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T. Rowe Price Group (TROW)

Founded in 1937, T. Rowe Price (TROW) is one of the world’s largest investment managers. The company uses fundamental and quantitative analysis to create and manage a wide variety of equity and bond funds, which have historically beaten their indexes and thus attracted consistent inflows of investor capital. 

The company makes money through investment advisory fees charged for managing clients' portfolios. Fees are generally assessed as a percentage of assets under management, so they are driven by the total value and mix of the funds T. Rowe manages for investors. 

T. Rowe Price had a record $991 billion in assets under management at the end of 2017, with roughly two-thirds of its assets in retirement accounts. Stock and blended asset portfolios account for 78% of T. Rowe Price’s total asset mix, with fixed income portfolios making up the remaining 22%. U.S. mutual funds account for 61% of the firm’s assets.

The business is very focused on the U.S. with international investors only representing about 6% of T. Rowe's assets.

Business Analysis

Performance and trust drive the asset management business, and T. Rowe has both. The firm has been in business for more than 75 years, demonstrating impressive investment performance over most time periods. 

The performance data below shows the percentage of T. Rowe Price U.S. mutual funds that outperformed their comparable Lipper averages (benchmarks devised by Thomson Reuters to measure performance) on a total return basis and that are in the top Lipper quartile for the one-, three-, five-, and 10-years ended December 31, 2017.

You can see that the performance of the firm's institutional strategies against their benchmarks remains very competitive, especially over longer time periods (81% of funds have outperformed their peers over the last 10 years).

Approximately 88% of assets under management in T. Rowe’s rated U.S. mutual funds were also given an overall rating of four or five stars from Morningstar, providing yet another stamp of approval for investors to consider as they decide which firms to entrust with their hard-earned money.
Source: T. Rowe Price Earnings Release

With large, risk-averse institutional investors such as endowments and pension funds driving the majority of industry revenue, investment funds need to have appropriate scale, secure back-end processes, and a long track record of performance success to gain their business. 

Before making an investment decision, institutional investors undertake an in-depth review of funds, analyzing historical performance, tenure length and quality level of fund managers, the efficiency of back office functions, fund expenses, and the breadth of products offered. Not surprisingly, bigger funds are able to put on a better show and engender more trust throughout the review process.

As one of the largest asset managers in the world, T. Rowe Price is able to check all of these boxes. Given its brand strength, stable operations, and performance track record, it would likely take a long stretch of underperformance or extreme staff turnover before its largest investors decided to take their money elsewhere. 

While the industry is pretty fragmented, there aren’t that many mega-sized asset managers to meet the needs of the largest institutional investors – less than 3% of firms have more than 100 employees, making the biggest firms’ relationships with big institutions even stronger (fewer alternative firms to manage their money). T. Rowe's business is especially sticky because of its fee structure, asset mix, and product breadth.

Fees contribute significantly to a fund’s overall performance. T. Rowe Price has been a low-cost leader when it comes to fees for its actively managed funds, helping its overall performance and keeping it further out of the crosshairs of lower-cost passive management. 

T. Rowe’s average annual fee is less than 0.5%, which is meaningfully below the 0.77% charged by U.S. stock mutual funds, according to The Wall Street Journal. Its fee is also below the average fees reported by the Investment Company for equity (0.63%), bond (0.51%), and hybrid (0.74%) mutual funds. The company’s scale and operational synergies allow it to offer its clients lower costs without hurting its overall profit margins.

While lower fees certainly help performance and client retention (less incentive to switch asset managers as long as performance is “good enough”), T. Rowe’s business also benefits from its heavy mix of retirement-related assets, which account for about two-thirds of the firm's assets under management (including 23% in target-date retirement funds). 

Retirement-related assets are generally stickier than other types of accounts because these clients are especially looking for a manager offering stability, safety, and trust to ensure their goals are met. 

In other words, they are less likely to chase performance as wealth preservation is of utmost importance. With more baby boomers nearing retirement by the day, T. Rowe Price seems well-positioned for continued growth and increased business stability.

Finally, T. Rowe has a wide breadth of equity and fixed income mutual fund products and numerous distribution channels. Given the company’s high quality reputation and performance figures, it is able to meet most investors’ needs if they want to reallocate assets among different funds. Smaller funds do not possess this optionality since their fund options are much more limited. 

This also helps T. Rowe introduce new products faster to meet different investment trends, such as increasing demand for emerging market funds. The company’s reputation and distribution reach allow it to market and scale new products quickly, ensuring the firm stays relevant and continuously increases client retention as trends change.

A final appealing aspect of this business is that revenues rise with the market over time since recurring investment advisory fees are driven largely by assets under management. As long as fund performance remains strong enough to continue retaining clients and fighting off fee pressure, the market's long-term appreciation is a boon for fund managers. Thanks to the strong market, T. Rowe Price enjoyed over 20% asset growth in 2017, for example. 

