Who was T. Rowe Price?
Thomas Rowe Price Jr. (1898-1983) is often called the father of growth investing. In 1937 he founded T. Rowe Price Associates, the Baltimore advisory firm that still carries his name, and over the following decades he launched a series of funds built on a single conviction — the Growth Stock Fund, the small-company New Horizons Fund in 1960, and the natural-resources New Era Fund. He had worked out the core of his thinking in the 1930s, set it down in a run of Barron's articles in 1939, and refined it in pamphlets for his clients. Where most investors of his era traded in and out of stocks on the business cycle, Price argued they should behave like the owners of a private business and simply hold a good one while its earnings compounded. "Change is the investor's only certainty," he wrote that same year, and repeated for the rest of his life. The T. Rowe Price Screen is AAII's attempt to turn that philosophy into fixed rules.
The core idea
Price viewed companies through a "life cycle" — growth, maturity, then decline — and wanted to own them in the first phase, when earnings power expands fastest and the risk of overpaying is lowest. The best moment to buy, he said, was while a company was still small, before its shares "gained in stature" and commanded a high multiple. He hunted for businesses in fertile fields for growth: new industries, older industries reinvigorated by new products, and specialty firms with expanding markets. His test of a genuine growth stock was strict — earnings had to reach a new high at the peak of each successive business cycle, and grow faster than inflation — because he wanted to separate real secular growth from a cyclical company merely riding a recovery. But he would not pay any price for it. Price judged a stock's price-earnings ratio against its own history and preferred to buy before institutions glamorized the name and bid the multiple up.
What the T. Rowe Price Screen looks for
- Three-year earnings-per-share growth in the top 25% of the database (percentile rank of 75 or higher).
- Five-year and seven-year earnings-per-share growth each in the top half of the database (percentile rank of 50 or higher).
- A current price-earnings ratio below the company's own five-year average P/E — which also requires five years of positive earnings to compute.
- A five-year average P/E under 40, and a P/E under 40 in each of the last five years individually, to strip out distorted years.
- Insiders owning at least 20% of the shares outstanding.
- A dividend payout ratio under 100% over the trailing 12 months, and positive cash flow over the same period.
- Return on assets above the industry median.
- A net profit margin above the industry median, at least as high as the last fiscal year's, and above the level of five years ago.
- An operating margin above the industry median, at least as high as the last fiscal year's, and above the five-year average.
- Over-the-counter (OTC) stocks excluded.
Why the T. Rowe Price Screen can work
The engine is compounding held over time. Buy a company with durable, above-average earnings growth early enough — before the crowd re-rates it — and the return comes from both the rising earnings and the eventual expansion of the multiple, without the drag of having overpaid at the outset. The quality filters are what separate this from chasing any fast grower. Requiring return on assets and profit margins above the industry median, and rising over five years, is a search for the durable advantage Price prized; he wanted high and expanding returns on capital as evidence that management was compounding value rather than just growing revenue. (Stock Investor substitutes return on assets for Price's preferred return on invested capital, and operating and net margins for his broader margin tests — the usual compromises of turning a qualitative philosophy into hard numbers.) The insistence on a P/E below its own five-year norm is the discipline that kept Price out of trouble in the early 1970s, when he warned that growth-stock valuations had run too far and correctly anticipated a severe downturn.
What to keep in mind
This is a genuinely strict growth screen, and strict growth screens can return nothing. As of the latest data the filter passes zero stocks — which is itself information: after a long expansion, with the market richly priced, very few companies combine above-average multi-year growth with a below-average multiple and improving margins. That is the screen working as designed, not a fault. Several rules are also blunter than they look. The 20% insider-ownership test leans on the SEC's definition of a beneficial owner, which counts any holder above 5% — so an outside fund can register as an "insider," and the passing names deserve a look at the actual proxy statement. And because OTC stocks are excluded and the growth thresholds are measured relative to the database, the results shift with the market's mood as much as with any single company's merit.
Sources
T. Rowe Price's growth-stock philosophy, drawn from his series of articles for Barron's (1939) and the client pamphlets of T. Rowe Price Associates.
American Association of Individual Investors (AAII) — Stock Investor Pro screen definition.