T. Rowe Value Group: This Dividend Monster Is On Sale (NASDAQ:TROW)

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T. Rowe Price Group (TROW) is a dividend monster. With assets under management continuing to grow, the future for T. Rowe Price remains bright.

Mutual fund performance remains strong with superior results relative to peers. Additionally, as broader domestic equity and bond indexes stagnate, investors may abandon passively managed index funds and increasingly seek active management through highly regarded firms such as T. Rowe Price.

In addition, the recent acquisition of Oak Hill Advisors broadens the company’s active management offerings and makes inroads into the Alternative Assets space. Opportunities in this realm will likely appeal to investors seeking diversification from standard equity and bond funds, as well as prospects of elevated compound annual growth rates.

Currently undervalued, continued growth of earnings, free cash flow, and dividends promises to reward patient shareholders with strong long-term investment returns.

Not only does T. Rowe Price sport a higher dividend yield than the S&P 500, but TROW grows that dividend at a faster pace – not to mention the occasional “special” dividend that serves as the occasional pleasant surprise.

Dividends, Price Returns, and Valuation of TROW vs SPY

Dividends, Price Returns, and Valuation of TROW vs SPY

The Author

TROW returns are not limited to dividends. Hyperbole aside, capital appreciation of TROW’s stock price clearly provided greater long-term returns relative to the S&P 500.

For emphasis, below is a 5-yr price graph of illustrating TROW’s outperformance versus the S&P500, represented by the exchange traded fund SPY (SPY):

Stock Price returns of T. Rowe Price vs S&P500 over the last 5 years

Stock Price returns of T. Rowe Price vs S&P500 over the last 5 years

Yahoo Finance

Yes, the 1-Yr and 2-Yr price returns of TROW generally match the S&P 500 index. The correspondence is almost entirely due to very short-term under performance, which culminated in a -6% down move on January 12.

The root cause: Recently stagnating equity market values and declining bond prices impact the value of assets managed by TROW’s funds. Regarding the 6% down move, apparently the market was expecting something greater than the reported +3% net increase in month-over-month assets under management.

This level of volatility should be within the comfort zone of any potential T. Rowe Price investor. The prudent investor ignores short-term market moves resulting from monthly performance volatility. On the contrary, the intrepid investor uses such volatility as leverage that can increase future investment returns.

Because of recent stock price declines, T. Rowe Price currently trades at an attractive valuation. The business is priced roughly 19% below its all-time high and it has dropped back down toward the S&P500 index. Over the prior 5 years, moments such as these have proven auspicious times to buy.

T. Rowe Price – the Asset Manager

The business model for TROW is simple and easy to understand. The company offers asset management services for investors through mutual funds, exchange traded funds, and now “private” investments.

TROW manages stock, bond, and multi-asset funds with over $1.6 Trillion of Assets Under Management (yes, with a “T”). According to Morningstar, funds within retirement accounts and variable-annuity investment portfolios comprise two-thirds of their managed assets. Target date portfolios have generated significant asset inflows over the last several years, growing at 8% annually. Continued 8% growth of a primary revenue driver bodes well for future returns

The company has global reach, with a local office in 17 countries. They also offer advisory and retirement planning services.

The basic business lines of T. Rowe Price, mid-2021.

The basic business lines of T. Rowe Price, mid-2021.

T. Rowe Price Investor Relations

Most funds offered by TROW are actively managed. Rather than following a pre-defined asset template, the managers actively seek what they consider to be the best investments for the funds.

With inflation headwinds, stock prices have begun stagnating and bond yields are now rising. I expect some investors will become impatient with nominally flat returns of passive index funds. Counter to the recent trend, I see investors increasingly turning toward active management and away from passive indexes as they search for higher real returns. TROW stands to benefit from this potential shift.

