Fund Spy

This Fund Filled With Dividend Payers Earns an Upgrade

Katie Rushkewicz Reichart, CFA

The following is our latest Fund Analyst Report for T. Rowe Price Equity Income Fund  (PRFDX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days. 

T. Rowe Price Equity Income has adjusted well to a manager change. Its Morningstar Analyst Rating is upgraded to Silver from Bronze. 

Manager John Linehan has gotten off to a good start since taking over for the retiring Brian Rogers in late 2015. Despite changes on the margins, Linehan has stayed true to the fund's mandate, investing in undervalued dividend-payers. But unlike some equity-income funds, absolute yield is not the only driver here: The potential for price appreciation, valuation, and the quality of company management also matter.

The robust process draws on T. Rowe's core strength of analytical research. The work involves understanding a company's cash flows, gauging management's commitment to a dividend, and stress-testing whether it is sustainable. But the fund is not just a simple yield play. Linehan draws on T. Rowe's deep analyst bench to understand changing competitive dynamics within industries to limit value traps. Within the embattled consumer discretionary sector, for instance, Linehan recognized in 2017 that  Macy's (M) real estate values had decelerated faster than expected. He sold it and bought  L Brands (LB), which he thought was better positioned with differentiated product offerings--and not priced to reflect that. Still, in a nod to prudent portfolio construction, that position consumed just 0.35% of assets as of March 2018 given potential downside risk.

Beyond T. Rowe's deep analyst bench, Linehan adds to the process. He is deeply involved in  DowDuPont (DWDP), for instance, which, postmerger, should extract cost savings and then may split into three separate businesses. His long-term mind-set comes into play with holdings like these that may take time to play out. Indeed, turnover was just 20% the past two years.

Linehan is off to a good start, with the fund beating the Russell 1000 Value Index, FTSE High Dividend Yield Index, and large-value Morningstar Category. While that's a short stretch, his success at former charge  T. Rowe Price Value (TRVLX) from 2003-09 bolsters confidence in his abilities here. Below-average expenses also help.

Process Pillar: Positive | Katie Rushkewicz Reichart, CFA 05/11/2018
This fund has stayed true to its roots under manager John Linehan, and he's executed well, earning a Positive Process rating. Like his predecessor, Linehan looks for companies trading cheaply relative to the market, industry, or historic norms. The portfolio consists of firms that offer at least a modest yield and the potential for price appreciation, which he seeks by buying out-of-favor names in a variety of sectors. Nearly all of the fund's holdings pay a dividend, but absolute yield is not the main objective; the fund's yield hasn't been notably high relative to equity-income large-value funds, but it is likely to land in the top half of the large-value category over time. The fund continues to look a bit lower quality than many equity-income peers, sporting a higher debt/capital ratio and lower returns on equity, assets, and invested capital. It remains diversified, with 100-120 holdings. But while his predecessor occasionally held some cash if bargains were scarce (which weighed on performance in the post-2008 bull market), Linehan will likely keep cash below 4%.

Linehan's process at T. Rowe Price Value from 2003 to 2009 didn't emphasize dividends as much as this fund, and it didn't hold up quite as well in market declines (though it did fare better than the Russell 1000 Value Index in both up and down markets). However, since taking over here in 2015, he has maintained the same approach that fund investors have come to expect.

John Linehan was announced as Brian Rogers' successor in 2014 and started weighing in on the portfolio a few months before the official October 2015 transition. Turnover, which was under 15% in Rogers' final years, picked up to 27% in 2015 as Linehan made changes, but has been around 20% since.

The fund benefited from holding on to some names that excelled in 2017, including  Microsoft (MSFT) and  Boeing (BA). However, the fund is squarely in the large-value section of the Morningstar Style Box. As of March 2018, the fund's sector weightings weren't too different from the Russell 1000 Value Index. The fund had slight underweightings to energy and healthcare and had above-benchmark stakes in industrials and materials. From a broad standpoint, Linehan has dialed back risk a bit, adding a few consumer staples names and utilities that he considered reasonably valued relative to the market, such as Kimberly-Clark Corp (KMB) and  Sempra Energy (SRE). Meanwhile, he's willing to take a long time horizon with names that may take awhile to play out, such as DowDuPont, which he purchased in late 2017 and may be broken up into separate entities.

The fund's cash stake has dropped to under 2% of assets from nearly 7% in December 2014; cash had been a headwind in strong markets, and Linehan doesn't plan to hold more than 4%. The fund occasionally owns some convertible bonds or preferred shares.

