We Downgraded T. Rowe Price Small-Cap Stock to Neutral

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Longtime T. Rowe Price Small-Cap Stock manager Greg McCrickard announced he'll step down from the fund as of Oct. 1, 2016, after a successful 24-year tenure. He'll remain at the firm in a role mentoring analysts. As a result of the change, the fund's Morningstar Analyst Rating has dropped to Neutral from Silver.

Successor Frank Alonso joined T. Rowe in 2000 and has worked alongside McCrickard since 2013 as the fund's associate portfolio manager. That role gives him familiarity with the fund's holdings, and he'll benefit from a six-month transition period. His experience as a diversified manager dates back to October 2013, when he took over the T. Rowe Price US Smaller Companies Equity strategy, available to investors outside the United States. During his tenure through March 2016, that offering outperformed its Russell 2500 benchmark by nearly 2 percentage points annualized.

It's encouraging that Alonso posted good results during his short tenure at US Smaller Companies Equity, though there are some differences. That strategy is a small/mid-cap offering with a higher average market cap. Because of a smaller asset base, the portfolio has been leaner than this fund, recently owning 200 stocks to this fund's 311. There will be more to keep an eye on here, though Alonso owned 113 holdings in common with this fund as of December 2015. He'll also have the assistance of new associate manager Curt Organt, an industrials analyst who has worked closely with McCrickard since the 1990s.

T. Rowe has a strong history in small-cap investing, and Alonso has good analytical resources at his disposal. However, his tenure on the small-cap team only dates to 2013, and he will be running significantly more assets here ($10 billion) than currently ($800 million). That may take some getting used to, especially since liquidity constraints for small-cap stocks can prove challenging. He doesn't anticipate major changes to the fund's process or risk profile, but until we see how he settles in as lead manager, the fund is rated Neutral.

Process Pillar: Neutral | Katie Rushkewicz Reichart, CFA 04/12/2016 Incoming manager Frank Alonso doesn't expect to drastically change the fund's process upon taking over in October 2016. However, with some uncertainty about the types of changes he might make or how successfully he'll execute, the fund's Process rating is Neutral.

This fund aims to strike a balance between value and growth stocks. Outgoing manager Greg McCrickard used discounted cash flow analysis and evaluated businesses on other factors, including company management, product cycles, catalysts for change, and cash flow generation, to avoid value traps. Growth stocks generally fit a growth-at-a-reasonable price profile, but the fund also owns some highfliers. For riskier industries like biotechnology, individual position sizes have been limited so that one pick can't upend the fund.

As of March 2016, the strategy was over $10 billion in assets, and the fund is one of the industry's bigger actively managed small-cap offerings. The fund has maintained success with its large asset base by keeping a broadly diversified portfolio (more than 300 stocks) and keeping turnover relatively low. The fund closed to new investors on Dec. 31, 2013, a timely decision given the huge run small-cap stocks have experienced in recent years. It was previously closed in the mid-2000s, reopening in 2009 after the financial crisis. Alonso will have to adjust to a much larger asset base, having previously run less than $1 billion in assets.

Since late 2013, Alonso has run a small/mid-cap strategy sold to non-U.S. investors that is benchmarked against the Russell 2500 Index. It has more mid-cap exposure, and its nearly $3 billion average market cap was higher than this fund's $2 billion as of December 2015. It also holds a leaner portfolio of 200 names to this fund's 311. However, it does have about 50% overlap in assets. As of December 2015, that strategy owned 113 of this fund's 311 stocks. Sector weightings were relatively similar between the two funds.

While the fund previously resided in the small-blend Morningstar Category, its portfolio has skewed toward growth during the past decade, prompting a category change in 2012. Indeed, the fund has sported higher average price multiples than the Russell 2000 benchmark. Some of the fund's more growth-oriented holdings have been among the biggest contributors to performance in recent years, particularly within the biotechnology industry. Alonso's small/mid-cap charge lands in a similar spot in the Morningstar Style Box from a growth standpoint as this fund.

The fund had lower REIT and technology stakes and higher industrials exposure than its benchmark as of December 2015. The fund's cash stake has ranged from 4% to 8% in recent years.