Fund Performance

As far as fund performance is concerned, TROW offers a meaningful record of outperformance. The majority of funds offered by TROW surpass their peers and benchmarks:

T. Rowe Price median fund performance vs peers and benchmarks.

T. Rowe Price median fund performance vs peers and benchmarks.

T. Rowe Price Investor Relations

Moreover, TROW funds exhibit superior performance in all categories, including U.S. stocks, International stocks, Domestic and International Fixed Income (bonds), Multi-Asset funds, and Target Date Retirement funds.

Even when competing in the Passive Index Fund realm, their median fund performance is better than the corresponding benchmark – so their indexes also provide differential returns.

As a result of their strong fund performance, total Assets Under Management continuously trend upward. Assets managed as of December 31, 2021 amount to $1.69 Trillion.

Assets under management from 2011 to 2021

Assets under management from 2011 to 2021

T. Rowe Price Investor Relations

T. Rowe Price clearly is positioned to capture an increasing proportion of actively managed fund inflows. This trend shows no signs of reversing. The longer median fund outperformance lasts, the more investors will seek active management by TROW.

Money-Making Expense Ratios

TROW makes the vast majority of its money by charging investors an expense ratio, or a fixed percentage fee, on all funds which it manages. For this active service, TROW charges a premium rate. With > $1.6 Trillion of assets under management, annual revenue sums add up quickly

In addition, by offering superior fund performance compared to competitors, TROW can charge investors a premium. Expense ratios commonly range from 0.25% – 0.80% for domestic equity, bond, and multi-asset funds.

For international and global funds, expense ratios are higher and reach up to 1.41%. Many of their international funds are ranked 4 or 5 stars by Morningstar (5 of 5 is the best rating possible).

International equities have struggled for well over a decade. Because of this category-wide underperformance, investors are clearly willing to pay up for TROW’s active international management that achieves superior results.

By analogy, if domestic equity markets struggle to digest the elimination of quantitative easing and increasing interest rates, TROW may capture increased active management inflows. Expense ratio increases for strongly performing domestic funds could be merited as demand for 4 or 5 star funds increases.

TROW Buys Oak Hill Advisors

At year-end 2021, T. Rowe Price completed the purchase of investment manager Oak Hill Advisors for a total sum of $4.2 Billion, including performance incentives.

Strategically, the deal is designed to complement the existing investment opportunities offered to clients and leverages TROW’s global reach. Oak Hill offers investments in three general alternative asset realms, including Private Markets, Liquid Strategies, and Structured Credit.

Asset types managed by Oak Hill are complementary to those of TROW and generally do not overlap in scope.

Asset types managed by Oak Hill are complementary to those of TROW and generally do not overlap in scope.

T. Rowe Price Investor Relations

Most assets currently held by Oak Hill are derived from pension plans, family offices, sovereign wealth funds, and institutional investors.

The distribution of clients types that invest with Oak Hill Advisors.

The distribution of clients types that invest with Oak Hill Advisors.

T. Rowe Price Investor Relations

That said, demand for alternative investment strategies appears to be soaring as real interest rates remain negative, equity valuations are generally excessive, and money market rates remain poor. Growth in Oak Hill’s assets under management in recent years is impressive, ranging from a 9% to 50% Compound Annual Growth Rate.

Recent growth rates in the assets managed by Oak Hill.

Recent growth rates in the assets managed by Oak Hill.

T. Rowe Price Investor Relations

Once again, growing demand for active management is in TROW’s favor. This is especially the case if investors do not see strong positive returns via broad-based equity indexes. Alternative investments offer just that – an alternative. It is likely that TROW will offer some of these services to select clients as a means of broadening existing relationships and providing excess returns beyond passive index strategies.

I view the deal as a net positive for TROW. Recent organic growth in Oak Hll’s assets under management will likely boost TROW’s future growth rate. Increased diversification of services and investment offerings may partially hedge fluctuations managed asset values, as well as attract new funds from existing investors. Additionally, the deal is expected to be immediately accretive to 2022 earnings.

Financial Performance

T. Rowe Price’s Debt Profile

T. Rowe Price’s debt profile is quite good. TROW has zero long-term debt and has carried negative net debt for at least the last 5 years. They always have excess cash on hand, which allows them to make accretive business acquisitions.

