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Larry Puglia and the T. Rowe Price Blue Chip Growth Fund Synopsis and Objectives

Set in 2016, the case recounts the remarkable performance record of the T. Rowe Price Blue Chip Suggested Growth Fund (Blue Chip Growth Fund), a mutual complementary case in fund managed by LarryPuglia at T. Rowe Price, Inc. investment management The case describes the investment style of Puglia, and financial whose record with the fundover its 23-year history performance: “Warren E hadon average beaten the Standard &Poor’s 500 Index. 1 The tasks for the student are to assess the performance of the fund, consider the sources of that success, and decide on the sustainability of Puglia’s performance. Consistent with the introductory nature of this case, the analysis requires no numerical calculations. The instructor should not be deceived, however, because the absorption of the capital-market background and the implications of the finance concepts in the case will fully occupy the novice. The case updates and replaces “Bill Miller and Value Trust” (UVA-F-1481).2 The case is intended for use in the opening stages of a finance course. It provides a nontechnical introduction to the U.S. equity markets and sets the foundation for some basic concepts in finance. The following are the specific teaching objectives: 

Motivate a discussion of the concept of capital-market efficiency

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Impart some recent capital-market history—in particular, regarding the market crash of 1987, the Internet bubble of the late 1990s and early years of the 2000s, and the credit crisis/recession of 2007–09

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Convey a perspective on the role of large institutionsin setting the price of securities

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Introduce the basic concept of value additivity. As illustrated by the net asset valuation of mutual funds, the value of a firm will be equal to the sum of the value of its parts

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Introduce the principle of risk and return and affirm the notion of using market benchmarks to assess performance

Suggested Questions for Advance Assignment to Students

1. How well has the Blue Chip GrowthFund performed in recent years? In making that assessment, what benchmark(s) are you using? How do you measure investment performance? What does good performance mean to you? 2. What might explain the fund’s performance? To what extent do you believe an investment strategy, such as Puglia’s, explains performance? 3. How easy will it be to sustain Puglia’s historical performance record into the future? What factors support your conclusion? 1 The S&P 500 is a market-capitalization-weighted index of shares of the 500 largest companies traded on both the New York and American Stock Exchanges. 2 Sean D. Carr and Robert F. Bruner, “Bill Miller and Value Trust,” UVA-F-1481(Charlottesville, VA: Darden Business Publishing, 2005).

4. Consider the mutual-fund industry. What roles do portfolio managers play? What are the differences between fundamental and technical securities analysis? How well do mutual funds generally perform relative to the overall market? 5. What is capital-market efficiency? What are its implications for investment performance in general? What are the implications for fund managers, if the market exhibits characteristics of strong, semistrong, or weak efficiency? 6. Suppose that you are an advisor to wealthy individuals in the area of equity investments. In 2016, would you recommend investing in Puglia’s Blue Chip Growth Fund? What beliefs about the equity markets does your answer reflect? Collateral Readings

Peter Lynch, the legendary former manager of Fidelity’s Magellan Fund, has written (with John Rothchild) One Up on Wall Street: How to Use What You Already Know to Make Money in the Market.3 This book is an engaging exposition of Lynch’s investing style and could be used to supplement the discussion of the case. Lynch makes numerous statements about market efficiency and other theories of modern finance that stand in stark contrast to the standard textbook presentations.4 The case distills the two points of view: Lynch versus the theorists. Readings from this book could be assigned in a supplementary or a follow-on fashion and should be expected to stimulate a spirited discussion. As a counterpoint to Lynch, the instructor may find it useful to review Burton Malkiel’s, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing.5In this, the 11th edition of the book, Malkielsurveys mutual-fund performance and different trading rules over a 40-year history and finds some evidence of “hot hands” and “cold hands,” but concludes that the evidence provides no reason to abandon the theory of capital-market efficiency. Hypothetical Teaching Plan and Class Discussion Questions

