New Study

Discovering Long-Term Winners Among Small-Cap Stocks

Imagine if you had invested in Apple in
the 80s or Google a decade ago. Many
investors dream of getting in early
on the next big thing, an innovative
company that changes the world and
enriches them.
But a T. Rowe Price study shows that
finding these companies is extremely
difficult and holding them through
rough markets can be even harder. They
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industries as social media and technology but are engaged in such mundane
undertakings as bread making.
To identify companies that achieved
a 20% or more annualized return over
10 yearsa sixfold total gainthe
study examined all companies in the
Russell 3000 Index with $1 billion to
$3 billion in market capitalization over
rolling 10-year periods, from 1996
through 2013.
In the 11 different 10-year periods, an
average of only 18 companies achieved
such stellar performance per period.
When not double counting companies
that hit the mark in more than one
10-year span, the average dropped to 10.
Overall, there were just 116 unique
companies that achieved this distinction
over the entire 17 years.
The ability to grow revenue at a
double-digit pace is really, really hard
to do over an extended period of time,
and to be able to compound wealth at
20% or more is very rare, says Henry
Ellenbogen, manager of the small-cap
New Horizons Fund.
Accomplishing this feat was even
more difficult when overall market
performance was subdued.
In the studys worst-performing 10
years, ended December 2008, small-cap
stocks (as measured by the Russell 2000
Index) had an average annual return of
only 3%. Yet 11 companies averaged 20%
or better annually in that period. (See
chart next page.)

Briefly
A new T. Rowe Price study found
from 1996 through 2013:
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more annualized return over a
10-year period were rare.
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been difficult because on average
each experienced steep declines at
some point in that 10-year period.
r


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relatively mundane enterprises.
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investors, also seek such rare smallcap winners, but from a different
starting place.
While discovering such potential
overachievers may be rare, sticking
with them through rough patches can
be even more challenging. To reap the
outsized rewards these stocks eventually
provided, investors had to endure an
average decline of 27.1% at some point
during that decade.
It shows you that even during a
period when a stock is compounding
between six- and eightfold, its price
could drop significantly along the way,

high-growth sectors as information

technology and biotechnology. In fact,
the leading sectors for outstanding
performance included consumer staples,
energy, and industrials.
Flowers Foods, for example, makes
bread, snack cakes, and other household
staples but was one of the few companies
to star in multiple 10-year periods.
Heres a company whose end market
breadhas had modest growth at best,
Mr. Ellenbogen says. But its a company
with good systems and people, runs
itself very efficiently, allocates capital
well, makes smart acquisitions, and has
organically gained market share.

Success Keys
Not surprisingly, the companies that
achieved exceptional performance
over 10-year periods exhibited superior
financial characteristics. On average,
these leaders had median annual
sales growth of 19.5%, median annual
earnings growth of 17.1%, and average
annual return on invested capital of
18.4%all significantly higher than
the average firm in the study.
You can see a huge revaluation of a
company over a period of years when
the margins and return on invested
capital are improving, says David
Wagner, another small-cap manager.

...even during a period when a stock is compounding

between six- and eightfold, its price could drop signicantly
along the way. So you have to be patient...
Mr. Ellenbogen says. So you have
to be patient and know that you are
going to go through a rocky period
where the company may be in transition in which it has to reload for the
next phase of growth.
The study also demonstrates that
such success is not concentrated in such

Superior financial results, of

course, suggest strong management
teams, another crucial ingredient. A
mediocre management can ruin a nice
turnaround, says Preston Athey, the
veteran manager of the Small-Cap
Value Fund. Conversely, a great
management team can take a very

mediocre company and at least make

it above average.
Early-stage innovative companies
account for about a third of the New
Horizons Funds holdings. Mr. Ellenbogen has found that for a company
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need to move from its first act to a
second act in which it goes beyond
its initial business model.
Sometimes companies have to go
through transitions, and we ask ourselves whether it is prepared for this,
he says. Are the people and process
systems able to scale and adapt to
change, is there a strong management
team that realizes it has to handle

this transition, can they continue to

operate their core businesses well
while consistently laying the seeds for
future growth, are they being intellectually honest about their challenges
and properly measuring whether or
not they are succeeding?
Twitter is one example, he says.
The New Horizons Fund invested in
the real-time social media company
in 2009. Although it was still a
private company with a market value
of less than $1 billion at the time,
Mr.Ellenbogen says its Act I was well
underway, showing rapid user growth.
As the companys leadership
matured, he says, it invested in the

systems needed to increase its scale,

adapting to the secular trend toward
mobile technology and enabling the
company to build a platform that it
could monetize.

