T. Rowe Price: Bull market winner

NEW YORK (Money) -- Fund manager T. Rowe Price reported stellar earnings on Friday. For the fourth quarter, fully diluted earnings per share were up 23 percent on a 21 percent rise in revenues.

Results for the full year were equally impressive. Earnings were up 20 percent on a 20 percent increase in revenues.

The chief reason for these strong gains was the stock market rally in the second half of 2006.

The shares of mutual fund companies typically track the stock market, and gains are often even greater than those of the broad indexes. Some analysts have recently become more optimistic about the outlook for T. Rowe Price (Charts) this year and have raised their ratings.

T. Rowe's earnings are projected to rise 20 percent this year and 15 percent next year. Average growth during the next five years is expected to be at least 12 percent annually.

T. Rowe's stock, which historically has carried a premium valuation of 10 percent over the S&P 500, currently trades at 21 times this year's estimated earnings. That's not cheap, but it's merited if the company hits its profit targets.

A healthy stock market will certainly help on that score, and I'm optimistic about the near-term outlook. The economy is likely to slow a bit in the first half of the year. But real gross domestic product is still estimated to be up 2.3 percent for the year, only slightly below the long-term average.

Moreover, any mild slowdown would allow inflation pressures to abate and lay the groundwork for an eventual decline in interest rates. That would increase the chances that the bull market revives and lasts longer.

No one can really predict short-term market moves, and it's possible that the economy could surprise everyone with a more serious slowdown.

In my view, however, the most important argument for T. Rowe Price is the long-term one.

As you can see from T. Rowe's most recent financial results, fund companies can raise profit margins only so much - to get more earnings, they need more in revenue. And revenue growth depends directly on how much money the company manages in its mutual funds.

Asset undermanagement can grow two ways. If the stock market goes up, the value of the assets in the funds goes up. The fund company can also gain more assets if shareholders invest new cash.

Growth in assets at T. Rowe Price was $15.7 billion in the fourth quarter. Four-fifths of that came from market appreciation and one-fifth from new contributions.

If you simply project that model out over the next 20 years, the case for T. Rowe Price looks quite good.

Most of the stock market is fairly valued right now and some groups, such as big growth stocks, are still undervalued. So assume that share prices increase at least in line with historical averages. Over the past 30 years, the Dow rose at nearly a 9 percent compound annual rate.

With a slight improvement in profit margins, T. Rowe Price might be able to grow earnings at around 10 percent a year, based solely on general stock market growth.

The kicker is the extent of new cash inflows. If a lot of investors decide to put money into T. Rowe Price funds, the company's earnings could increase a lot faster than the overall market. And that means its share price would outpace the overall market, too.

My guess is that's very likely to happen. The oldest Baby Boomer hits age 62 in 2008. That means there are 78 million Boomers facing a rapidly approaching retirement. And most of them haven't saved enough.

The result is likely to be a savings scramble over the next 20 years, as Boomers in peak earnings years save as much in mutual funds as they can.

In addition, while 44 million American workers still have defined-benefit pension plans, corporations are trying to replace such plans with tax-deferred savings plans, such as 401(k)s that mostly direct workers' savings to mutual funds. T. Rowe Price, which ranks among the top half-dozen fund companies, should be a prime beneficiary.

I think T. Rowe should do well this year, though it would certainly suffer if there is a surprise dip in stock prices. But if you're managing a long-term portfolio, what really matters is how a stock is set for the next 20 years. And by that standard, T. Rowe is positioned for long-term success.

Other financial stocks in the Sivy 70: American Express (Charts), Bank of America (Charts), J.P. Morgan Chase (Charts), Merrill Lynch (Charts)

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