Q: Could you give us some background information on the fund?
The T. Rowe Price Diversified Mid-Cap Growth Fund was launched in December 2003, but its strategy has a track record of more than 20 years. My partner, Donald J. Peters, who started the fund joined T. Rowe price in 1993. I joined the firm in 2000 as a technology analyst, then went on to work on the fund in 2004, and became a co-manager in 2009.

The fund is part of a bigger mid-cap growth strategy that we call Structured Active Mid-Cap Growth. The retail fund has $420 million in assets, with a total of just over $2 billion managed under the strategy.

There have been no significant changes in the last ten years in the strategy and the management of the fund. The team, which includes Donald, myself, and the support of Sudhir Nanda, has been stable throughout this period. Sudhir Nanda also runs the T. Rowe Price Diversified Small-Cap Growth Fund and our quantitative group. In our portfolio construction process, we use a quantitative approach and we look at many of the same names, so we are in regular communication.

Q: How would you describe the investment philosophy behind the fund?
The investment philosophy behind the find is to provide investors with exposure to superior companies in the mid-cap asset class. We take the word “diversified” in the name quite literally. Typically, the portfolio has 250 to 300 names because we believe that large bets on single names can ruin the opportunity to participate in the goodness of that asset class. We do not try to time the market, so the fund is fully invested, with cash representing less than 100 basis points of the portfolio.

Instead of playing the big alpha game, we give our clients exposure to an asset class that we like and understand, and which has proven to be a great space to invest in over time. Long-term data suggests that the risk/return ratio of the mid-cap space is quite favorable. We view it as a favorable hunting ground for growth companies that are seasoned enough to have a market cap greater than $2 billion but also young enough to have growth ahead of them.

Then we layer the alpha in our stock selection, looking for quality companies that are enjoying earnings growth. It really is that simple. After all, if you can find companies that consistently grow their earnings per share over time, they tend to be stocks with good performance. Typically, such companies have strong capital allocation and the ability to buy back stock, or are in a growing industry.

In the short term, investors often get caught up in the day-to-day movements of stocks. Because there is so much noise, it is easy to lose sight of companies that are not exciting in a particular quarter of year. Over the longer term, however, it is amazing what compounding earnings growth can do.

We believe that if we can find and hold companies that compound earnings growth, the fund will be successful. It does not necessarily mean success every quarter or every year, but means strong performance in the long run.

Q: What is the investment process that you employ?
The strategy has a strong fundamental bottom-up focus with a quantitative overlay. We look at return on invested capital because we aim to find companies that can consistently generate greater returns than their weighted average cost of capital. We invest in companies with strong free cash flow, good margins, balance sheet strength, management quality, and market leadership.

On the quantitative side, we select companies with lower earnings variability than the average, because they can hold up better in a downturn and can compound earnings growth. We also like companies that are adept in allocating capital. Businesses that generate strong cash flow, and whose management does not squander the cash, are often great stocks to ride for the long term. One such long-time holding has been AutoZone, Inc. The company significantly reduced its outstanding shares and its earnings growth has been consistently in the double digits.

As an actively managed fund we make bets, but these are not sector bets. Our strength is in making our bets at the security level in a diversified way. We are typically in-line to plus or minus 200 to 300 basis points in a sector versus our benchmark, Russell Midcap Growth Index.

Ideally, we make our alpha in the more difficult parts of the business cycle. At the top of the cycle, our competitors tend to be fairly aggressive, while we pay attention to valuation. We do not overpay for stocks just because we feel that momentum is strong. If the valuation does not make sense, we either modulate our position or eliminate it altogether.

Q: What is your research process and how do you look for opportunities?
Although we do not have a magic growth rate in mind, we like to clearly see a company that can have top-line growth and can leverage that growth into high earnings per share growth through a cycle. We avoid companies that we believe grow too slowly.

We also look at estimate revisions as we search for companies with growing estimates. It is quite important how the company translates its earnings into free cash flow. Very often you can see yellow flags on the cash flow statement that are not apparent on the income statement.

Balance sheet strength is another key factor in our stock selection. Companies with high levels of debt should have a business model that generates the cash necessary to service the debt. Even during the financial crisis, we did not have many companies with balance sheet issues. As a rule, we are lower on the leverage scale than the benchmark. Another feature that we look for is lower variability of the earnings, because such companies tend to do better in downturns.

Many of the names that we buy come from our analyst pool. As far as our research team is concerned, most of the analysts are in Baltimore, Maryland; we are all located on the same floors, which facilitates frequent personal interaction. We have an open-door collegial culture that allows for free flow of information and sharing of ideas. We are agnostic to where the ideas come from, but most of the new ideas come from our internal analysts.

Typically, we sit down with the analysts to go through their space on a weekly or bi-weekly basis. During these meetings we discuss how the analyst’s space will evolve over time and which companies are best positioned not just for the next year, but also for the next three to five years. We receive many valuable insights from the analysts, who are experienced and cognizant of the nuances of the companies.

Also, we meet occasionally with the sell-side analysts to get their input. We have our own screens that generate names to work on and even if our analysts do not cover a particular name, they have met with the company at some point or have some knowledge. We always check with our experts before going forward with our work on a particular name.

