Earlier this week, I did something that I really don’t like to do.
I sold a stock from our Top 20 Dividend Stocks and Long-term Dividend Growth portfolios, exiting my position in T. Rowe Price (TROW).
T. Rowe Price, perhaps best known for being one of the 51 dividend aristocrats, is one of the world’s largest investment managers with over $800 billion in assets under management (AUM).
I originally purchased shares of T. Rowe Price during the summer of 2015 and was attracted to the company for several reasons:
- Few companies have earned the trust of their clients like TROW, made possible from its long-term track record and scale.
- Over 80% of TROW’s mutual funds outperformed their comparable Lipper averages over the last 3-, 5-, and 10-year periods.
- TROW’s average annual fee is less than 50 basis points, much less than the 77 basis points charged by the average U.S. mutual fund.
- Approximately two-thirds of TROW’s AUM is tied up in retirement and annuity funds, stickier products that benefit from the aging population.
- As the highly fragmented fund industry continues facing pressure on fees, TROW’s scale could make it a natural consolidator.
When I buy shares of a business, I hope to hold my ownership stake forever.
In fact, our three dividend portfolios reported turnover rates of just 16%, 9%, and 7% in 2016, reflecting my belief that buy-and-hold investing is one of the most effective habits of successful dividend investors.
While such a strategy isn’t the most exciting approach, its simplicity and focus on the long-term resonate well with me.
However, the future doesn’t always play out how I expect it to, which prompts me to make an occasional adjustment or two in my portfolio.
Even the best investors are usually wrong more than 40% of the time. That’s just the nature of investing, which contains a good deal of uncertainty.
The hard part is knowing when we are wrong and taking the appropriate corrective actions.
Generally speaking, there are four primary reasons why I will sell a dividend stock:
1) The safety of a company’s dividend payment has come into question due to unexpected fundamental weakness.
2) The company’s long-term earnings power appears to have become impaired as a result of new competition, secular changes, etc.
3) The stock’s valuation reaches seemingly excessive levels.
4) I have a new stock idea with a much more attractive long-term outlook and reasonable valuation.
T. Rowe Price certainly doesn’t violate my first or third reasons. The company’s Dividend Safety Score of 93 indicates that T. Rowe’s dividend remains extremely secure.
TROW’s stock also trades at a forward P/E multiple of 14.5, a meaningful discount compared to the broader market and far from an excessive level by almost any definition.
Rather, my decision to sell T. Rowe Price was driven by reasons two and four.
I am increasingly concerned about the company’s long-term growth potential, and in a portfolio holding just 20 to 25 stocks, there is little room to hold a stock if I no longer have much conviction behind it.
Simply put, there are other fish in the sea that have appear to have stronger long-term outlooks than T. Rowe Price, in my opinion.
While I don’t believe T. Rowe Price faces any sort of imminent decline in its business fundamentals (barring a quick bear market), there are several cracks forming with my long-term thesis.
At risk of beating a dead horse, low-cost passive investing continues taking market share from actively managed funds, which continue struggling to outperform index funds.
As you can see below, actively managed U.S. stock mutual funds have experienced net outflows for more than 10 years while passively managed index funds have taken off.
Today, active funds hold roughly $10 trillion in AUM compared to $5.8 trillion in passive funds and ETFs, according to data from Morningstar.
Active management is certainly needed for capital markets to function efficiently, but the big question is where the point of equilibrium is between active and passive strategies.
If the ultimate split is 55% active, 45% passive, another $1.3 trillion in AUM could shift from actively managed funds to passive ETFs over time.
No one knows, but this trend seems unlikely to reverse unless there is some sort of unexpected shock in passive funds (e.g. a sharp drop in liquidity; horrible performance in the next bear market, etc.).
T. Rowe Price’s relatively strong performance and low fees compared to its actively managed peers have helped it hold onto assets much better than many rivals.
However, last quarter the company reported net withdrawals of approximately $5 billion, including $1.9 billion from the firm’s target-date retirement portfolios as investors moved to passive products.
Those figures may not seem like a big deal when compared to T. Rowe Price’s total AUM of $811 billion.
However, the withdrawals marked T. Rowe Price’s first-ever quarterly outflow in the target-date retirement area, and the company has no meaningful presence in passive products to hedge its bets.
Fee pressure is another risk to the company’s long-term earnings power.
While it’s true that the company’s average fees are almost half as much as the average fees for U.S. stock mutual funds, there is still a very large gap compared passively managed funds.
Even if T. Rowe Price is able to hold onto its assets better than peers, clients seem likely to continue applying downward pressure on fees over time.
There is also the issue of recent management changes and how they could impact the company’s culture, which is very important for investment firms.
Brian Rogers, T. Rowe Price’s former chairman and chief investment officer, retired at the end of March after working for the company for 35 years.
T. Rowe’s CFO is retiring this year as well, and the company’s current CEO took over only at the end of 2015.
The company’s investment team has more than doubled in size since 2005 as well.
The number of key personnel changes risks shaking up the company’s culture during a fragile time for the active fund industry.
Finally, the eight-year-old bull market has been very good for most asset managers’ businesses, even despite their generally lackluster performance and AUM outflows.
Equity-related products account for more than 70% of T. Rowe Price’s AUM, so higher stock prices have meaningfully lifted AUM and improved the company’s earnings during this time.
In fact, T. Rowe’s AUM nearly tripled from $276.3 billion at the end of 2008 to $810.8 billion at the end of 2016.
With the stock market trading at a relatively high multiple compared to history, total returns over the next 5-10 years seem likely to be lower than the annual returns investors have enjoyed during this bull market, which is the second longest bull market ever recorded.
T. Rowe Price does not fare well during bear markets, either. TROW’s stock dropped by nearly 70% during the financial crisis.
Closing Thoughts on T. Rowe Price
At the end of the day, I think T. Rowe Price is a business that is here to stay for many years to come.
I expect the company to continue paying safe, growing dividends, and the firm is really the best house in a bad neighborhood (i.e. actively managed funds).
The stock’s relatively cheap valuation multiple could even help TROW outperform the market over the short-term.
However, long-term growth seems likely to be challenged by the continued migration from active to passive products, pressure on fees, cultural changes within the firm, and less robust returns from equities.
For those reasons, I decided to exit T. Rowe Price while the current bull market continues on, reallocating my capital into other ideas for our Top 20 Dividend Stocks portfolio.