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“...even during a period when a stock is compounding between six- and eightfold, its price could drop significantly along the way. So you have to be patient...”

While discovering such potential overachievers may be rare, sticking with them through rough patches can be even more challenging. To reap the outsized rewards these stocks eventually provided, investors had to endure an average decline of 27.1% at some point during that decade.

“It shows you that even during a period when a stock is compounding between six- and eightfold, its price could drop significantly along the way,”

Mr. Ellenbogen says. “So you have to be patient and know that you are going to go through a rocky period where the company may be in transi-tion in which it has to reload for the next phase of growth.”

The study also demonstrates that such success is not concentrated in such

Imagine if you had invested in Apple in the ’80s or Google a decade ago. Many investors dream of getting in early on the next big thing, an innovative company that changes the world and enriches them.

But a T. Rowe Price study shows that finding these companies is extremely difficult and holding them through rough markets can be even harder. They

industries as social media and technol-ogy but are engaged in such mundane undertakings as bread making.

To identify companies that achieved a 20% or more annualized return over 10 years—a sixfold total gain—the study examined all companies in the Russell 3000 Index with $1 billion to $3 billion in market capitalization over rolling 10-year periods, from 1996 through 2013.

In the 11 different 10-year periods, an average of only 18 companies achieved such stellar performance per period. When not double counting companies that hit the mark in more than one 10-year span, the average dropped to 10.

Overall, there were just 116 unique companies that achieved this distinction over the entire 17 years.

“The ability to grow revenue at a double-digit pace is really, really hard to do over an extended period of time, and to be able to compound wealth at 20% or more is very rare,” says Henry Ellenbogen, manager of the small-cap New Horizons Fund.

Accomplishing this feat was even more difficult when overall market performance was subdued.

In the study’s worst-performing 10 years, ended December 2008, small-cap stocks (as measured by the Russell 2000 Index) had an average annual return of only 3%. Yet 11 companies averaged 20% or better annually in that period. (See chart next page.)

high-growth sectors as information technology and biotechnology. In fact, the leading sectors for outstanding performance included consumer staples, energy, and industrials.

Flowers Foods, for example, makes bread, snack cakes, and other household staples but was one of the few companies to star in multiple 10-year periods. “Here’s a company whose end market—bread—has had modest growth at best,” Mr. Ellenbogen says. “But it’s a company with good systems and people, runs itself very efficiently, allocates capital well, makes smart acquisitions, and has organically gained market share.”

Success KeysNot surprisingly, the companies that achieved exceptional performance over 10-year periods exhibited superior financial characteristics. On average, these leaders had median annual sales growth of 19.5%, median annual earnings growth of 17.1%, and average annual return on invested capital of 18.4%—all significantly higher than the average firm in the study.

“You can see a huge revaluation of a company over a period of years when the margins and return on invested capital are improving,” says David Wagner, another small-cap manager.

Superior financial results, of course, suggest strong management teams, another crucial ingredient. “A mediocre management can ruin a nice turnaround,” says Preston Athey, the veteran manager of the Small-Cap Value Fund. “Conversely, a great management team can take a very

New Study

Discovering Long-Term Winners Among Small-Cap Stocks

BrieflyA new T. Rowe Price study found from 1996 through 2013:

more annualized return over a 10-year period were rare.

been difficult because on average each experienced steep declines at some point in that 10-year period.

-larly concentrated in high-growth

relatively mundane enterprises.

investors, also seek such rare small-cap winners, but from a different starting place.

troweprice.com 9

mediocre company and at least make it above average.”

“Early-stage innovative companies” account for about a third of the New Horizons Fund’s holdings. Mr. Ellen-bogen has found that for a company

need to move from its “first act” to a “second act” in which it goes beyond its initial business model.

“Sometimes companies have to go through transitions, and we ask our-selves whether it is prepared for this,” he says. “Are the people and process systems able to scale and adapt to change, is there a strong management team that realizes it has to handle

this transition, can they continue to operate their core businesses well while consistently laying the seeds for future growth, are they being intel-lectually honest about their challenges and properly measuring whether or not they are succeeding?”

Twitter is one example, he says. The New Horizons Fund invested in the real-time social media company in 2009. Although it was still a private company with a market value of less than $1 billion at the time, Mr. Ellenbogen says its Act I was well underway, showing rapid user growth.

“As the company’s leadership matured,” he says, “it invested in the

systems needed to increase its scale, adapting to the secular trend toward mobile technology and enabling the company to build a platform that it could monetize.”

Value, TooExceptional performance does not just come from high-growth companies. Value investors seek the same outcomes but from a different starting place.

“We’re trying to find companies that may offer the same kind of compelling growth prospects but they’re not necessarily fully valued and are actually cheap,” Mr. Wagner

Defying the Odds: Companies That Gained at Least 20% Annually During a Poor Decade for Small-Cap StocksDecember 31, 1998, Through December 31, 2008

To identify companies that achieved 20% or more annualized returns over a decade, the study examined all companies

in the Russell 3000 Index with $1 billion to $3 billion in market capitalization over rolling 10-year periods, from 1996

through 2013. That period’s worst-performing decade ended December 2008, with small-cap stocks (as measured by

the Russell 2000 Index) earning an average annual return of only 3%. In that period, only 11 companies averaged 20%

or better annually.