Q: Could you share some names that have met your criteria?
Sherwin-Williams, a paint company, would be a great example. We purchased the stock for the first time in 2006-2007, when the housing market was weak and Sherwin-Williams was struggling to grow. However, we found that paint is actually a good business. House painting is usually outsourced to contractors, who buy the paint. Price sensitivity is low.

We found that Sherwin-Williams has been an active buyer of its own stock, thus significantly reducing its share count over time. The company was in trouble because of the housing market, but we were confident that it would come back.

Our analyst recommended the name and we discussed possible scenarios. The analyst maintained that earnings power would be significantly higher than expected. We had to be patient, but once the housing market started to pick up in 2010 and 2011, and people started to spend more money and to repaint, the company was perfectly positioned and significantly outpaced the estimates.

The stock grew from $60 to nearly $300 over the next few years, which is a great example of having a long-term horizon, being patient with the high quality name you have selected, and being rewarded. Sherwin-Williams runs a good business with pricing power, market leadership and a strong brand and was relatively cheap at the time of purchase. It is not an extremely high margin business, but that’s actually a positive factor because, when margins are too high, you invite competition.

Another example would be Ross Stores, an off-price retailer. The company is in an interesting niche—it picks up last year’s fashion and sells it at a significant discount. There is certainly a treasure hunt aspect to the business that they use to target primarily the female shopper, who tries to find fashion items much cheaper than in a department store.

The company’s same-store sales grow by 3% to 5%, and the square footage has been growing in the mid to high single digits. At the same time the margins have been going up and the company buys back its stock. The earnings have probably compounded at a rate of 15% for many years. We have owned the stock for about 10 years already. While it was $10 or $15 back in 2006 and 2007, right now it is trading at $98 per share.

The power of a really good business is often the power of a management team that knows exactly what to do and what to avoid. The management of Ross Stores buys back a lot of stock, shrinks the share count, and compounds earnings growth. An interesting fact about Ross Stores is that it benefited from the financial crisis because as people were struggling, they traded down to cheaper alternatives. So, new customers discovered the store, decided they liked it, and stuck around. Overall, the company has solid, consistent performance.

Q: What is your portfolio construction process?
Diversification is a key feature of our portfolio, so we do not make big bets on any stock. We start with small positions, usually at 20 basis points, and then the positions grow as the stock performs well, or whenever we add to them as we gain confidence.

With a less diversified portfolio, one poorly performing stock can sink your annual return. And even with the best thesis and selection process in the world, no one is safe from a harmful event that is impossible to forecast. Moreover, in the mid-cap space, just the sheer number of interesting names makes it harder to operate a narrow portfolio.

We do not focus on making sector calls. If we really believe in a theme, we may have higher exposure, but we are always sector aware. We are not sector neutral, but we are aware. For example, if technology represents 15% to 20% of the benchmark, we are not going to invest 30% in technology stocks.

Q: What would be a reason to sell a stock?
One reason to sell a stock is fundamental deterioration. If the underlying thesis is not playing out, we are willing to be very patient, but we are also willing to admit when we are wrong. Selling part of a name, or eliminating it completely from the portfolio, when you feel that your thesis has broken down, is often the right thing to do.

Another reason to sell a stock is when it gets too big. Such an example would be T.J. Maxx, which we have previously owned. Naturally, that is a good reason to sell because it means that you have made a good return on the stock. The average market cap of the portfolio is $9 billion to $10 billion, while the Russell Midcap Growth index has companies with market cap of over $30 billion. So, once a company passes the $30 billion market cap, it would be very difficult to call it a mid-cap stock.

Apart from getting the internal analysts’ input, we also have significant management interaction with our companies. It is rare that a week goes by where we are not meeting with several of our company’s management teams, or with the management teams of potential holdings. These are usually detail-orient meetings, which continue for one or two hours. Additionally, we attend investor conferences to find new ideas or to meet with existing holdings.

The turnover of the fund tends to be in the 20% to 30% range. Since we invest in companies that we can own for three-to-five years or more, and we are not obsessed with the next quarter or year, we have a low turnover approach with a very long-term focus.

Q: How do you define and manage risk?
Diversification, sector awareness, and position size management, by definition, limit the risk of the portfolio. We look at beta as a crude measure of risk and we do not tend to differ much from the benchmark. I also believe that the earnings-per-share variability is a good measure of risk, because it identifies companies that can hold up in a downturn.

Every quarter we have a discussion with our risk analyst, who is responsible for all the mutual funds. His report essentially shows where the different risk hotspots are and what we should be aware of. For example, we may have an implicit bet on interest rates going up and the risk hotspot would identify it. Since we run a diversified portfolio, we rarely have such risks, but it may still happen. We would not necessarily change our positioning, but it is important to know and moderate one’s bets.

Historically, mid-cap stocks have delivered better risk-adjusted returns than both small-cap and large-cap stocks. When compared to the small-cap space, mid-cap companies are often more seasoned, with business models that have proven themselves over longer periods of time. There tends to be less dispersion of outcomes in the mid-cap space vs small-cap, but the companies are still small enough to have the opportunity to grow into large caps.