Performance Pillar: Positive | Katie Rushkewicz Reichart, CFA 04/12/2016 This fund has bounced between the small-blend and small-growth categories (it's currently in small growth), but its record under longtime manager Greg McCrickard looks good either way. Since his late-1992 start date through March 2016, the fund has gained 11.5% annualized, beating 80% of all small-blend and small-growth funds that have been around that long and staying well ahead of the Russell 2000 Index's 9.3% annualized return. It looks even better on a risk-adjusted basis and earns a Positive Performance rating.

As is customary with manager changes, the fund's performance rating will reset to Neutral when incoming manager Frank Alonso officially takes over in October 2016. Alonso doesn't have a very long record managing money, but has posted good results during his short stay at a small/mid-cap strategy sold outside the U.S. That strategy, T. Rowe Price US Smaller Companies Equity, has gained 7% annualized from his October 2013 start through March 2016, surpassing its Russell 2500 benchmark by nearly 200 basis points. It's also done well on a risk-adjusted basis, which bodes well for this fund; under McCrickard, this fund typically outperformed peers and the benchmark in market pullbacks. The risk profile of this fund is unlikely to drastically change following Alonso's start. Given its asset base, the portfolio will likely remain very diversified, limiting stock-specific risk.

People Pillar: Neutral | Katie Rushkewicz Reichart, CFA 04/12/2016 Greg McCrickard will step down from the fund in October 2016 after 24 years at the helm. McCrickard will remain at T. Rowe in a role that involves mentoring the analysts, but he will hand off the fund to Frank Alonso, who has been associate portfolio manager since late 2013. Alonso joined T. Rowe in 2000 and was previously a consumer analyst who contributed to the firm's analyst-driven strategy. In 2013, he took over T. Rowe Price US Smaller Companies Equity, a small/mid-cap strategy sold outside the U.S. that recently had about $800 million in assets. He will hand off his duties there to focus on this fund. Curt Organt, an industrials analyst who has worked closely with McCrickard since the 1990s, will become associate portfolio manager during the transition.

The six-month transition period is a plus, as it will give Alonso time to gain more familiarity with the portfolio. At this point, however, the fund receives a Neutral People rating, as Alonso has only been involved on the small-cap side for 2.5 years, and it will be an adjustment to run $10 billion in assets.

The small-cap franchise has lost some experienced leaders to retirement in McCrickard and Preston Athey of T. Rowe Price Small-Cap Value PRSVX. However, T. Rowe has demonstrated consistent success in small-cap investing through the years, and Alonso will be able to draw from a talented analyst team.

Parent Pillar: Positive | Katie Rushkewicz Reichart, CFA 11/24/2015 T. Rowe Price is an industry leader, with a strong lineup of funds across asset classes. The firm's disciplined, risk-conscious investment process has consistently produced successful results across its fund lineup, often with less volatility than peers. Many managers spend their careers at the firm, providing continuity for fund shareholders. Manager retirements are typically announced well in advance, allowing for a long transition process.

After a few unexpected departures of top managers in 2013 and 2014 and an uptick in analyst departures on the U.S. equity team, the pace of turnover has slowed. The departure of head of fixed income Mike Gitlin was a surprise, but the firm quickly filled the role with 31-year T. Rowe Price veteran Ted Wiese. Other executive changes have been handled with ease, including that of CEO James Kennedy, who will be succeeded by Bill Stromberg in 2016. Meanwhile, the firm is in a strong financial position and remains amply resourced.

T. Rowe Price has acted in fundholders' interests by closing funds with surging asset bases and avoiding trendy fund launches. Reasonable fees and a manager compensation plan focused on long-term performance are other pluses. One area of weakness is manager ownership of fund shares, which is not among the industry's best and could stand to improve.

Price Pillar: Positive | Katie Rushkewicz Reichart, CFA 04/12/2016 The bulk of the fund's assets are in the no-load share class, whose expense ratio is low relative to other no-load small-cap funds. However, it's not quite as cheap as its small-cap sibling, T. Rowe Price Small-Cap Value, which is of similar size. The Advisor share class (which holds few assets) is priced average relative to similarly sold peers. The fund's low-turnover approach has kept other costs in check. For instance, its brokerage commissions as a percentage of net assets are well below the category norm. Overall, fund investors here get a good deal, and the fund earns a Positive Price rating.