Assuming the case is taught early in an introductory finance course, I like to start the class with the coin-flipping exercise described by Malkiel. All students are asked to stand up and prepare to flip a coin. After each round, those who get tails are asked to sit down. Usually cheers and humor accompany the final rounds. 1. Question for the student who won at coinflipping: The case mentions that Malkiel suggests this exercise. What concept is he trying to illustrate, and how does this exercise illustrate it? This question provides an entry into the theory of efficiency, and especially the arguments of its proponents like Malkiel. This exercise illustrates weak-form efficiency by starting with what we know to be a random process (coin flipping) and showing the illusion created by the 3

(New York: Simon & Schuster, 2016). For instance, “It seemed to me that most of what I learned at Wharton, which was supposed to help you succeed in the investment business, could only help you fail,” Malkiel, 34. 5 (New York: W.W. Norton, 2016). 4

person with the longest string of head flips in a row. We know statistically that there is always a chance of getting five or six heads, such that a room full of coin flippers will invariably produce one person with that outcome. However, it does notsuggest that skill is required to win any more than skill is required towin the lottery. 2. What is the efficientmarket hypothesis? What does it imply for the performance of mutual funds? This question builds on the first question and aims to establish the null hypothesis against which the performance of Puglia and the Blue Chip GrowthFund can be evaluated. If students have not encountered the difference between strong, semistrong, and weak forms of efficiency, here would be an opportune moment to discuss it. Most will conclude that the weak form surely exists, and the strong form requires too many perfectmarket assumptions to be completely true. This puts most students in the semistrong-efficient-market camp, which should make them skeptical of the ability of a manager to consistently outperform the market, but also allows them to entertain the possibility that a small number of managers could possess superior analytical skills. 3. What would Puglia say in response to the claim that his success is luck? What is his investment style? With this question, the discussion turns to the other side of the debate. The instructor should list the components of Puglia’s investment style on the board. Based on these attributes, the instructor can ask the students whether Puglia is following a fundamental- or technical-analysis approach. This segment of the discussion should flesh out what active management means, namely, that one looks for pricing inefficiencies.Students will find it productive to explore the ways in which gaining an advantage in the market depends on an investor having access to all the available information and processing it better than the average investor. Information has been increasingly democratized with the easy access provided by the Internet, but digesting that information and turning it into meaningful investment hypotheses is difficult and time consuming. Mutual-fund analysts spend an enormous amount of time and effort looking for small mispricings, which most of us do not have the time or skill to do. In this sense, mutual funds/institutional investors help make the market semistrong efficient and could reasonably earn small profits while doing so. 4. Tell me about the Blue Chip Growth Fund. Has it been successful? How big a factor is the fund, or all ofthe equity mutual funds, in the stock market today? Most students will immediately talk about the performance of the Blue Chip Growth Fund. Case Exhibits 1 and 2 are extracted from a Morningstar report that is packed with information, such as the size of the fund, itsnet asset value, and Morningstar ratings and return performance over different time periods.Here the discussion turns to the significant role that large institutional investors play in the equity markets. The bulk of trading takes place among institutions—individuals are not significant in setting equity prices.

