February 22, 2013
|David Giroux, lead manager of the T. Rowe Price Capital Appreciation Fund|
The S&P 500 returned 16% in 2012, an above-average performance that David Giroux, lead manager of the T. Rowe Price Capital Appreciation Fund, attributes to improvements in the housing market, falling oil prices, and expectations for stronger Chinese economic growth in 2013. As the new year unfolds, Giroux considers equities to be more attractive than other asset classes and sees limited value and real risk of losses in traditional fixed income securities. He has positioned the fund to benefit from businesses that allocate capital wisely, to reduce the impact of rising interest rates on shareholders, and to own companies that may unlock value for shareholders through a corporate event.
At year-end 2012, the fund's net equity exposure was in the very low 60s versus the middle to high 50s at midyear. We consider the low 60s to be somewhat of a neutral level for the fund. We would likely increase this equity exposure on market weakness and/or as more attractive risk/reward opportunities present themselves. At present, we consider equities to be the most attractive asset class in which we invest, but that is mostly due to how unattractive the other asset classes are as opposed to how appealing equities are on an absolute basis.
After two years (2010-2011) of investors chasing yield and driving up valuations of high-dividend stocks to unattractive levels, we finally saw such stocks underperform in 2012. In the latter part of the year—really for the first time in at least 18 months—we started to find a couple of attractive ideas among high-dividend-yield stocks. We have always liked higher-dividend-yield stocks given their attractive risk/reward characteristics, especially because they tend to perform well in weak equity markets, but in recent years we have been materially underweight this class of stocks given their expensive valuations. To the extent higher-dividend stocks continue to underperform, we will likely continue to add to these names.
We see limited value and real risk of losses in traditional fixed income securities, including Treasuries, investment-grade bonds, and high yield debt. With Treasuries and investment-grade bonds, the absolute yields are so low that even if interest rates were to drop modestly from here, the upside potential is low. But if rates rise or credit spreads widen, it is possible to lose a considerable amount of money. Hence, the risk/reward trade-off is very negatively skewed, especially as we believe rates are much more likely to rise than decline over the next three to five years. While we do own a number of investment-grade bonds, almost all of them have a very short duration and, thus, limited risk of loss from rising rates or wider credit spreads. In the case of high yield bonds, while absolute yields look attractive on the surface relative to investment-grade or Treasury bonds, they are not attractive. High yield bond yields are now at all-time lows. While 5% to 6% yields may sound fine, in a recession, the high yield bond index can easily decline in value by 10% to 20% or more.
We think the leveraged loan asset class still looks reasonable, especially on a relative basis. The advantages of leveraged loans are that they are at the top of the capital structure, which can reduce risk of principal loss, and that they are floating rate in nature and, thus, not exposed to rising rates.* The challenge for this asset class is that most new issues are now coming without good covenants (i.e., the terms and stipulations between a borrower and a lender that may affect certain factors or restrict certain activities of the borrower), and we have chosen not to buy bank debt without good covenants. In addition, a number of names with attractive yields have rallied strongly to levels where we have cut back our exposure.
- Companies With Good Capital Allocation. We believe the market fundamentally underappreciates good capital allocation. We believe the fund is materially overweight, relative to the market, in companies that deploy capital wisely (reasonable dividends, repurchase stock, and good acquisition strategy).
- Being Positioned for Rising Rates. We believe negative real (inflation-adjusted) interest rates are unsustainable and that nominal interest rates are likely to revert to more normalized levels over the next three to five years. Within fixed income, we believe that our exposure to holdings with short durations and to floating rate securities can help reduce the impact of rising rates on our shareholders. In equities, we own a number of companies that we believe should benefit from rising rates.
- "Free" Optionality. We try to find investment opportunities, both in equities and bonds, where the odds of a company getting acquired, going private, or breaking up into pieces may be small but where we acquire that option for "free" because the market is not appropriately valuing the potential for a corporate action.
*Floating rate loans represent amounts borrowed by companies or other entities from banks and other lenders. In many cases, they are issued in connection with recapitalizations, acquisitions, leveraged buyouts, and refinancings. These loans are often referred to as "leveraged loans" because the borrowing companies have significantly more debt than equity.
All mutual funds are subject to market risk, including possible loss of principal. The fund's value orientation carries the possibility that the market will not recognize a security's intrinsic worth for an unexpectedly long time, or that a stock judged to be undervalued may actually be appropriately priced. Since bank loans are mostly issued by below investment-grade companies, they are subject to increased credit and liquidity risk and can be more volatile than investment-grade bonds. Leveraged loans tend to underperform during periods of economic weakness and are considered speculative. They involve greater risk of default and price decline than higher-rated bonds because, in many cases, they are issued by borrowing companies with more debt on their balance sheets than their investment-grade counterparts.