Market Upheavals, Leaders, and Lessons: 20-Year Perspectives
Three T. Rowe Price equity managers recently marked their 20th anniversary managing the same fund, and another will celebrate that milestone in a few months. Taking note of “T. Rowe Price’s 20-year club,” Morningstar, the fund rating service, commented: “…At big firms with extensive fund lineups, it’s highly unusual to see so many managers running the same fund for so long. …T. Rowe has set up a solid investment culture that makes it more likely that managers will succeed and will want to stick around.”*
In this discussion, these managers reflect on some of the more significant market developments and insights gained over the past two decades. The managers are Brian Berghuis (Mid-Cap Growth Fund), Larry Puglia (Blue Chip Growth Fund), Preston Athey (Small-Cap Value Fund), and Greg McCrickard (Small-Cap Stock Fund). (In addition, Brian Rogers has managed the Equity Income Fund since its inception in 1985.)
One of the most striking changes over the past 20 years has been globalization, which has presented both opportunities and challenges. In the average large-cap portfolio, about 45% of the operating earnings now come from outside the U.S. That, of course, provides access to faster-growing markets and more diversification. But with the greater synchronization of the global economy, portfolios are more subject to changes overseas, and we’re seeing that now with concerns about growth in China.
Another striking development was the bursting of the tech bubble in 2000, which caused distrust of large technology companies for quite a long time. Its unwinding was certainly very palpable, but, ironically, from the ashes you saw the ascension of some very dramatic growth leaders, like Amazon and Google.
It’s interesting that 20 years ago technology ranked as the ninth-largest sector in the S&P 500 Index, accounting for just 6% of its market capitalization. Now it’s the largest sector, accounting for a fifth of the assets. That’s consistent with the spending on technology in the economy and the importance of the Internet. It also reflects the thirst for real-time information and the rise of e-commerce and social networking and the increasing dominance of hand-held devices such as smartphones or tablets.
Of course, the global economic and political landscapes were vastly different 20 years ago. The Internet was still mainly the province of academics; mobile phones were a cumbersome luxury; and the world’s most powerful computer, by one calculation, was roughly as powerful as today’s iPad.
Today, there is far more debt in the financial system, particularly at the government level, and the prospects for growth in the developed world are much more modest than in the 1980s, 1990s, and through most of the 2000s. The current period seems more like the 1970s, with many individual investors shunning stocks following years of poor returns.
The rise of hedge funds and high-frequency traders, which now account for most of the trading volume, also has been significant. The time horizon of investors has become very, very short. Many are focused solely on the next data point, and price momentum and earnings revisions have become the metrics of choice rather than a company’s prospects over two or three years. That can provide a tremendous advantage for patient investors who focus instead on a company’s fundamentals and long-term prospects. Some of our best investments have been lower-profile, moderately growing companies that are able to compound earnings over a long period of time.
In the small company arena, I would say the sector gets more attention now than it did in the early 1990s in the sense that there are more market participants, though the rise of hedge funds has probably brought increased volatility. But there’s a lot more liquidity than there was 20 years ago. The increased interest in the sector has changed the definition of small-cap stocks. It used to be a company with a market capitalization of $500 million or less. Now the Russell 2000 Index is revised at $3 billion.
Twenty years ago, small-cap investing was synonymous with emerging growth—rapidly growing high technology- or medical products-type companies. Today, small-cap value is a distinct asset class. There is a whole subset in the small-cap market that are not the most rapidly growing, sexiest stories but where one can invest in solid companies and do well.
But small-cap companies are much less followed on Wall Street than they were 20 years ago, partly because new rules have severely reduced commissions in these stocks. So it’s less costly to trade in these stocks, but investors have to rely more on their own research.
In addition, the hurdle to become a public company is much higher today. The companies going public tend to be more substantial, with higher revenues and profits, so the quality of the initial public offering market has improved. We’re also seeing greater variety in the types of companies going public, so the market’s more diversified. There are opportunities in the small-cap world in every sector you can name. And, generally, fewer small companies are going public. Many are staying private longer, or in some cases they sell out to larger companies rather than go public.
Another big change that has affected investors generally is the huge increase in information and media coverage of the markets. Twenty years ago we didn’t have CNBC or smartphones and tablets giving us instant news all the time. So investors are better informed, but it’s often about minutiae rather than important things.
