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Special Report

Behind T. Rowe Price Capital Appreciation's Gold Rating

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The following is an excerpt from Morningstar's Premium Analyst Report for T. Rowe Price Capital Appreciation (PRWCX), a moderate allocation fund that receives a Gold Fund Analyst Rating from Morningstar analysts. Premium Members can  click here to see the full Analyst Report. Not a Premium Member? Take a free Premium trial to access this and hundreds more reports.

Process Pillar: Positive |  04/17/2014
In the equity portfolio, David Giroux typically looks for blue chips selling at a discount based on their P/E or price/book ratios; he values more-cyclical companies on their earnings across a full market cycle. The fund typically owns 65 to 80 stocks, and individual positions rarely get much above 3% of assets. Equities have typically been held around two years, on average, but holding periods are expected to lengthen now: Some higher-quality picks were sold too soon in recent years, so he's developed a longer internal rate of return measure that extends to six to seven years. That shift has resulted in some portfolio changes as the new measure has been implemented over the past two years. Sector weightings can vary significantly from those of the S&P 500 Index, but big bets are infrequent.

Giroux typically keeps 55% to 65% of the fund's assets in stocks but tends to look at the fund's overall equity exposure based on its stock weighting plus its convertible bonds' sensitivity to stocks. That can exceed 70% of assets when Giroux finds a lot of cheap companies, as he did in early 2009.

The rest of the portfolio is quite flexible. Giroux has found convertible bonds increasingly less attractive during his tenure, so their weighting has declined to nearly zero. The fund has at times also held double-digit weightings in traditional bonds (both investment grade and high-yield debt), leveraged loans and cash.

The fund held 72% of its assets in stocks in mid-2011, but it hasn't come close to that level lately as manager David Giroux has found fewer compelling ideas. The equity portfolio has become a bit more concentrated in the process; it held 66 stocks at the end of 2013 and its top position, industrial conglomerate  Danaher (DHR), comprised more than 4% of assets.

The fixed-income portfolio has seen shifts as well. The fund's stake in convertible bonds (once in the teens) has shrunk to less than 1% because of a dearth of attractively valued new issues, as well as a lack of large enough deals to accommodate the fund's increasing size. Leveraged loans became more than a 10% weighting in recent years. That weighting has since declined a bit as some picks have been sold on valuations. But Giroux still likes several of them. Although leveraged loans are classified as sub-investment-grade, he argues that issuers such as Dunkin' Brands (DNKN) are highly unlikely to default on their debt.

The fund has largely avoided investment-grade bonds in recent years because of historically low yields. But as they have risen since May 2013, Giroux has added a smattering of investment-grade corporate bonds to the fund, as well as a 5% stake in Treasury bonds. And if yields continue to rise, he expects to add more Treasuries to the mix. The fund's cash stake was 5% at the end of 2013.

Performance Pillar: Positive | 04/17/2014
This fund has been remarkably successful on manager David Giroux's watch. It has outpaced 97% of its moderate-allocation peers from June 2006, when he took the helm, through April 16, 2014 (95% on a risk-adjusted basis). It's been a very consistent performer: Over rolling five-year periods during Giroux's tenure, the fund has beaten the S&P 500 Index (its benchmark) 85% of the time, and it's surpassed the Morningstar Moderately Aggressive Index (a mix of stocks and bonds to which the fund's returns have been more correlated) 100% of the time. The fund has also beaten more than three fourths of its category peers in every one of those periods.

Giroux and the team behind him have added value across the types of securities in which they invest. The equity portfolio has beaten the S&P 500 during his tenure by a hefty margin and the fixed-income sleeve has outpaced the Barclays U.S. Aggregate Bond Index. Also, before the firm stopped including data on the performance of the convertibles subportfolio (because it shrank to less than 1% of assets), that portion of the fund handily beat its benchmark.

Although Giroux will boost the fund's equity exposure significantly when valuations are low (as he did in early 2009), thus occasionally juicing volatility, the fund has held up slightly better than its typical peer when stocks decline. The fund has also captured 116% of its typical peer's gains in rising markets.

People Pillar: Positive | 04/17/2014
David Giroux has managed this fund since June 2006. He had a comanager for the first 12 months, Jeff Arricale--but Arricale was then asked to become the head of the firm's financials team. In mid-2012, Steven Kirchbaum, a key analyst since 2007, was promoted to associate portfolio manager.

Giroux had been an analyst, primarily in the industrials sector, for eight years before taking over the fund. During that time, he was named to Institutional Investor magazine's Best of the Buy Side list once. He also was informed nearly two years in advance that he (and Arricale) would be running the fund. They began managing the convertibles portion of the fund six months in advance.

This is a big job because the fund invests in equities, convertible bonds, various types of traditional bonds, and cash. Giroux also now sits on the firm's asset allocation committee, which meets monthly. But he has relied in the past on members of the fund's investment committee (which each T. Rowe Price fund has) to some degree, and now has more help in Kirchbaum, as well as dedicated research associate Sushama Dasari, hired in April 2013. Giroux relies generally on the firm's scores of equity and fixed-income analysts, though he'll turn more often to those who cover value-oriented sectors. Kirchbaum handles much of the communication with analysts to save Giroux time.

Parent Pillar: Positive | 12/31/2013
T. Rowe Price has long exhibited many attractive attributes. The firm's disciplined, risk-conscious investment process has consistently produced successful results across its fund lineup, often with less volatility than peers. Many managers spend their careers at the firm, providing continuity for fund shareholders. Manager retirements are typically announced well in advance, allowing for a long transition process.

T. Rowe experienced a few unexpected departures in 2013, including Kris Jenner of  T. Rowe Price Health Sciences (PRHSX) and Joe Milano of  T. Rowe Price New America Growth (PRWAX), who independently left to start their own hedge funds. While their exits are a loss for the firm, such occurrences are rare, and flight risk for other managers (beyond retirements) does not appear heightened. Departures on the analyst side also bear watching, as the domestic-equity team saw a few more than usual in 2013, particularly within the health-care sector. Elsewhere, the firm has bolstered resources, particularly on the fixed-income side, which saw a rise in analysts from 33 in 2007 to 74 in 2013.

More broadly, the firm has acted in fundholders' interests by closing funds with surging asset bases and avoiding trendy fund launches. Reasonable fees and a manager compensation plan focused on long-term performance also help. However, manager ownership of fund shares is not industry-leading.

Price Pillar: Positive | 04/17/2014
The 0.71% expense ratio of the fund's Investor shares, which hold 95% of the assets, earns a Morningstar Fee Level of Below Average for no-load moderate-allocation funds. The Advisor shares charge 1.02% and earn an Above Average fee level, but they hold just 5% of the assets. True, the fund should be cheaper than most of its peers, given its sizable $20 billion asset base. And its fees have declined very gradually since 2005--but the fund's asset base hadn't grown much over that span until 2012-14. Fees should drop further given recent, rapid asset growth. 

Greg Carlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.