November 9, 2009
Key Points:
- The T. Rowe Price Capital Appreciation Fund has performed very well in 2009 as financial markets have rebounded from severe losses in 2008.
- We are cautious regarding lower-quality and high-price/earnings (P/E) stocks that have done best since March. Steadier, more consistent businesses with compelling valuations, attractive dividends, and solid balance sheets have a better risk/reward tradeoff.
- We have reduced the fund’s stock allocation and decreased its exposure to cyclical and lower-quality companies this year in favor of companies that tend to hold up well in a slower economy. Allocations to convertible securities and bonds have also declined.
David Giroux, who joined T. Rowe Price in 1998 as an analyst covering stocks in the industrials sector, assumed management of the Capital Appreciation Fund in 2006. In the following discussion, he shares his thoughts about this relatively conservative growth fund and his role in managing it.
The T. Rowe Price Capital Appreciation Fund has performed very well in 2009 as financial markets have rebounded from severe losses in 2008. We believe it is possible for the markets to continue climbing if the economy moves from stabilization to a normal recovery and corporate earnings growth resumes. However, this downturn has been unlike most previous ones. But the past is not necessarily prologue, and we should expect the unexpected.
Average annual total returns include changes in principal value, reinvested dividends, and capital gain distributions. Current performance may be higher or lower than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or loss when you sell your shares. For the fund’s most recent month-end performance, call 1-800-225-5132 or visit troweprice.com.
*Returns are annualized. Average annual total return figures include changes in principal value, reinvested dividends, and capital gain distributions. The S&P 500 Stock Index measures the performance of 500 stocks of mostly large-cap U.S. companies. It is not possible to invest directly in an index. Morningstar data is as of 10/22/09.
We are cautious regarding segments of the equity market that have done best since March. Many of the lower-quality names that have rallied sharply need a substantial economic recovery to justify their stock prices. If such a recovery does not materialize, they could have substantial downside. Also, high-P/E growth stocks have been very strong performers. For these companies, we see limited upside and potential for their valuations to contract.
In our opinion, the investments with the best risk/reward tradeoff currently in the market are some of the steadier, more consistent businesses whose valuations are compelling, whose dividends are attractive, and whose balance sheets are solid. While such companies may sound boring to investors looking for rapid growth or a quick way to recoup last year’s losses, we are comfortable playing the tortoise while the market plays the hare. We are not speculators—we are patient investors who believe that a risk-aware strategy that focuses on valuations, cash flows, and underlying asset values has the potential to produce solid risk-adjusted returns over the long term.
Stocks. As the financial markets have rallied, we have been adopting a neutral or more defensive stance toward stocks. We have generally reduced our stock allocation and decreased our exposure to cyclical and lower-quality companies while adding to holdings that tend to sustain better during a slower economy, especially health care, consumer staples, and utilities companies.
Convertibles and Bonds. Our exposure to convertible securities has also declined because those that fit our investment process are becoming scarce. Bonds have become less attractive investments as yields have declined. We have sold our Treasuries but continue to hold corporate bonds that should benefit from an economic recovery—such as cable, energy, unregulated health care, and utilities—and floating rate bank loans that are high in a company’s capital structure.
Cash. The portfolio’s cash position has been rising, reflecting our less constructive stances regarding equities, convertibles, and fixed income securities. If the markets continue to rally, we may decide to let our cash reserves increase further.
In pursuit of its objectives, the Capital Appreciation Fund uses a value-oriented approach to invest at least 50% of assets in well-established, large and mid-cap stocks. It also has the flexibility to invest in income-producing securities—such as convertibles and corporate bonds—and to maintain a meaningful cash position when market conditions warrant.
To learn more about the fund’s approach, watch the video.
With regard to stock selection for the fund, Portfolio Manager David Giroux looks for some key characteristics. “We want to invest in companies where there’s already some controversy surrounding that name,” says Giroux. In addition to low valuations, he looks for:
- good long-term fundamentals,
- strong balance sheets, and
- attractive sustainable dividends.
To learn more about the stock selection process for the fund, watch the video.
“The market systematically underestimates the value of dividends in terms of total return over time,” Giroux says. “When we can buy a company that has a 4%, 5%, or 6% sustainable dividend yield, we’re already getting anywhere between 50% to 75% of our long-term return over the course of a year before the stock moves up one penny.”
“Convertibles have been an important part of the portfolio, because they are essentially a microcosm of what we’re trying to do with the whole portfolio, and they usually have very attractive risk/reward characteristics. Our exposure to convertible securities has declined this year because those that fit our investment process are becoming scarce.”
To determine industries and sectors that should be emphasized at any given time, the fund combines rigorous bottom-up and top-down analysis. “When we look at fixed-income instruments, we’re looking at absolute market-risk-free yields and spreads over Treasuries and putting those in a historical context,” Giroux says. “And when investing in equities, there’s always the inherent risk of investing in the stock market itself.”
“The market environment in 2008 was unusual in that all asset classes that had any volatility risk associated with them—whether it be fixed income, leveraged loans, convertibles, or the equity market—became very highly correlated, more so than they’ve ever been historically.”
The information presented was current as of October 22, 2009. The managers' views and the funds' portfolios may have changed since that time. This material should not be deemed a recommendation to buy or sell shares of any of the securities discussed.
Stocks and sectors may not perform in line with the manager's expectations. All funds are subject to market risk, including possible loss of principal. The value approach carries the risk that the market will not recognize a security's intrinsic value for a long time, or that a stock judged to be undervalued may actually be appropriately priced. Fixed-income investing is subject to currency risk and interest rate risk. High yield bonds carry a greater default risk than higher quality bonds.
Multiple or Price/Earnings Ratio (P/E) - The price of a stock divided by its earnings per share. This ratio gives investors an idea of how much they are paying for a company's future earnings power.
S&P 500 Index - Tracks the stocks of 500U.S.companies.
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