T. Rowe Price and Small-Cap Stocks

T. Rowe Price and Small-Cap Stocks: The Sage of Baltimore
A Daily Reckoning White Paper Report
by James Boric, contributor The Penny Sleuth (Sign up FREE today! )

T. Rowe Price was one of the greatest investors of all time…

Forbes magazine called him the “Sage of Baltimore” and Barron’s referred to him as a visionary.

At a time when most investors were either afraid of the market or were investing only in “safe” stocks like railroads and auto manufacturers, Price was buying small, unknown growth companies for pennies on the dollar — and making a fortune.

For instance…

In the 1930s, he bought Dow Chemical, Coca-Cola, Minnesota Mining and J.C. Penney. In the 1940s, he picked up shares of IBM. In the 1960s and ’70s, he acquired stock in Motorola, Texas Instruments, Avon, Black & Decker, General Electric and Pfizer. And over the years, he also picked up shares of Xerox, Merck and DuPont.

To say those were “wise investments” at the time would be the understatement of the last 100 years. They were some of the best investments ever made — period.

When it was all said and done, he walked away with profits of 23,666% on Merck, 17,025% on Minnesota Mining (3M), 15,528% on Avon Products, 8,540% on Black & Decker and a mere 6,184% on Xerox.

Most people dream about finding just ONE stock that rises thousands of percent or more in a lifetime. Price found dozens of them. But it wasn’t always an easy road to wealth.

T. Rowe Price and Small-Cap Stocks: Investing in Baby Stocks Soon After Birth

Price was a big fan of small-cap stocks. He likened them to human beings after birth. Just as a baby grows out of his clothes every four weeks, a young, growing company can increase its earnings 100% or more for several years in a row. To capitalize on this rapid-growth stage, Price opened a small-cap mutual fund in 1960.

The Baltimore-based visionary loaded up on shares of Xerox and Texas Instruments — small caps he thought would survive the high-inflationary period that engulfed the ’60s.

Great move, right? Didn’t look so at first.

Two years after opening his fund, Price was down 29%, while the S&P 500 was off only 9%. Investors wanted his head on a silver platter. How dare he lose money — especially more than the broad markets? Outrage!

Reporting on this ugly two-year period for Price, Nikki Ross, author of Lessons From the Legends of Wall Street , said, “Clients complained and Price became disappointed and distraught. But he stayed with it, and performance improved. Five years later, the fund gained 44%; the S&P 500 increased only 9%.”

VINDICATION. Price stuck to his guns, and it paid off. In fact, by 1968, small-cap stocks were such the rage that he actually had to close his fund to protect his shareholders from any sort of mania buying at ridiculous prices.

Imagine how all those fair-weather folks who sold off when they were down 29% must have felt!

T. Rowe Price and Small-Cap Stocks: Buying + Holding + Big Fortune

Price knew that true stock market fortunes were made by people who bought and held — even when the market suffered or stocks underperformed for a few years. As he put it, “The owners of businesses such as Black & Decker, Disney, DuPont, Eastman Kodak, Sears and countless others were long-term investors. They did not attempt to sell out and buy back ownerships of the businesses through the ups and downs of the business and stock market cycles.”

Of course, early investors in all of those companies made a fortune so large it’s ridiculous to even think about. And if you want to make a fortune of your own, there’s a lot you can learn from Price.

First, Price had a long-term investing horizon. He didn’t sell stocks just because their prices fell. He sold only for two reasons: one, if his buying thesis (the reason for owning the stock in the first place) were no longer true, and two, if he needed to raise cash to invest in an even more promising opportunity. If the market simply punished a stock that was perfectly sound, Price believed that was an opportunity to buy more shares. But he certainly wouldn’t sell.

Second, Price believed investors have to be flexible — meaning they have to adapt with the market. During the 1960s, Price bought gold (when no one else was buying) at $35 an ounce. He also bought stock in companies like Atlantic Richfield (oil), Alcan Aluminum, Homestake Mining Co. (gold) and International Paper. His thesis for owning these out-of-favor natural resource companies was simple: The United States was spending millions to fund the Vietnam War and taxes weren’t increasing. As Nikki Ross put it, Price “reasoned that with the large U.S. budget deficit at that time and no increase in taxes to pay for the war, the costs would be paid in the form of accelerating inflation.”

As you know from the last few years, natural resources rise when the economy is in a shambles. And that’s exactly what happened in the 1960s. Once again, Price made a fortune.

Finally, T. Rowe Price believed in the power of solidly run small-cap companies. He bought companies with strong operating margins, track records of increasing sales, solid R&D, low debt loads and potential to grow for years — even when the market was weak. Price knew that a well-selected small-cap stock would grow even when the rest of the market was getting killed. His track record certainly proved him to be correct.

I have a feeling we’ll need to rely on Price’s fortitude in the coming years.

T. Rowe Price and Small-Cap Stocks: Will You Buy-and-Hold, or Trade Small-Caps?

I believe we are entering into a period in which small-cap stocks won’t grow like wildflowers — like they have since 2003. The margin of safety is gone in the small-cap market, especially if you compare them with the average large-cap stock on the S&P 500.

In March 2000, the average P/E ratio of the 50 smallest stocks on the S&P 500 was just 10.1, while the 50 largest traded for 35.6 times earnings. Today, the 50 smallest stocks trade for a P/E of 20, while the 50 largest trade for 17.3 times earnings. In other words…

Small-cap stocks aren’t cheap anymore. In fact, the average small-cap stock is overvalued. Anyone who thinks they can trade in and out of small-cap stocks and walk away with 20% gains a year is foolish.

We are entering a phase in which investors with patience will be rewarded and everyone else will go home crying.

You need to decide right now if you are truly a small-cap investor who is interested in owning fundamentally sound and growing small-cap stocks for the long haul (like Price was) or if you are a trader looking to flip stocks in two months for a gain.

If you are an investor (as I am), we’ll continue to look for great businesses to own at fair prices. If you are a trader who has dreams of making a quick buck, it’s time to look somewhere else. The small-cap market is not where you should be right now.

Happy investing,

James Boric
The Penny Sleuth

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Useful links about T. Rowe Price and Small-Cap Stocks:

Bull Investors A list of the world’s greatest investors and how they have shaped investing analysis.
Financial Gurus An informative biography of T. Rowe Price.
Investment Gurus Profiles of famous investors, business leaders and financial experts.
T. Rowe Price The website of the investment management firm founded by the “Sage of Baltimore” himself.

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