprise to the market, the equity market has been a little weaker and rates have actually been a little bit lower, and utilities have been really good stocks in the first quarter-plus of the year.
So we're always willing to go where we see long-term value, but the market may not. We're always hopefully ahead of the market, and I think that's the arbitrage that won't go away.
Stipp: David, a lot of managers will say, we look for high-quality companies; we want to buy them at a good price, but not a lot of managers can execute that successfully over long periods of time like we've seen executed successfully in your fund.
What do you think is the part of your process that allows you to have that edge and execute this philosophy successfully?
Giroux: I see a couple of things. One, on the equity side, we tend to be a little bit more concentrated in our positions. We don't believe there are 100 or 150 really good ideas in the equity market. We are not an index-hugger. We really believe that at any given point in time, there are probably between 20 and 50 really good ideas. So, if you look at our portfolio, we typically don't own more than 60 stocks in the portfolio at any one time. That's probably a little different than a lot of our peers.
Again, we're usually willing to buy into fear. We're willing to buy into a stock that's under pressure. I think a lot of our peers, they want to see the turn. They want to see the stock already up a lot before they invest. We would invest after a lot of pain already has been felt, where valuations are attractive, where the downside is limited, where if something better happens over a two- to three-year period, you have significant upside. That's where we think the risk-adjusted returns in the equity market are so powerful. I think very few of our competitors are willing to do that on a systematic basis.
Stipp: David, understanding the fund and how it performs, and the way that your strategy works--you mentioned how you like to go in when there has been some pain felt. You also said that you have a bit of a quality bias in the selections that you make.
What [should] an investor know before investing in your find? What things should they keep in mind about when the fund will look out of step with the market or with its peer group? What are some of those things investors need to know to use your fund better?
Giroux: I would say, one, generally speaking, we are contrarian. We are a contrarian who does a lot of fundamental work. So right now, people are generally pretty positive about the equity market. We're a little more pessimistic. In 2011, 2009, we were a lot more optimistic than the market. We're always going to be a little more of a contrarian.
I would also say, this is a strategy with three main objectives: We want to generate strong risk-adjusted returns every year. That doesn't mean we're going to keep up with the market necessarily, but what it means is that we want to generate high returns in the risks we're taking. Second, we don't want to lose money on a three-year basis. And third, we want to generate, over a full market cycle, equity-like returns with less risk than that of the overall market, which we've done over a long period of time. So that's the return threshold.
But in any one given year, it's clear that if the market is up 50%, we're not going to be up 50%. Hopefully when the market is down 50%, we won't be down 50%. I think there are a lot of investors, clients, who like the upside participation of our strategy with a lot less downside. That's really the return profile we're trying to generate for our clients.
Stipp: David Giroux of T. Rowe Price Capital Appreciation, thanks so much for opening the curtain a bit on to your process and your strategy.
Giroux: It's my pleasure.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.