Performance Pillar: Positive | Katie Rushkewicz Reichart, CFA 05/11/2018 
John Linehan is off to an impressive start. With the fund handily beating the Russell 1000 Value Index and large-value category on his watch, its Performance rating is upgraded to Positive.

Since Linehan took over in late October 2015 through April 2018, the fund's 12.2% annualized gain beat the Russell 1000 Value Index's 10.3% and the large-value Morningstar Category's 10.1%. It also edged the FTSE High Dividend Yield Index and maintained an edge on a risk-adjusted basis against those bogies as well.

While 2017 was a year that favored growth, this fund benefitted from hanging on to Microsoft and Boeing--both big winners. For the year to date through April, the fund has posted a smaller loss than its category and relevant benchmarks.

While Linehan's record here is still fairly short, he posted good results at his previous charge, T. Rowe Price Value. He led that fund to an 8.3% annualized gain from April 2003 to December 2009 versus the Russell 1000 Value Index's 6.9% and this fund's 7.2%. T. Rowe Price Value did better in rising markets than this fund on his watch but not as well in pullbacks, and it was more volatile (based on standard deviation) than its average large-value peer and the Russell 1000 Value Index. However, with this fund's stated equity-income objective, he should be able to adjust to a more muted risk profile.

People Pillar: Positive | Katie Rushkewicz Reichart, CFA 05/11/2018 
An experienced manager and a solid analyst bench lead to a Positive People rating.

John Linehan succeeded Brian Rogers, manager of this fund since its late-1985 inception, on Oct. 31, 2015. Linehan joined the firm in 1998 as an industrials analyst. Linehan has experience running money, having led T. Rowe Price Value to peer- and benchmark-beating results from 2003 to 2009. He has also comanaged T. Rowe Price Institutional Large Cap Value (TILCX) since 2004, though arguably much of his time from 2009-15 was devoted to his role as head of U.S. equities. He vacated that managerial role upon the succession announcement in 2014, which gave Linehan time to re-engage with the analysts, and he started weighing in on the portfolio a few months before the official transition. He also took on the role of CIO of U.S. value equities in early 2017.

Linehan has access to the same analyst team as Rogers, and that team has generally been strong. Heather McPherson is associate manager; she previously held the same role at Gold-rated  T. Rowe Price Mid-Cap Value (TRMCX) for nearly a decade and now comanages T. Rowe Price Institutional Large Cap Value alongside Linehan and Mark Finn. This fund is much bigger than T. Rowe Price Value was on Linehan's watch, but his prior experience and record, as well as the general strength of the analyst bench, work in its favor. Linehan invests over $1 million in the fund.

Parent Pillar: Positive | Katie Rushkewicz Reichart, CFA 04/06/2017 
T. Rowe Price is evolving but retains the strong research-focused culture that's driven its long-term success. Despite the retirements of some long-tenured portfolio managers, the former CEO, and outgoing CIO Brian Rogers, the firm's careful focus on succession planning and long transition periods have eased the process. Even with a changing of the guard, there's no lack of talent. Successful former portfolio manager Rob Sharps is now co-head of global equities and oversees five CIOs who are among the firm's top managers. The analyst team is on solid footing, and the firm has continued hiring despite the pressures facing active managers. CEO Bill Stromberg, who joined T. Rowe in 1987 as an analyst, maintains an investment focus while recognizing that the business must evolve to flourish in an industry that's gravitated toward passive investing. The firm is bolstering its technology resources and is expanding its distribution overseas, achievable goals given its pristine balance sheet. In 2017, the firm opportunistically acquired the Henderson High Yield Opportunities team, led by a former T. Rowe employee, as it addresses demand for capacity-constrained strategies that are also part of its popular target-date lineup and potentially new multiasset products down the line (several T. Rowe strategies are closed). T. Rowe is sensibly adapting, and its fundholder-first mentality and ability to attract and retain investment talent support its Positive Parent rating.

Price Pillar: Positive | Katie Rushkewicz Reichart, CFA 05/11/2018 
The no-load share class, which holds the majority of assets, is priced below average relative to similarly distributed peers; its 0.65% expense ratio is well below the 0.89% peer median. The institutional shares are also priced below average. A small portion of assets is housed in the advisor and R share classes, which have average expenses. The fund's relatively low turnover keeps trading costs down. Overall, shareholders benefit from reasonable costs here, earning the fund a Positive Price rating.

Katie Rushkewicz Reichart, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.