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T Rowe Price Equity Income Fund Seeks Strong Value in 3rd Quarter

- By James Li

During the third quarter, the T Rowe Price Equity Income Fund (Trades, Portfolio) took a position in KeyCorp (KEY) and tripled its stake in Johnson Controls International PLC (JCI). Additionally, the fund trimmed its position in General Electric Co. (GE) and Bank of America Corp. (BAC). These transactions align with the mutual fund's value-oriented investment approach.


Introduction to the fund and its investing strategy

As mentioned in its prospectus, the equity income fund seeks high levels of dividend income and long-term capital growth through investments primarily in undervalued, large-cap company stocks. Such companies have low price-earnings (P/E) ratios relative to the Standard & Poor's 500 index, a strong balance sheet and good financial strength and high dividend yields.

With the All-in-one Guru Screener, we can implement the mutual fund's investment approach using the following filters:

  • The company has a market cap of at least $20 billion and does not trade on the over-the-counter market.
  • The company has a strong balance sheet as indicated by the following characteristics:
  • The company's trailing 12-month P/E ratio is less than 26, the average P/E (ttm) for S&P 500 companies based on market valuations.
  • The company's trailing dividend yield is at least 2.1%.

Ten companies, including Canon Inc. (CAJ), Procter & Gamble Co. (PG) and Valero Energy Corp. (VLO), made the "T Rowe Price Screener" list.

Mutual fund takes stake in robust capital market company

John Linehan, manager of the equity income fund, purchased 9.2 million shares of KeyCorp at an average price of $11.97 per share. The fund's portfolio increased 0.53% with this transaction.

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Even though KeyCorp has a modest financial strength rank of 5, the company's profitability rank is a strong 7 out of 10. This suggests that the Cleveland-based regional bank has a higher profitability and is likely to stay that way. KeyCorp's operating margin, net margin and return on assets are currently near a 10-year high of 33.65%, 23.26% and 1.14%.

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As discussed in the company's recent press release, KeyCorp is one of the largest financial services companies in the U.S. The investment banking company's technology specialists, Pacific Crest Securities, showed robust growth rates among private software-as-a-service companies. The survey showed a median revenue growth rate of 44% in 2015 among private SaaS companies, with 25% of companies operating above the "Rule of 40%," a threshold suggesting high profitability and earnings performance. Likely due to the high growth potential of KeyCorp's technology specialists, KeyCorp has expanding operating margins. Additionally, the company's trailing dividend yield is near a five-year high.

T Rowe Price's equity income fund has the second-largest share stake in KeyCorp, representing 0.85% of total shares outstanding.

Fund triples stake in top-performing energy optimizing company

The equity income fund purchased 6,267,602 shares of Johnson Controls International at an average price of $44.88, increasing its position by 217.94%. This transaction increased the fund's portfolio 1.38%.

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The automotive battery manufacturing company has a slightly lower profitability rank than does KeyCorp. Despite this, the company's operating margin and Greenblatt return on capital are currently near a 10-year high. Additionally, the company's Piotroski F-score is a good 6 out of 9.

As discussed in several recent press releases, Johnson Controls had a strong fiscal fourth quarter. The Alliance to Save Energy presented the Star of Energy Efficiency Chairman's Award Sept. 23 to Johnson Controls for the company's "innovative start-stop battery technology." This initiative allows a vehicle's engine to shut off when stopped at red lights or traffic jams, which can improve fuel efficiency by about 5%. The start-stop battery technology can reduce gas emissions by about 6 million metric tons annually. Additionally, the Korean Standards Association named Johnson Controls "Best Automotive Battery Maker," as mentioned in the Oct. 5 press release.

With the Sept. 6 acquisition of Tyco International PLC (TYC), the management at Johnson Controls can drive new technology innovations in smart buildings and expand into future cities. As mentioned in the press release, this merger expects to realize $1 billion in cost savings and other previously announced merger synergies.

Likely due to the merger completion announcement, Linehan eliminated its position in Tyco and tripled its Johnson Controls stake with the proceeds. As mentioned in its third-quarter fact sheet, Johnson Controls is among the fund's top five holdings. Among the gurus that have positions in Johnson Controls, the T Rowe Price Fund has the fourth-largest stake with 1.43% of shares outstanding. Martin Whitman (Trades, Portfolio) increased his stake in Johnson Controls by 71.48% albeit just owning 0.09% of total shares outstanding.

As financial outlook weakens, mutual fund sells portions of two positions

The equity income fund axed 32.45% of its stake in GE, selling 6.75 million shares at an average price of $31.13 per share.

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Although the company has high net margins, its operating margin contracted to a 10-year low to 6.25%. Based on its 15-year financials, the diversified industrials company is likely a value trap: while the company's free cash flow margin increased, GE's gross margin steadily declined over the past 15 years.

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As implied by GE's competitive comparison analysis, several of GE's competitors, including 3M Co. (MMM) and Danher Corp. (DHR), have higher predictability ranks. These companies likely took away GE's competitive power. As the company has decreasing value potential, Steven Romick (Trades, Portfolio) also trimmed his position in GE.

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The T Rowe Price Fund also sold 37.04% of its position in Bank of America. Although the company reported strong third-quarter earnings, including a 3% revenue increase, the company's profitability still ranks a modest 5 out of 10. The company's three-year revenue growth is -1.40%, underperforming 71% of global banks. Additionally, the company's operating margin and return on equity underperforms 64% and 74% of global banks.

See also

As discussed in a new feature announcement, you can now customize the 15-year financials view (i.e., you can just display the desired financial information for the company). For example, you may only want to display GE's ratios and valuation/quality metrics. Simply select "Add View," which is the last entry in the gray ribbon that begins with "Standard View." To remove sections and items from the standard view, simply click on the red "X" for that row. You can view all items for a particular section by clicking on the section title. As you remove sections and items, you should see "+(n)" next to the words "Sections" and "Items," where "n" is the number of sections or items excluded. You can add these sections or items by clicking on the "+" next to "Sections" and "Items."

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Disclosure: The author has no position in the stocks mentioned in this article.

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This article first appeared on GuruFocus.