Company Industry Average Annual Return

Median AnnualSales Growth

Median AnnualEarnings Growth

Average Annual Return on

Invested Capital

Largest 12-Month Price Decline

Gilead Sciences Biotech 34.9% 50.9% 6.4% -5.3% -5.3%

Caremark Health 30.1 26.7 11.4 68.9 -21.1

C.H. Robinson Worldwide Transport 25.1 12.7 20.1 27.2 -10.6

EOG Resources Energy 23.2 10.0 27.1 18.3 -28.1

Varian Medical Systems Health 22.6 12.9 14.5 22.3 -24.2

Apache Energy 21.9 24.9 26.3 14.2 -27.1

Expeditors International Transport 20.8 17.5 20.1 23.2 -35.1

Express Scripts Health 20.7 22.5 25.6 17.5 -51.4

Mandalay Resort Group Gaming 20.5 11.2 7.6 2.5 -36.7

Harrah’s Entertainment Gaming 20.3 13.7 10.4 6.8 -22.1

Phelps Dodge Mining 20.2 11.3 18.8 1.6 -40.1

Annual Average for Group 23.7% 19.5% 17.1% 18.4% -27.1%

Annual Average, All Other

Companies

-1.7% 13.0% 10.0% -3.0% -49.5%

Note: The total cohort for this decade consisted of 604 companies in the Russell 3000 Index (excluding the 20% plus gainers) that

had a stock market capitalization of $1 billion to $3 billion at the start of the decade. As of June 30, 2014, none of the stocks in this

table were owned by the New Horizons Fund, the Small-Cap Stock Fund, or the Small-Cap Value Fund.

Source: T. Rowe Price.

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says. “These are companies that for whatever reason may have fallen on hard times and their returns may actually be decreasing, but with the strategic moves that could actually make them look like a growth stock down the road.”

Mr. Athey adds that value investors sometimes can “just catch lightning in a bottle. The company may be near bankruptcy or is a really deep value situation. But it turns out that the company or industry is not dead and over a period of time you can make an extraordinary return.”

Cliffs Natural Resources, for example, is an iron ore producer that Mr. Athey acquired in 2000. (It was known then as Cleveland-Cliffs.)

“At the time, the world was sup-posedly never going to build another steel mill, never need another ton of iron ore, and so the stock was trading below book value,” he says. “Then in 2007, all of a sudden the Chinese are building steel mills, the United States is still making steel, and iron ore prices are going way up. So in this case management didn’t change, but the environment changed.

“There generally are three ways

small companies might achieve outperformance,” Mr. Athey says. “The first is that it is truly a growth company and consistently puts up high-growth numbers. The second is a company that may be near bank-ruptcy or is really deep value and it comes back from the dead.

“The third is a little of both—a company that may be under the radar screen, perhaps with a checkered history, and it’s really cheap, but not because it’s a horrible company. It’s just been neglected and hasn’t performed very well, but maybe new management comes in and the company starts doing better.”

Whether a growth or value investor, Mr. Wagner says, the study’s lessons are the same: “Think long term, be patient, and recognize that even the best com-panies on the planet will have periods when things don’t look so good.

“Also, when you find something really good that’s working well for you, you should appreciate that’s a rare thing. You have to recognize that you are going to look at a lot of companies before you find one that could be a really big compounder of returns.”

Small companies tend to have less experienced management and unpredictable earnings growth on limited product lines, which can cause their stock prices to fluctuate more than larger firms. As of June 30, 2014, Flower Foods accounted for 1.28% of the New Horizons Fund; Twitter was not in the fund. Cliffs Natural Resources stock was not held by the Small-Cap Value Fund.

Small-CapsContinued from page 9

Taking the Long View: Small-Company Funds’ Turnover Rates Have Been Relatively LowAs of December 31, 2013

T. Rowe Price managers typically take a long-term perspective when investing in smaller companies, as reflected in the

number of companies held in these three small-cap funds longer than 10 years and in these funds’ relatively low turnover

rates compared with their peer group averages.

Number of Stocks Held:

Fund 1015 Years 1520 Years More Than20 Years

Longest Holding/Year Purchased

Average Annual Turnover Rate

Industry Average 19942013

Small-Cap Value 49 22 22 Culp (1988) 12% 80%

Small-Cap Stock 32 6 7 Glacier Bancorp (1992)* 26 106

New Horizons 13 4 N/A Henry Schein (1995) 36 106

*Four other stocks—Woodward, Coal Creek, Heartland Express, and Makepeace—were also initially acquired by the fund that year.

Note: As of June 30, 2014, Henry Schein accounted for 0.69% of the New Horizons Fund; Culp made up 0.15% of the Small-Cap

Value Fund; and Glacier Bancorp, Makepeace, Coal Creek, Heartland Express, and Woodward comprised 0.69% of Small-Cap Stock

Fund assets.

Sources: T. Rowe Price and Morningstar, Inc.

Whether a growth or value investor...the study’s lessons are the same: “Think long term, be patient, and recognize that even the best companies on the planet will have periods when things don’t look so good.”