There’s more anxiety, and many people are traders rather than investors. They’re less willing to look long term and more likely to make irrational decisions based on emotion. Just because we have more information, are we better off? Yes, if we use it wisely; otherwise it’s just noise.
(Note: Of the 10 largest companies in the S&P 500 Index in terms of market capitalization in 1992, five still retain that position (ExxonMobil, AT&T, IBM, General Electric, and Procter & Gamble). The other five have been replaced by Apple, Microsoft, Google, Chevron, and Johnson & Johnson.)
History will tell you that change occurs and the leadership of the market changes accordingly. It has been very difficult for companies to sustain dominant positions. But it’s much more difficult to sustain leadership in the technology area where companies are subject to shorter product life cycles.
I think it’s noteworthy that IBM has been able to maintain its leadership, and the reason is that it has been strong in services and software rather than being solely subject to product life cycles. It’s also a little easier for companies in staples, such as Procter & Gamble, to maintain leadership over time.
I was surprised that five of the top 10 are still there. It shows that there is more stability and persistence in our economy and in corporate America than perhaps is commonly perceived. Our economy is evolving, but that’s not to say that if you invest in a blue chip company today it won’t still be a reasonably vibrant company a generation later if it is well managed.
Insights and Lessons Learned
Twenty years has taught me that a consistent process is really important. While the environment and the fund’s holdings have changed over the past two decades, the characteristics we look for have not changed. We have always focused on the quality of a firm’s management, the long-term viability of its business model, the company’s balance sheet and cash flow, and its valuation. While we are willing to pay more for growth, we prefer to buy companies when their prospects are subject to doubt and tend to sell them when others seem overly confident about their prospects.
One of the mistakes I’ve seen investors make over the years is following the crowd because a certain sector or strategy is working at the time. There’s often a tremendous pressure to conform, and that’s almost always a mistake. It might feel good for a few weeks, months, or even a year, but it usually ends badly. Maintaining a balanced perspective and a consistent process is a good recipe for long-term success in investing, but it doesn’t always work over shorter periods.
I agree that the key tools for evaluating stocks really haven’t changed. Stock prices ultimately follow earnings and cash flow. We have empirical data going back to 1954, for example, that show that free cash flow growth has been a good indicator of future stock returns.
Another lesson is that even though we have had these major bear markets and dislocations in the economy, there are always opportunities, especially during crises.
A third lesson comes from Warren Buffett, who said that when a good management meets a bad business the bad business wins every time. We don’t think we can compound wealth for clients investing in inferior business models. You really have to invest in companies that have a high return on invested capital or return on equity.
I also think that you always need to be looking out for what people are not worried about, and few are worried about inflation now and many assume bonds will continue to do well. With the policy measures that have been pursued, I think we’ll see a moderate increase in interest rates over time that will cause dislocation in longer-term bonds.
I’ve also learned not to get too caught up in trends. I tend to lean a little bit against the wind from time to time. If you are willing to be a contrarian, the markets will give you opportunities to invest in good companies at very attractive prices.
Another lesson is what I call the pain trade. If some sector is doing particularly well and you are not participating in it, don’t chase it, because that’s often when your biggest mistakes will occur.
The consensus opinion often turns out to be wrong. So I also think you want to look at what people do not like. A lot of retail investors view the equity markets as stacked against them now. That negative sentiment can create tremendous opportunity for those willing to look out a few years.
We’ve had some pretty violent cycles in the past 20 years, especially the 1999–2000 tech bubble and the hangover from that and then the housing bubble that led to the financial crisis of 2008 and early 2009. Despite that, the equity markets have performed reasonably well over the past 20 years. But many investors have foresworn stocks for bonds because they can’t stand the pain.
I think they will be disadvantaged long term because, from today’s levels, stocks are much more attractive than fixed income despite the problems in the U.S. and Europe and the question marks in China. History does tend to repeat itself in one way or another, so I feel very confident in saying this.
The American economy is an amazingly resilient engine of growth, and not just over the last 20 years. So I’ve learned that panicking at the bottom of bear markets never works. Patience and a sense of history can see you through a lot of rough patches.
All funds are subject to market risk, including possible loss of principal. The chart above is for illustrative purposes only and not intended to represent the returns of any specific security. Past performance cannot guarantee future results.