Finding fixable and lovable stocks: A study in partnership

Hello. And thank you for joining us today to discuss a case study, digging into a specific investment, which we're going to refer to as “Company A,” but also a case study digging into what we really think is the secret sauce of our investment approach here at T. Rowe Price.

And that is when our investment analysts and our portfolio managers come together to do deep fundamental analysis that is enhanced by partnership and collaboration. I'm Jackie Fortner. I’m the portfolio specialist for our Mid-Cap Value Strategy here at T. Rowe Price. And I'm joined today by Anna Nussbaum, an investment analyst on our tech team covering semiconductors and hardware, and Vincent DeAugustino, the portfolio manager of our Mid-Cap Value Strategy.

So, thank you both very much for being here today.

And, Anna, maybe just to lead off the conversation, can we talk about how the two of you work together and what really made this case study possible in the first place? And maybe, Anna, if you don't mind, I'll start with you.

Yeah. Since I joined T. Rowe Price five years ago as an associate analyst on the value team and made the progression toward a covering analyst on the tech team, mentorship has been a key part of my development journey.

Vincent has been a consistent partner, not just in developing my investment process, but also in developing my ability to more deeply engage with our portfolio companies. Beyond the case study today with Company A, we've worked together on a number of complex situations, including spins and restructurings, which Vincent’s strategy has more experience with. An initial investment discussion may start around a model, then lead us to a muddy field or muddy construction site visiting a semiconductor fab to see the progress. And then in some cases, as we'll discuss, as we become longer-term investors in a company, we may even share our perspectives on value creation with the company.
And that is where having the support and engagement with our portfolio managers helps an analyst like me develop.

So, I'm just really excited to be here to talk about Anna and I’s partnership and then Company A. But just to start, at T. Rowe Price we're really blessed to have strong talent interest in from both aspiring and experienced investors in joining our team.

I started as an associate analyst within equity research. And I just have a heartfelt interest in supporting our associate analysts. And myself as an associate analyst once, turned analyst, turned portfolio manager, there's just a lot of pattern recognition that I had seen in Anna with her grit and determination and just her just tireless pursuit of driving positive outcomes for our clients.

And so I first started working with Anna when she was on the value team as an associate. And leaning in with her was not only an easy decision, it also was just led to this wonderful partnership that starts with digging into models, as Anna said, traveling to obscure factories, and at times just reflecting on tough investment decisions.

And so this has led to a strong foundation for us and just is really the jumping off point where we start with this case study. And that's just based on our trust, our partnership. And, lastly, I'd say just the fun that we have with this job that I think has made it all possible.

So, Vincent, maybe can you tell us a little bit more about what you think makes this product special in the market? You coined the term “fixable and lovable” to describe what we're looking for in companies in this strategy. But could you maybe explain that a little bit more for our audience here?

Yeah, sure. I mean, just to start, fixable and lovable, you're probably not going to find that in an investing textbook.

But we generally are initiating an investment in a stock that has underperformed. Something has generally gone wrong and there's some challenge or debate that is really just obscuring value for other investors. And that I would say is a classic value or contrarian approach. But this lovable test is, I think, what makes this an interesting component.

And so again, just put simply, we're coming in with a view after something's gone wrong where there might be a fix and the stock has underperformed, and sometimes, to something that Anna had mentioned before, we may even be advocating for a certain strategic change or path. Something like a spin, as one example.

But the lovable test, this adds to the question of whether or not the business emerges stronger through stress to a point where it can command a higher valuation than even when the company was operating through normal times pre-stress.

And so some examples of this would be us using cyclical weakness to really buy into a secular trend that we wouldn't normally see in a value strategy because valuation would have been a constraint.

But we're using the special situation to really invest in something that can grow and graduate into a core long-term, compounding holding for us. And it graduates into that “loved” category as part of our strategy.

So then maybe against that backdrop, can you kind of walk us through or tell us what you can about Company A and sort of how it fits into that fixable and lovable framework?

Company A has a 170-year-old track record of material sciences innovation that has led to numerous world-changing inventions spanning data communications, consumer electronics, even pharmaceutical applications.

An attractive investment opportunity arose here when Company A’s shares became pressured when several of its main businesses were experiencing end-market weakness at the same time that foreign exchange pressures were building. As I mentioned, the company has a long track record of developing and commercializing material sciences innovations. These investments at times, such as when cyclical pressures are building, have concerned investors.

