The Allocation Fund Investors Wish They Owned

The following is our latest Fund Analyst Report for T. Rowe Price Capital Appreciation PRWCX. 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.

A proven lead manager, a disciplined investment process, and below-average fees support T. Rowe Price Capital Appreciation's Morningstar Analyst Rating of Gold.

The fund has amassed an remarkable record under David Giroux, who has managed the fund for more than a decade. The fund has outpaced its typical allocation--50% to 70% equity Morningstar Category peer in each calendar year since 2008. Moreover, during the past 10 years, the fund outperformed the S&P 500 by more than 1 percentage point annualized with about three fourths of the volatility.

That's an impressive feat given that equities have represented just 63% of assets, on average, over the past decade. Attribution provided by T. Rowe Price indicates that the stock sleeve about doubled the return of the S&P 500 during that span, and the bond sleeve outpaced the Bloomberg Barclays U.S. Aggregate Bond Index by more than 150 basis points annually. Giroux and team leverage the firm's highly regarded equity and bond research groups, but they also conduct rigorous analysis on their own by projecting internal rates of return for every holding.

Giroux has also made some savvy allocation moves, typically increasing the portfolio's risk during sell-offs. Equities have ranged from 57% to 72% of assets. The remainder of the portfolio has consisted of a flexible mix of investment-grade and high-yield corporate bonds (currently 21% of assets), convertible bonds and preferred stocks (3%), and leveraged loans (2%). Cash has ranged from 3% to 20% of assets (currently 14%), as Giroux likes to keep dry powder on hand to take advantage of market corrections. In addition, he often writes call options on some equity holdings to generate income (currently 8% of total assets). Giroux also opportunistically allocates to Treasuries.

The fund closed to new investors in 2014, which has been effective in slowing growth; it experienced net outflows so far in 2017. Giroux runs about $45 billion in the strategy. While the fund's size bears monitoring, the portfolio hasn't shown signs of becoming too large.

Process Pillar: Positive | Leo Acheson, CFA 11/01/2017 David Giroux typically keeps 55% to 65% of this fund's assets in stocks. However, he prefers to measure the fund's sensitivity to equities via its delta-weighted equity exposure--a proprietary calculation that adjusts for covered calls and convertibles. Giroux expects that exposure to remain between 50% and 70%, but it can fall outside of that number when Giroux finds a lot of cheap companies.

In the equity portfolio, Giroux typically looks for blue chips selling at a discount based on their price/earnings or price/book ratios; he values more-cyclical companies on their earnings across a full market cycle. The fund typically owns 60-80 stocks, and individual positions rarely get much above 3% of assets. Giroux historically held equities for about two years, but he had sold some higher-quality picks too soon. Thus, in recent years, he's added a longer internal rate of return measure that extends to five years. Sector weightings can vary significantly from those of the S&P 500.

The rest of the portfolio is quite flexible. Giroux has found convertible bonds increasingly less attractive during his tenure, so their weighting has declined. The fund has at times also held double-digit weightings in traditional bonds (both investment-grade and high-yield debt), leveraged loans, and cash. Giroux also writes call options on some holdings. The fund's distinctive, wide-ranging approach earns a Positive Process rating.

The fund held 72% of its assets in stocks in mid-2011, but it hasn't come close to that level lately as Giroux has found fewer compelling ideas. As of September 2017, the portfolio held 61% in equities. However, the portfolio's delta-weighted equity exposure stood at 56%, reflecting Giroux's somewhat cautious view on the market. (Calls written against stock holdings reduce the portfolio's sensitivity to equities.)

The equity portfolio has recently moved from the large-blend portion of the Morningstar Style Box to large growth. That's primarily due to two factors: First, within financials, the fund has largely steered clear of beaten-down money center banks and instead favored insurance companies that have commanded modestly higher valuations, such as

The fixed-income portfolio has seen shifts as well. The fund's stake in convertible bonds (once in the teens) has shrunk to less than 3% because of a dearth of attractively valued new issues, as well as a lack of large enough deals to accommodate the fund's increasing size. Leveraged loans became more than a 10% weighting in recent years, but that stake has declined to 2% due to valuations. The fund added a slug of Treasuries in mid-2013 when yields rose but eventually sold that stake when the bonds rallied.

Performance Pillar: Positive | Leo Acheson, CFA 11/01/2017 This fund has been remarkably successful on manager David Giroux's watch. It outpaced all of its peers in the allocation--50% to 70% equity Morningstar Category from his June 2006 start through October 2017, and beat more than 90% of those peers on a risk-adjusted basis, as measured by the Sortino ratio and Sharpe ratio. The fund has also been a consistent performer: Over 77 rolling five-year periods during Giroux's tenure, it has surpassed a 60%/40% mix of the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index 100% of the time. The fund has also beaten at least 75% of its peers in every one of those periods. The fund earns a Positive Performance rating.

Giroux and the team behind him have added value across the various types of securities in which they invest. The equity portfolio has beaten the S&P 500 during his tenure by a hefty margin, and the fixed-income sleeve has outpaced the Bloomberg Barclays U.S. Aggregate Bond Index. Also, before the firm stopped including data on the performance of the convertibles subportfolio (because it shrank to a sliver of assets), that portion of the fund handily beat its benchmark.

Although Giroux will boost the fund's equity exposure when valuations are low (as he did in early 2009)--potentially juicing volatility in the process--the fund has lost 93% as much as its typical peer when stocks decline and captured 117% of its typical peer's gains in rising markets.

People Pillar: Positive | Leo Acheson, CFA 11/01/2017 This fund benefits from a veteran manager. David Giroux has run this fund since June 2006. He had Jeff Arricale as a comanager for the first 12 months, but Arricale became the head of the firm's financials team and later left the firm. In mid-2012, Steven Krichbaum, a key analyst since 2007, became associate manager. Giroux had been an analyst, primarily in the industrials sector, for eight years before taking over the fund. He was informed nearly two years in advance that he (and Arricale) would be running the fund.

Giroux has a big job because the fund invests in equities, convertibles, various types of traditional bonds, and cash. Giroux also co-heads the firm's asset-allocation committee, which meets monthly. While in the past he has relied on members of the fund's investment committee to some degree, he now has more help with Krichbaum, as well as associate analyst Michael Signore and researchers Erik Ringo and Chen Tian. Giroux relies broadly on the firm's scores of equity and fixed-income analysts, though he'll turn more often to those who cover value-oriented sectors. Krichbaum handles much of the communication with analysts to save Giroux time.

Giroux invests more than $1 million in the strategy, aligning his interests with shareholders. His record here, experience, and supporting cast earn a Positive People rating.

Parent Pillar: Positive | 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 | Leo Acheson, CFA 11/01/2017 The 0.70% expense ratio of the fund's Investor share class, which holds 88% of the assets, earns a Morningstar Fee Level of Below Average and comes in 20 basis points cheaper than the median for similarly sold peers. The expense ratio (0.60%) for the I share class came down by 4 basis points over the past year. This share class holds 8% of the assets and earns a Low. The Advisor share class charges 1.00% and earns an Above Average, but it holds just 4% of the assets. True, the fund should be cheaper than most of its peers given its sizable $29 billion asset base, but it earns a Positive Price rating.