Value, Too
Exceptional performance does
not just come from high-growth
companies. Value investors seek the
same outcomes but from a different
starting place.
Were trying to find companies
that may offer the same kind of
compelling growth prospects but
theyre not necessarily fully valued
and are actually cheap, Mr. Wagner

Defying the Odds: Companies That Gained at Least 20% Annually During a Poor Decade for Small-Cap Stocks
December 31, 1998, Through December 31, 2008
To identify companies that achieved 20% or more annualized returns over a decade, the study examined all companies
in the Russell 3000 Index with $1 billion to $3 billion in market capitalization over rolling 10-year periods, from 1996
through 2013. That periods worst-performing decade ended December 2008, with small-cap stocks (as measured by
the Russell 2000 Index) earning an average annual return of only 3%. In that period, only 11 companies averaged 20%
or better annually.
Largest 12-Month
Price Decline

Median Annual
Sales Growth

Biotech

34.9%

50.9%

Health

30.1

26.7

11.4

68.9

-21.1

C.H. Robinson Worldwide

Transport

25.1

12.7

20.1

27.2

-10.6

EOG Resources

Energy

23.2

10.0

27.1

18.3

-28.1

Varian Medical Systems

Health

22.6

12.9

14.5

22.3

-24.2

Apache

Energy

21.9

24.9

26.3

14.2

-27.1

Expeditors International

Transport

20.8

17.5

20.1

23.2

-35.1

Express Scripts

Health

20.7

22.5

25.6

17.5

-51.4

Mandalay Resort Group

Gaming

20.5

11.2

7.6

2.5

-36.7

Harrahs Entertainment

Gaming

20.3

13.7

10.4

6.8

-22.1

Phelps Dodge

Mining

20.2

11.3

18.8

1.6

-40.1

Annual Average for Group

23.7%

19.5%

17.1%

18.4%

-27.1%

Annual Average, All Other

Companies

-1.7%

13.0%

10.0%

-3.0%

-49.5%

Industry

Gilead Sciences
Caremark

Median Annual
Earnings Growth

Average Annual
Return on
Invested Capital

Average Annual
Return

Company

6.4%

-5.3%

-5.3%

Note: The total cohort for this decade consisted of 604 companies in the Russell 3000 Index (excluding the 20% plus gainers) that
had a stock market capitalization of $1 billion to $3 billion at the start of the decade. As of June 30, 2014, none of the stocks in this
table were owned by the New Horizons Fund, the Small-Cap Stock Fund, or the Small-Cap Value Fund.
Source: T. Rowe Price.

troweprice.com 9

Small-Caps
Continued from page 9

says. These are companies that for

whatever reason may have fallen on
hard times and their returns may
actually be decreasing, but with the
strategic moves that could actually
make them look like a growth stock
down the road.
Mr. Athey adds that value investors
sometimes can just catch lightning
in a bottle. The company may be near
bankruptcy or is a really deep value
situation. But it turns out that the
company or industry is not dead and
over a period of time you can make an
extraordinary return.
Cliffs Natural Resources, for
example, is an iron ore producer that
Mr. Athey acquired in 2000. (It was
known then as Cleveland-Cliffs.)
At the time, the world was supposedly never going to build another
steel mill, never need another ton of
iron ore, and so the stock was trading
below book value, he says. Then
in 2007, all of a sudden the Chinese
are building steel mills, the United
States is still making steel, and iron
ore prices are going way up. So in this
case management didnt change, but
the environment changed.
There generally are three ways

small companies might achieve

outperformance, Mr. Athey says.
The first is that it is truly a growth
company and consistently puts up
high-growth numbers. The second is
a company that may be near bankruptcy or is really deep value and it
comes back from the dead.

Also, when you find something

really good thats working well for
you, you should appreciate thats a rare
thing. You have to recognize that you
are going to look at a lot of companies
before you find one that could be a
really big compounder of returns.

Whether a growth or value investor...the studys lessons are

the same: Think long term, be patient, and recognize that
even the best companies on the planet will have periods
when things dont look so good.
The third is a little of botha
company that may be under the radar
screen, perhaps with a checkered
history, and its really cheap, but
not because its a horrible company.
Its just been neglected and hasnt
performed very well, but maybe
new management comes in and the
company starts doing better.
Whether a growth or value investor,
Mr. Wagner says, the studys lessons are
the same: Think long term, be patient,
and recognize that even the best companies on the planet will have periods
when things dont look so good.

Small companies tend to have

less experienced management and
unpredictable earnings growth on
limited product lines, which can cause
their stock prices to fluctuate more
than larger firms. As of June 30, 2014,
Flower Foods accounted for 1.28%
of the New Horizons Fund; Twitter
was not in the fund. Cliffs Natural
Resources stock was not held by the
Small-Cap Value Fund.

Taking the Long View: Small-Company Funds Turnover Rates Have Been Relatively Low
As of December 31, 2013
T. Rowe Price managers typically take a long-term perspective when investing in smaller companies, as reected in the
number of companies held in these three small-cap funds longer than 10 years and in these funds relatively low turnover
rates compared with their peer group averages.
Number of Stocks Held:
1015 Years

1520 Years

More Than
20 Years

Small-Cap Value

49

22

22

Small-Cap Stock

32

New Horizons

13

N/A

Fund

Longest Holding/
Year Purchased

Average Annual
Turnover Rate

Industry Average
19942013

Culp (1988)

12%

Glacier Bancorp (1992)*

26

106

80%

Henry Schein (1995)

36

106

*Four other stocksWoodward, Coal Creek, Heartland Express, and Makepeacewere also initially acquired by the fund that year.
Note: As of June 30, 2014, Henry Schein accounted for 0.69% of the New Horizons Fund; Culp made up 0.15% of the Small-Cap
Value Fund; and Glacier Bancorp, Makepeace, Coal Creek, Heartland Express, and Woodward comprised 0.69% of Small-Cap Stock
Fund assets.
Sources: T. Rowe Price and Morningstar, Inc.

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