5. What does it mean to beat the market? How do you define excellent performance? In this stage of the discussion, the instructor should introduce the notion of the investors’ opportunity cost—the ability to invest in an index fund that aims to match the performance of a broad equity market index. For students new to finance this is an important opportunity to ingrain the importance of using a risk-adjusted benchmark for performance. Against this benchmark, students should be nudged to consider the risk-return characteristics of an actively managed fund like the Blue Chip Growth Fund. 6. What is T. Rowe Price, Inc.? What is its relationship to the Blue Chip Growth Fund? What are T. Rowe Price’s core competencies? This segment of the discussion considers the economic justification of mutual funds in a world of efficient markets. The possible justifications include the scale efficiencies of research (i.e., the effort to identify pricing inefficiencies), goalsetting, monitoring of managers and low-cost diversification efficiency for investors. Per the scale-efficiency story, this is where a fund family like T. Rowe Price could gain scale economies in the collection and interpretation of data. This is also the time in the class when the lowfees associated with passive investing, such as index funds and exchange-traded funds (ETFs), should be offered by students as the reason to avoid actively managed funds, even those as successful as the Blue Chip Growth Fund. 7. Would you invest in the Blue Chip GrowthFund in 2016, given the information in the case? Many students are attracted by the stock-picking skill (or hot hand) of the fund’s Puglia. Other students will be impressed by the coin-flipping exercise and will opt toinvest in low-cost index funds or ETFs. The instructor may choose to close the discussion with a vote on the investment recommendation and then distribute Exhibit TN1 to see if the annual performance data for the Blue Chip Growth Fundchanges any votes. The annual-return data in Exhibit TN1 reveals that Puglia has beaten the S&P5006for only 13 years of the fund’s 23-year history. Moreover, the Blue Chip Growth Fund is clearly highly correlated with the S&P 500 and has lost money whenever the S&P 500 has lost money. The difference has been that the Blue Chip Growth Fundhas outperformed the market handily in more than a few years and has never underperformed by a large margin (i.e., a few excellent years are driving the overall average of beating the market). This may concern some students, but others may argue that this performance record is exactly what one should expect of an excellent manager—mostly similar to the broad market and having occasional high-performance years. The instructor can use the last five minutes of the class to lead a discussion of the performance of Puglia and the Blue Chip GrowthFund since the publication date of the case. The instructor could use the update as a springboard for closing comments on capital-market efficiency. Websites for T. Rowe Price and Morningstar are highly recommended as sources of updated 6 The S&P 500 is a market-capitalization-weighted index of shares of the 500 largest companies traded on both the New York and American Stock Exchanges.

information; http://www.troweprice.comandhttp://www.morningstar.com/funds.html.

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Case Analysis

This note assumes that the instructor is familiar with the efficientmarket hypothesis and the academic research surrounding it. The discussion that follows will focus on other teaching opportunities in the case discussion. Large institutional investors and the structure of U.S. capital markets

An important objective of the case is to introduce the Discussion novice to the structure of the U.S. capital markets. Later, this questions 2, foundation is useful for students when they encounter 3 &4 concepts founded on capital-market efficiency, investor rationality, and perfect competition. The case conveys the role played by institutional investors who take advantage of arbitrage opportunities by moving massive volumes of money away from overpriced securities and toward underpriced securities in the markets. This trading serves to push down the high-priced securities and pull up the low-priced securities, which keeps the markets more efficiently priced. Simple demographics are an important descriptive element. The capital marketscan be segmented into the stock, bond, and money markets. Within the stock market, there are major segments by type of player: pension funds, mutual funds, hedge funds, and individuals. The mutual-fund segment, in turn, can be broken down by investment objective: growth, income, large cap, small cap, and so forth. The magnitude of the market (in terms of dollars and people) and the heterogeneity of investors underscore the difficulty of achieving superior performance consistently. The case highlights several important trends in the capital markets: 

A 12.3% compound average growth rate in dollars under management by all mutual funds between 1990 and 2015 ($1 trillion in 1990 to $18.1 trillion in 2015)

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A 7.5% compound average growth rate in the number of mutual funds from 1970 to 2015 (361 funds in 1970 to 9,520 funds in 2015)

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By 2015, 31% of the outstanding stock in all U.S. companies was owned by mutual funds

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Domination of trading by lead steers, which is reflected in the trading characteristics of those institutional investors, such as higher trading volumes, bigger size of trades, and block trading.