The company does not have a credit rating from Standard & Poor’s because it doesn’t need one.

TROW has zero long-term debt and an enviable balance sheet.

TROW has zero long-term debt and an enviable balance sheet.

T. Rowe Price Investor Relations

Earnings History

TROW justifiably touts their long-term record with respect to earnings growth, revenue growth, dividend growth, and total stock return. Results have been consistently strong for the last 30 years and show few indicators of slowing. Total stock returns during that time span compounded between 12% – 19% annually – far greater than the S&P 500 index.

Long term growth rates and returns for T. Rowe Price over the course of 30 years.

Long term growth rates and returns for T. Rowe Price over the course of 30 years.

T. Rowe Price Investor Relations

Since the end of fiscal year 2000, TROW has grown earnings at a 12% CAGR. As seen in the image below, earnings generally rise during economic expansions but trend downward during recessions as financial markets suffer and managed asset levels decline.

TROW earnings and price history since 2000. The black line represents stock price. The blue line is the historical average P/E Ratio.

TROW earnings and price history since 2000. The black line represents stock price. The blue line is the historical average P/E Ratio.

FastGraphs.com

Despite growing and maturing as a company, TROW’s earnings growth since 2008 has actually accelerated, reaching a 14.7% CAGR. Free cash flow trended upward at an 18% CAGR. Once again, very robust performance.

T. Rowe Price Free Cash Flow since 2008. The blue line represents the average Price / Free Cash Flow ratio during the time period.

T. Rowe Price Free Cash Flow since 2008. The blue line represents the average Price / Free Cash Flow ratio during the time period.

FastGraphs.com

Dividends and Stock Buy-Backs

Beyond regularly increasing annual dividends every year for 35 years, the company occasionally pays special dividends. This includes a large $3.00/share special dividend in 2021. As a percentage of free cash flow, the regular dividend typically represents a 35-45% payout ratio, leaving ample room for share buybacks, strategic acquisitions, or special dividends.

With respect to buybacks, TROW reduced the total number of shares outstanding by 7.6% since December 2016.

T. Rowe Price remains focused on returning cash to shareholders while still maintaining an emphasis on growth.

Disruptive Forces and Recent Performance

We can all see that past performance for TROW was excellent.

But, really, isn’t TROW primarily a dinosaur mutual fund company that will soon be obsolete due to the rise of exchange traded funds and disruptive brokerage firms like Robinhood?

Let’s examine the disruptive forces bear thesis.

Revenue Trends

First, take a look at the Total Revenue trends for TROW, which show a 71% increase over the prior 5 years:

ChartData by YCharts

No issues there, as revenue keeps increasing. The expectation for obsolete dinosaur companies is static or decreasing revenue.

Profit Margins

Skeptics might argue that TROW is merely increasing revenue because assets under management rise with the stock market. Perhaps, but now take a peek at gross profit margins for the last 5 years, which represent the percentage of profit after accounting for the cost of generating the services sold. These have been incredibly stable in the realm of 54-60%.

ChartData by YCharts

Additionally, net income margins generally increased since 2016 and now comfortably exceed 40%.

Graph of 5 year net income margins

Seeking Alpha, Data by YCharts

What’s the message from the profit margins graphs? These data tell me that the rise of exchange traded funds and discount brokerages has minimally impacted the performance of TROW, if at all.

If T. Rowe Price was feeling material pressure from “disruptive” forces in the financial services industry, management would respond by dropping the prices charged for services. This would, in turn, create downward pressure on profit margins.

In fact, margins have held steady or improved, indicating that TROW is handling the feared “disruption” situation just fine. Further, they have responded by introducing multiple exchange traded funds of their own.

Competitors

As a last measure, compare the 5-year stock price performance of TROW to competitor BlackRock (BLK), provider of the ubiquitous iShares exchange traded funds.

Stock performance of T. Rowe Price <span class=

Stock performance of T. Rowe Price vs. competitor BlackRock

Yahoo Finance

TROW’s stock price has outperformed that of BlackRock for most periods. Further, TROW exhibits sustainably higher profit margins by approximately 5-10%.