Key Risks

Over the short term, perhaps the biggest risk to consider is an eventual bear market. Equities and bonds have recorded excellent performance following the financial crisis, helping T. Rowe's fee revenue compound at a double-digit pace as assets under management soared. 

However, when markets fall, assets under management shrink and many investors fearfully withdraw some of their funds. Lower assets mean less fee revenue, so T. Rowe is very sensitive to the market’s direction, especially given that over 75% of its capital is invested in more volatile stock and blended asset classes. 

To highlight this point, consider the stock’s performance during the financial crisis. The S&P 500's peak-to-trough loss from 2007 through 2009 was 55%, but T. Rowe dropped 63% during this period.  

The market’s level should rise over longer periods of time (as it always has), but it’s important to be aware of the potential for near-term volatility impacting business results (including assets under management and perhaps fund performance).

Pressure on fee revenue is a much bigger long-term concern. Passively managed mutual funds still cost just a fraction of their actively managed counterparts.

Not surprisingly, the fee gap has been slowly closing over time. As seen below, in 2000, equity fund investors incurred an average expense ratio of 0.99%, or $9.90 for every $1,000 invested. By 2016, that average had fallen to 0.63%, a decline of 36%. The average bond fund fee fell by 33% over this time period as well. 
Source: Investment Company Fact Book
The rise of lower-cost passive investment vehicles and generally disappointing performance of active managers are driving this trend. Low-cost passive investing continues taking market share from actively managed funds, which continue struggling to outperform index funds.
As you can see below, actively managed U.S. stock mutual funds have experienced net outflows for more than 10 years while passively managed index funds have taken off.
Today, active funds hold roughly $10 trillion in assets under management compared to $5.8 trillion in passive funds and ETFs, according to data from Morningstar. 

Active management is certainly needed for capital markets to function efficiently, but the big question is where the point of equilibrium is between active and passive strategies.

If the ultimate split is 55% active, 45% passive, another $1.3 trillion in assets under management could shift from actively managed funds to passive ETFs over time.

No one knows, but this trend seems unlikely to reverse unless there is some sort of unexpected shock in passive funds (a sharp drop in liquidity, horrible performance in the next bear market, etc.).

T. Rowe Price’s relatively strong performance and low fees compared to its actively managed peers have helped it hold onto assets much better than many rivals. The company is also trying to avoid introducing cheap or no-fee products, such as robo-advisors and most passive funds. 

Instead, T. Rowe seems opportunities in other channels with less price sensitivity. For example, over $30 trillion of assets are managed in international markets, regions thay account for just 6% of T. Rowe's assets today. The $18 trillion financial advisor market is another example of a profitable area for expansion since T. Rowe only has $380 billion in assets there, according to Forbes. 

Despite above-average fund performance and a focus on profitable growth strategies, the company's stock and blended strategies still reported net asset withdrawals of $6.8 billion in 2017. That figure may not seem like a big deal compared to T. Rowe Price's total stock and blended assets of $772 billion.

However, the withdrawals notably included the company's first-ever outflow in its target-date retirement area, and T. Rowe does not have a meaningful presence in passive products to hedge its bet (only around 5% of its assets use passive index strategies, according to Forbes).
Source: Forbes

Even if T. Rowe Price is able to hold onto its assets better than peers, clients seem likely to continue applying downward pressure on fees over time.

There is also the issue of recent management changes and how they could impact the company’s culture, which is very important for investment firms.

Brian Rogers, T. Rowe Price’s former chairman and chief investment officer, retired at the end of March 2017 after working for the company for 35 years. 

T. Rowe’s CFO retired in 2017 as well, and the company’s current CEO took over only at the end of 2015. The number of key personnel changes risks shaking up the company’s culture during a fragile time for the active fund industry.

The company’s investment team has more than doubled in size since 2005 as well. Such growth comes with cultural changes that could meaningfully help or hurt the company over time. 

Closing Thoughts on T. Rowe Price

Despite some of the real pressures facing active investment managers, T. Rowe Price is likely a business that is here to stay for many years to come. However, long-term growth could be challenged by the continued migration from active to passive products, pressure on fees, cultural changes within the firm, and less robust returns from equities given today's high valuations.

While the company should be able to continue paying safe and growing dividends, which is something it has done every year since its IPO in 1986, investors considering the stock be comfortable with T. Rowe's sensitivity to financial markets, as well as the disruption that's taking place in the asset management industry.

For now, T. Rowe's solid performance relative to peers, large scale, strong reputation, and high mix of stickier retirement-focused assets are helping the company insulate itself from the worst of the passive investing movement. But like with all investments, past performance is not necessarily indicative of future results. 

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