Increasing liquidity in the market, increasing investor demand for mutual funds, segmentation of the market by mutual funds, switching among funds by investors, increasing volatility, and increasing attempts to time the swings in the market—many of these factorsare believed to be indicators of “hot money” in the stock market. In addition to demographics, another important descriptive element is recent capital-market history, especially the stock-market bubble of the late 1990s and early years of the 2000s, the market crash of 1987, and the credit crisis of 2008,

Discussion question 5 whichresulted in the market (S&P 500) falling by over 50% before beginning a long, slow recovery. Here the novice confronts the dynamic nature of the market and the essential challenge to investors posed by changing conditions. Those conditions can motivate discussion on the use of market timing and technical analysis as investment strategies and onthe relative significance of the basic buy-and-hold strategy. A third descriptive element concerns the structure of the mutual-fundmanagement industry itself. One could characterize money management as a cottage industry—thousands of small firms and relatively easy entry—but such a view is misleading. It ignores the huge barriers that block entry into the group of large mutual-fund managers, including: 

Reputation (past success)

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Investment expertise

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Economies of scale in administration, trading, and research

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Some skill in market segmentation of investors.

Despite those barriers, sustaining a comparative advantage in the competition for the management of investors’ funds remains difficult. Key success factors are high-quality research and trading talent. Puglia’s strategy and performance: the measurement issue

The case relates the elements of Puglia’s management approach for bluechip growth stocks: 

Blue-chip growth stocks were defined by their earnings per share (EPS): “We decided that it was durable, sustainable earnings-per-share growth that confers blue-chip status on a company.”

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Select stockswith the intent to hold over the long term to allow the strength of the fundamentals to reward investors with price appreciation. By taking the long view, the fund could avoid high turnover (i.e., frequent selling and buying that generates higher operating fees).

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Screen stocks for the basics of EPS growth and self-sustaining growth rate, but then look for any investment ideas available in news reports, economic data, and rival portfolios. These data could be used in Michael Porter’s framework7 to identify firms that have competitive and sustainable advantages in their industries.

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Choose stocks of companies with a growing market share and market size. A leading market position conferred both cost advantages and pricing advantages and often gave a company more pricing flexibility.

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Find companies that have a seasoned managementwith a demonstrated track record. These characteristics were evidence of management’s ability to allocate capital to the highest-return businesses, pare away lowreturning businesses, and manage expenses aggressively.

7 Michael E. Porter. “The Five Competitive Forces that Shape Strategy,”Harvard Business Review 86, no. 1 (2008): 86–104.

With this strategy, case Exhibit 1 shows that Puglia had successfully outperformed the market (the S&P 500)such that investing $10,000 over the 10year period (June 2006 through June 2016) would have created 16% more wealth than the average investor would have gained: $24,101 for the Blue Chip Growth Fund versus $20,644 for the S&P 500. 8Other statistics from case Exhibits 1, 2and 3 are equally impressive. The Blue Chip GrowthFund beat the S&P 500 and large-growth indices on average for the past 3, 5, 10, and 15 years. It was because of Puglia’s consistent longer-term performance that Morningstar awarded the fund its top five-star rating, which was only awarded to the top 10% of funds in a fund’s category (large growth for the Blue Chip Growth Fund).Since its inception, the fund had better average annual returns than most of the other equity funds in the T. Rowe Price fund family. Growth of the fund’s net assets over the 1994–2015 period was a compound rate of 38.4% (versus 7.1% for the S&P 500, and an inflation rate of about 2.3%). Yet Puglia was able to achieve such stellar and consistent returns with relatively little trading: The Blue Chip Growth Fund’s turnover rate had not surpassed 35% since 2011 and had been as low as 24% in 1997.9 Some information provided in case Exhibit 1 invites caution, however. First, true to Puglia’s strategy of choosing growth stocks, the Blue Chip Growth Fund’s portfolio in March 2016 included the stocks of a number of Internet firms, such as Amazon, Alphabet (Google), Facebook, Priceline, andMicrosoft. The “top sectors” section of the exhibit shows that the Blue Chip Growth Fundwas overweighted in the technology sector and underweighted in the consumer and healthcare sectors. Students should recognize that Puglia’s success was based on the ability to choose both individual firms as well as sectors within the economy that would experience higher-than-average performance. This comes with risk, and most would agree that tech-sector and Internet companies were among the most volatile, perhaps indicating that the Blue Chip GrowthFund was achieving its high returns...