Relative to TROW, the stock performance of famed brokerage “disruptor” Robinhood Markets (HOOD) has been quite poor.

Stock price performance of the incumbent, T. Rowe Price (<a href=

Stock price performance of the incumbent, T. Rowe Price vs. newcomer Robinhood Markets since Robinhood’s IPO

Yahoo Finance

T. Rowe Price still creates abundant free cash flow from mutual fund management with strong profit margins. The mutual fund business remains highly profitable.

The disruption thesis is flawed.

Current Valuation

Depending on the day, TROW trades for a Price/Earnings Ratio of roughly 14-15. Given the revenue, earnings, and free cash flow generating capacity of the business, this is an excellent opportunity for long-term investment compounding.

In addition, the historical average P/E ratio for TROW for the prior ten years is 16.7. This relative comparison further indicates that shares are presently undervalued by approximately 15%. Eventually, shares will likely revert to the average Fair Value P/E ratio.

For an additional data point, Morningstar currently places Fair Value for TROW stock at $212/share, indicating roughly 15% undervaluation.

Looking forward, analysts project TROW to see 7% revenue and earnings growth in 2022, along with 5% earnings growth in 2023.

Ignoring the possibility of a recession and the associated stock market crash, I consider these forward estimates to be fairly reliable.

Expected Investment Returns

Given current stock prices, eventual reversion to a fair value P/E ratio, and applying historical earnings growth rates, I am estimating the following returns on investment:

2 Years: 40% total return, or approximately 19% annualized.

5 Years: 73% total return, or approximately 12% annualized.

For dividend-focused investors, I created a matrix of dividend growth rate ranges and resulting yield on cost for 5-year and 10-year periods into the future. Yield on cost is the future dividend yield for an investment relative to the original price paid to obtain that investment.

Yield on Cost estimates for 5, 10, and 15 years, assuming current dividend yield and a range of annualized dividend growth rates.

Yield on Cost estimates for 5, 10, and 15 years, assuming current dividend yield and a range of annualized dividend growth rates.

From The Author

Continuous compounding provides the ultimate power behind Dividend Growth Investing.

Based on past performance for the last 30 years, these dividend growth rates appear to be entirely achievable. Lower-end estimates reflect the possibility of recessions and associated stock market downturns. On the other hand, higher-end estimates imply strong organic growth and resurgence of actively managed funds, to the benefit of T. Rowe Price.

An investment at these levels offers highly attractive dividend growth and total return potential.

For these reasons, I would consider committing additional funds up to a price of $205 / share.

Investment Risks

Frankly speaking, I see two more prominent risks in the long term:

First, a prolonged downturn in the domestic or global economy will depress stock market values, thereby reducing TROW’s assets under management and resulting revenues. This will eventually happen. However, my guess is that the Federal Reserve would counter this situation by turning on the money printing press and artificially inflating asset prices. TROW would be a direct beneficiary of this response.

Second, sustained deterioration in the performance of T. Rowe Price’s funds could cause an exodus of investors into lower cost options. If TROW’s funds no longer outperform their peers over extended periods, investors will cease to pay the relatively high expense ratios charged by the company. Again, the scenario is possible, but there are no clear signs of it materializing in the near future.

Summary

Given current levels of profitability and growth, T. Rowe Price is clearly undervalued relative to historical measures and conventional valuation methods. The company offers superior investment services relative to peers and assets under management continue to grow. For these reasons alone, I consider TROW a buy.

For further investment upside, a resurgence in demand for active management may occur if passive equity indexes fail to achieve double-digit annual gains as in recent years. Additionally, rising interest rates may push investors out of passive bond funds toward highly regarded, active management companies. Lastly, growth of the alternative assets category will serve as a tailwind for TROW revenues as Oak Hill Advisors become fully integrated into the company.

If increased demand for active management and alternative assets materializes, Mr. Market will likely re-rate TROW shares and award the company with a higher valuation, thereby boosting long-term returns.

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