Lower Risk Stocks

October 20, 2011

Sudhir Nanda, T. Rowe Price's head of quantitative equity research and manager of a broadly diversified small-cap growth portfolio, particularly focuses on companies with favorable characteristics that he believes can help the portfolio outperform in down markets.

T. Rowe Price portfolio managers and analysts have long approached equity research in a bottom-up way, studying the fundamental metrics and management of companies. But quantitative equity research supplements that with a top-down approach and can help identify companies for portfolio managers to avoid or consider.

• Supplements T. Rowe Price fundamental research by screening as many as 10,000 stocks globally for certain favorable characteristics, such as growing dividends, good free cash flow, and stock buybacks.
• Provides candidates for further analysis and can help identify companies with deteriorating financial profiles that should be avoided. Avoiding poorly performing companies can be as important to overall portfolio performance as finding outperformers.

• Avoid stocks with high beta (or high volatility), as well as companies that are highly leveraged (high debt ratios).
• Seek reasonably valued stocks with high return on equity, a measure of a company's profitability.
• Favor companies with high free cash flow, which can be used to pay or increase dividends or to buy back stock.
• Avoid companies with highly variable earnings and cash flow relative to industry peers.

• Since 1926, about 42% of the S&P 500's return has come from dividends.
• T. Rowe Price research shows that dividend-paying companies, especially those that grow their dividends, have outperformed over time, especially in down markets.
• High dividend yields with high payout ratios can signal distress, so lower payout ratios (the proportion of earnings paid out as dividends) and dividend growth also need to be taken into account.
• Companies with lower payout ratios have been able to sustain and increase their dividends.
• With the S&P 500's dividend yield above 10-year Treasury yields, dividends are particularly attractive to income-oriented investors.
• Historically, S&P 500 dividend growth over time has exceeded inflation—also a plus for income—oriented investors who rely on dividends.

• According to T. Rowe Price research covering the 10-year period ended September 30, 2011, three defensive sectors—consumer staples, health care, and utilities—have outperformed the S&P 500 in down markets 75% of the time.
• However, we prefer consumer staples and health care because they tend to have decent growth characteristics, may pay dividends, and have outperformed utilities in up markets.

• We look for fast-growing companies that have sustainable growth characteristics and reasonable valuations, produce lots of cash, have high returns on equity, and are buying back stock.
• Our goal is to provide steady outperformance with lower risk than that of the small-cap market. We believe preventing losses in down markets can help performance over time.

Past performance cannot guarantee future results. It is not possible to invest directly in an index. Unlike stocks, U.S. treasury securities are guaranteed as to the timely payment of interest and principal. Stocks generally fluctuate in value more than bonds and may decline significantly over short time periods. Stocks and sectors may not perform in line with a manager's expectations.

Securities issued by small-cap companies are likely to be more volatile than those issued by larger companies. Small-sized companies often have less experienced management, narrower product lines, more limited financial resources, and less publicly available information than larger companies. Investments in foreign securities may be adversely affected by political and economic conditions overseas, reduced liquidity, or decreases in foreign currency values relative to the U.S. dollar. These risks may be amplified in emerging market countries.

This information is provided for informational purposes only and is not intended to reflect a current or past recommendation, or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.