The legendary growth manager's warning for investors

Thomas Rowe Price Jnr., whose firm T. Rowe price is still around today, is credited for being the father of growth investing. Yet in the mid-1960s at the height of his powers, he sold his firm and told investors to sell growth stocks and buy natural resources and other real assets. His advice shocked Wall Street, which hung on his every word. Yet it proved prescient as growth stocks were annihilated in the 1970s.

Today, just about every fund manager is a growth investor or a closet one. Value investing is almost frowned upon. And many stocks with growth prospects are valued at extraordinary multiples.

The question for today’s investors is whether today’s growth mania have also reached an inflection point, like in the mid to late 1960s?

Let’s turn to Price’s fascinating career for clues, as well as other lessons on growth investing.

The formation of a giant

Price learned his trade during the Great Depression working with John Legg, of Legg Mason fame. In 1931, with the market tanking, Legg advised Price to sell his stocks and “take his licking”. Price couldn’t do it as he already believed that you needed to hold onto quality growth stocks:

“The realities are that most of the big fortunes of the country had resulted from investing in growing businesses and staying with them through thick and thin rather than switching from one security to another.”

Like many investors, he’d formed his views from studying the past:

“I observed Du Pont’s stock, which always seemed too high to buy when compared to most other stocks, grew and grew and grew in market value. Another observation which made a lasting impression on me was the fact that those employee shareholders who tried to make a greater profit in the stock of their own company, by selling when they thought it was too high and then trying to buy it back at lower prices, did not do as well as those who held their shares throughout the market cycle.”

Price and Legg parted ways in 1937 as their philosophies diverged, and Price formed his own firm.

After the 1930s Depression, Benjamin Graham’s strategy, based on buying deep value understandably held sway with investors. Yet, the ‘T. Rowe approach’, as it became known, overtook Graham in popularity on Wall Street in the 1950s and 1960s.

Family accounts that Price managed from 1934 to 1972 turned US$1,000 into US$271,201, a 15.9% net return per annum. Several stocks he held through that time, such as 3M and Merck, became 100-baggers (returned more than 100x).

A life cycle theory for companies

Price believed that to do well, investors need to seek ‘’fertile fields for growth’ and then hold on to stocks for long periods of time. A growth company is one which shows “long-term growth of earnings, reaching a new high level per share at the peak of each succeeding major business cycle and which gives indications of reaching new high earnings at the peak of future business cycles.”

Price didn’t believe in just finding a company and holding it forever. He developed a life cycle theory for companies with three phases: growth, maturity, and decadence.  Price wanted to buy growth and sell when a stock no longer offered growth.

His life cycle theory held that the most profitable and least risky time to own a company is in the early stages of growth. After a business matures, the investor’s opportunity to achieve above-market returns declines and their risk increases.

How to identify growth industries

Price wanted to buy growth industries and the best companies in those industries. How did he identify these ‘fertile fields of growth’? Price thought the two best indicators of growth industries were unit volume of sales (not value) and net earnings.

Note the emphasis on net earnings. Price’s growth indicators might have led you to buy software companies during the 2010s, yet it would have kept you out of those companies with no earnings – and there were plenty of those.

Price suggests that when an industry finally matures, it can do so “on leverage”: that is, profits fall faster than unit volume declines. Early in his career, he identified the railway industry as a maturing one. As railway tonne-miles started to drop, and with a largely fixed cost base, company profits plummeted.

Buying the best companies in growth industries

Once Price identified a growth industry, he’d look for the best companies in that industry. As mentioned earlier, he looked for businesses which had demonstrated improved earnings over the course of a business cycle. And Price had five other requirements for growth companies:

1. Superior research to develop products and markets
2. Lack of cutthroat competition
3. Comparative immunity from government regulation
4. Low total labor costs, but well-paid employees
5. At least a 10 percent return on invested capital, sustained high profit margins, and a superior growth of earnings per share.

If a business could retain these things over the long term, then it could be considered a growth stock.

Selling

Price thought it was vital to be able to identify when a company’s earnings growth is coming to an end. He didn’t spell out how to do it but raised three potential red flags:

1. A decline in return on capital. Which could mean a company is reaching maturity.
2. Recessions can provide a murky picture. It’s important to be able to study whether a business is being dragged down by general economic conditions, or it’s gone ex-growth.
3. Beware of industry cycles that are separate from economic cycles. This can muddy the picture further.

When Price flipped the script

By 1965, Price’s investment approach had produced 30 years of stellar results, and the investment community clung onto his every word. Around this time, though, he sold out of the firm he’d built.

Then, as a private investor, the world’s greatest growth advocate changed tack. Price thought growth stocks had been bid up too high and there weren’t many attractive opportunities left. He wrote of a new era of investing where neglected natural resource stocks deserved a place in portfolios. From the sale of his firm, Price put his family assets equally into bonds and stocks, the stocks mostly in resources, especially gold stocks.

Over the next decade, Price’s portfolio did extremely well. The same can’t be said for the firm he’d founded. From the mid 60’s, it rode investor enthusiasm for growth stocks, growing exponentially in funds under management, only to crash during the 1970s downturn. By 1974, the term ‘growth stocks’ became virtually taboo on Wall Street.

Lessons for Australian investors

What would Price make of today’s market environment? It’s impossible to say, though it’s worth considering whether he’d think growth stocks have become too frothy. In the US, you have Nvidia (NASDAQ: NVDA) trading on 25x revenue (not profit). In Australia, WiseTech Global (ASX: WTC) is priced even higher at 27x sales, and 104x earnings, Cochlear (ASX: COH) is on 58x current earnings, and even dowdy staples like Woolworths (ASX: WOW) are trading at 29x earnings.

Like the 1960s, could it be the time for real assets to outperform?

The other issue from Price that’s relevant to today is trying to identify industries and companies which may no longer be growing. It’s especially pertinent to a stock such as CSL (ASX: CSL). The company’s return on capital peaked in 2015 and has slipped sharply since:

Source: Schroders

The big question is whether CSL has matured or not. Some fund managers believe it has while our Morningstar analyst, Shane Ponrej, thinks it hasn’t. 

References: John Train, Money Masters of Our Time, and Cornelius Bond, T. Rowe Price: The Man, The Company and The Investment Philosophy

James Gruber is an assistant editor at Firstlinks and Morningstar.com.au