T. Rowe Price Small-Cap Value Fund Makes Money from Cheap Stocks

Editor's note: This story has been updated since its original publication.

"Undiscovered, unloved and cheap" could be Preston Athey's stock-picking mantra. Whatever you call it, his contrarian, bargain-hunting approach works. Since Athey took over the reins of T. Rowe Price Small-Cap Value (symbol PRSVX) in 1991, the fund has returned an annualized 12.1%, beating the Russell 2000 Value index by an average of 1.3 percentage points per year (all returns are through August 8).

Athey, a 34-year Price veteran, focuses on companies with market values of $150 million to $2.6 billion. He's disciplined about buying them only when they sell at bargain prices, but he's not strict in defining what constitutes a value. "We can be eclectic," he says. Although Athey will consider price to book value (assets minus liabilities), price to earnings and price to cash flow, he may also value a stock on absolute measures: its ten-year trading range, for instance, or how it compares relative to others in its industry. "The key is to find the measure or measures that best define the company in its industry," Athey says. For a gold-mining company, book value and earnings are meaningless; more important is the company's asset value. A service company, on the other hand, might be measured by its cash flow.

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When he finds a good stock, he holds on. He has owned Markel Corp., a specialty insurance firm, for 20 years, and Kirby Corp., a tank barge operator, for ten.

That may be the secret to this fund's impressive long-term record. The fund's turnover ratio is 5.5%, well below the average 79.9% for all small-company funds. A 5.5% turnover rate implies that Athey holds a stock for 18 years, on average.

Small-Cap Value's top holding, South Dakota conglomerate Raven Industries (RAVN), has been in the portfolio for 20 years. Athey first picked up shares at $3.70 in 1992; they closed at $33.03 on August 8. It's not the roughly 1,000% total return that Berkshire Hathaway generated over the same period, "but it's pretty good," he says. Raven's market capitalization now tops $1 billion, but Athey has no plans to sell: "If a company is growing and working and I believe it's still being discovered, why should I sell if I believe the performance will be better than average?"

With only one Wall Street analyst following Raven, it's fair to say that the company still hasn't been discovered, says Athey. Plus, he doesn't want to incur the capital-gains tax bill that comes with selling his winners. "And I don't have a lot of risk. I know the company and know the management. They've proven themselves."

Of course, if one of the 50-odd analysts who work with him presented this stock as a new idea today, says Athey, "I'd say, 'What are you smoking?' " because it's no longer the kind of super bargain it was when he first bought it.

This kind of situation happens to Athey a lot. In November 2009, when he picked up shares in PriceSmart at an average price of $21, it was largely ignored. The "Costco of Central America and the Caribbean," as Athey describes it, was selling for about 2 times book value (assets minus liabilities), and just one Wall Street analyst followed it. PriceSmart owns the international bits of PriceClub that Costco didn't want when it bought the rival warehouse-store operator in 1993. But Athey saw in PriceSmart (PSMT) a growing company trading at a reasonable price. The stock closed at $71.41 on August 8. "Today, I can't make a value case for PriceSmart; it's clearly a growth stock," he says. "But when I bought, it was undiscovered, misunderstood, not followed and relatively cheap."

Of course, at some point, "you have to declare a victory" and sell, says Athey. One reason for trimming a stock is a market value that shoots past $4 billion. Exceeding $5 billion is typically cause for complete ejection. That's the best way to avoid the style creep that causes successful small-company funds to turn into midcap funds, says Athey, who announced in mid-August that he plans to step down as manager of this fund in June 2014. Dave Wagner, currently an associate manager at T. Rowe Price Small-Cap Stock, will take over Small-Cap Value.

With just over $7 billion in assets, Small-Cap Value is hefty. Less is more when it comes to funds that invest in small companies -- it allows them to move in and out of stocks without affecting the stock price… much. In addition to practicing his buy-and-hold philosophy, Athey manages the large asset base of the fund by investing in more than 300 companies. "It's kind of a numbers game," he says. "You don't want to own more than 5% of any one company, so you do the math and it comes out to about 300 names."

In fact, Small-Cap Value has closed and reopened three times since the early 1990s. It's open now, "but we're not marketing or advertising the fund," says Athey. If a deep-pockets institution wanted to invest in the fund, "we'd say no, thank you." The fund is open to what Athey calls "long-term, modest shareholders" -- individuals, in other words. "We're happy to take that group." It's part of Price's culture. As Athey explains, "Mr. Price said, 'If you take care of the client, the client will take care of you.' "

Over the past year, Small-Cap Value returned 24.9%, edging the Russell 2000 index by 0.2 percentage point and putting it in the top third of small-blend funds. (Athey's tendency to hold onto winners is apparently what lands his fund in the small-blend category, which features funds that invest in stocks with a blend of value and growth attributes.)

Bottom line: Small-Cap Value is a steady performer that beats its benchmark over the long haul. During bad times, it holds up fairly well, too: In 2011, it lost 0.6%, well ahead of its bogey's 5.5% decline. Athey says you probably won't find his fund at the top of the charts for any given time period. But it won't be at the bottom, either.

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