Our work led us to believe that these pressures were not only fixable, but also short term in nature, and actions that the company was taking would lead to likely accelerated earnings on the other side, beyond a cyclical recovery. This is something we believe the market was missing.

Yeah, what I would say is that the world would simply just not be the same without Company. Its products – some of them are lifesaving. And you might be interested to know that many of you viewing this might be using one of their products right now. And so to Anna’s point, when the end markets were weak, we did think that there was a cyclical recovery opportunity that was likely to occur.

But more importantly, we thought that the business would be better on the other side of stress. And it was because of this new product adaption that was happening. And as new markets were opening for them, and as Anna had mentioned, as capital allocation was turning more positively, that was also an aspect of the fix.

And so just as an example of how the company was getting better, I mean, we already believed that the core business was attractive absent the cyclical pressures. But here where we thought it was getting better was that it was actually moving up the value chain with its customers and helping to solve complex challenges on the technology front.

And so that's something that we thought was going to be accretive to margins, to cash flow, and ultimately valuation. And that kind of speaks to just what other investors would ultimately love on the other side to help drive both the cyclical recovery but also just valuation expansion on top of that.

Yeah, that’s a super helpful insight. And maybe, we've talked a little bit about your partnership together. How did that partnership then translate into your partnership with Company A as you’re engaging?

Yeah. So I think when like we have this internal sort of partnership. And we use this term “partnership,” but like what does it mean? And so when we work more closely together we're going to ask more insightful questions.

We're going to be more deeply informed. And we're going to feel more comfortable—and this is like a really important point—we're going to feel more comfortable when situations are difficult. We're coming into stocks that have already underperformed in some cases. But having that foundation is going to give us the confidence with that level of work to lean into those difficult situations.

And then the other piece is that we end up through this with companies having more of a reputation of having a steady hand, and in markets like today where things are exceedingly volatile, those relationships and partnerships are really important.

So then going from there maybe, how did your investment thesis and your relationship with Company A ultimately play out?

As we began to see early signs of cyclical recovery, we continued to build our position in Company A, and we could see the potential for high incremental margins and a strong inflection in free cash flow. A key question remained whether these benefits would more fully drive a realized improvement in return on invested capital if there was an associated acceleration in capital expenditures. So, we combined data collected in partnership with our Investments Data Insights team, with investment case studies to show Company A where we thought there were opportunities for improving capital allocation and addressing investor concerns.

In particular, we encouraged them that more focus was needed on project selection to deliver incremental free cash flow when revenues normalized and that Company A’s foreign exchange risk was an issue for many investors.

Over the past year, Company A’s end markets have begun to recover. Contract renegotiations have resolved the foreign exchange risk. It is also seeing success with new products launched and has commenced a formal project outlining its expectations for strong revenue growth without a material ramp in capital expenditures. And this has been received favorably by the market.

Yeah. So what I would add is that when we have this level of engagement with a company and we may be addressing a concern that other investors have, and when you have those discussions and you realize through either making a presentation or even board engagement at times, when you realize that there's greater alignment and you actually can see the path to resolution just through that whole process, we end up having a much deeper appreciation for where there's, where we can meet in the middle and where there's, again, that pathway. And through that whole process, it really gives us the confidence to build those positions into, again, to when things are maybe still weak, we're going to be building that position into a larger one for the benefit of our clients. So that whole process I find to be very constructive in how we approach these situations.

So this has been like a really interesting story that you guys have walked us through. How often do these types of case studies come across in this market?

Yeah. So, because our strategy is specifically looking for turnarounds, there's often going to be some debates, controversy, and, through these, early recovery phases.

We're going to be having those, more proactive conversations. And so this isn't like a hard number through time. And it's certainly not a constant. But, at any point in time, about a fifth of our portfolio is going to be in this formative stage and when we’re having those deeper levels of engagement where ultimately our goal is to have them graduate, have these stocks graduate into the loved and compounding part of the portfolio.

But just to be clear, this case study with Company A, this was a good example of engagement and, but just to be clear, this was not an activist situation.

I hope what everybody takes away from this conversation is that when we get our portfolio managers, our analysts to come together to do kind of this deep fundamental analysis and work together in collaboration and partnership, and we really find ourselves well positioned to invest behind companies that may face challenges, but that which we feel can become stronger on the other side of the challenge and ultimately command a premium valuation in the market.

So thank you all for your time and for joining us today. And if you'd like to learn more, we hope that you'll check out the printed materials that go along with this conversation. Thank you, Vincent and Anna, for the time, and we appreciate it.