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John Rogers' Ariel Fund Q3 Commentary
Posted by: Holly LaFon (IP Logged)
Date: October 25, 2012 04:49PM
At Ariel, we are not thrilled the catchphrase "riskon/ risk-off" has become a part of the vernacular— although clearly there is nothing we can do about the term or the phenomenon. First of all, risk is a far more complicated concept than any of its proxies, such as beta, standard deviation, and so forth, suggest. Moreover, we simply disagree that joining a stampede from one asset class into another can be fairly characterized as a shift to lower financial risk. Secondly, although most market participants would accept that risk and return are tightly intertwined, few would be fully comfortable with the terminology "return-on/return-off." And yet the many investors who have lightened up on equities over the past year have missed some very handsome returns. From October 1, 2011 through September 30, 2012, the domestic large-cap S&P 500 Index gained +30.20%, the domestic small-cap Russell 2000 Index gained +31.91% and the international stock MSCI EAFE Index gained +14.33%. Meanwhile people have been fleeing to bonds and cash, whose returns have been a meager +5.16% and zero, respectively. If people were selling stocks after a big run in order to stick to an asset allocation policy, that would be okay, but such a practice is clearly different from "riskon/ risk-off." In the third quarter of 2012, Ariel Fund returned +6.66%, topping both the Russell 2500 Value Index and the Russell 2000 Value Index, which gained +5.85% and +5.67%, respectively.
With the positive quarter, we had some holdings that fared exceptionally well in the last three months. Diversified media company Gannett Co., Inc. (GCI) rose +22.05% as political advertising mounted. As we have noted many times before, the market has a very short-term focus—which has been on full display with this company in 2012. Anyone who has been paying any attention over the last few elections knows that political advertising continues to expand dramatically with virtually every new cycle. Our internal analysis has had this reality front and center for well over a year, and yet when word broke in early September that political advertising had prompted a dramatic upwards push in advertising demand, the market acted as if it were a surprise. In our opinion, Gannett is a leaner, financially stronger company than it was a few years ago. Thus, the high returns it generates from the election season are likely to be put to work in ways that will boost profitability going forward. In addition, title insurer First American Financial Corp. (FAF) gained +28.24% due to a solid earnings report. Wall Street had expected the company to earn $0.43 per share, but First American delivered $0.68 on very strong revenue growth driven by heavy refinancing activity. In our opinion, the analyst community continues to underappreciate the company's considerable operating leverage. Pretax margins were 11.7% for the quarter, well ahead of the company's full-year goal of 8%-10%. Despite the stock's considerable gains this year, it continues to be a remarkable bargain in our opinion; it still trades below its book value. As the market comes around to the now widespread view that housing-related companies are connected to a strong segment of the economy rather than a weak one, we think the valuation penalty they have lately suffered is reasonably likely to disappear or even turn into a benefit.
Some of our positions struggled to keep pace with the market during the quarter. Gaming manufacturer International Game Technology (IGT) fell –16.50% after an earnings miss. The company delivered $0.23 in earnings per share from $533 million in total revenue; the Street had been expecting $0.28 in EPS and 6% higher revenues. The company sees these results as a seasonal bump in the road. When it released the earnings report, it reiterated its full year guidance of $0.98 to $1.04 in earnings per share. Over the short term, the company's revenues, and therefore its earnings, are likely to bounce around a bit, especially in an uncertain economic environment in which casinos are unsure how to maneuver. Long-term, however, we continue to believe gaming is a secular growth area and see IGT as a leader in its niche. In the meantime, we applaud management's decision to take advantage of the company's bargain stock price via share repurchases. After announcing a new buyback program in mid-June, the company repurchased 23 million shares—more than 7% of shares outstanding—within seven weeks. Also, forprofit education company DeVry Inc. (DV) dropped –26.51% after materially lowering quarterly earnings guidance in late July. Specifically, the company guided revenue below Wall Street's expectations and forecast earnings per share to the $0.43 to $0.46 range—far below the consensus $0.78 that was in place at the time. Two weeks later the company reported earnings in line with the new forecast. During its official report, the company announced a new plan to improve performance quickly. The three-pronged plan included right-sizing its cost structure, re-establishing enrollment growth and investing toward future growth. To be candid, we were surprised by how abruptly the business downshifted but believe the gameplan to turn things around is a good one. We are patient, long-term investors who understand there will be bumps in the road in this controversial industry but similarly recognize its demographic and structural strengths. During the quarter, we purchased Life Technologies Corp. (LIFE), which focuses on improving the human condition, in Ariel Fund. Its systems, consumables and services enable researchers to accelerate scientific exploration, driving to discoveries and developments that better the quality of life. Conversely, we exited our position in Stanley Black & Decker, Inc. (SWK) in order to pursue more compelling opportunities.
Of course with stocks rising so much in one year, some wonder how much further they can climb. There is no easy answer to that question, but we can consider the risks of the major asset classes. From one perspective, cash has essentially zero risk: it does not have negative nominal returns, even in a crisis. Yet cash rarely outpaces inflation, and so when its return is zero (as it is now) it will lose purchasing power if there is any inflation. Also, there is clear opportunity risk—any asset with a positive real return is now a better investment than cash. Most people think of bonds as low-risk, but bonds of many maturities have all-time low yields. If interest rates simply remain stable, they will deliver poor returns. They are unlikely to fall to even lower records and thereby push up their prices—plus there is not much further to go anyway (for instance, the 10-year Treasury yields just 1.6%). In the most likely scenario, they will begin climbing toward their more lofty long-term average yields, causing their prices to fall—in some cases, sharply. Finally, there are international and domestic stocks. Many worry about the global macroeconomic picture, but those worries are well understood and almost certainly priced in. Growth has been tepid lately, so although that makes some nervous it means growth may well revert to its much higher average. Finally, both international stocks and U.S. stocks are neither screamingly cheap nor frighteningly pricey—but within their normal valuation ranges. All told, we think equities represent a straightforward, balanced risk/reward proposition in a world where the risks of the other major asset classes are relatively high. This commentary candidly discusses a number of individual companies. These opinions are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
Bonds are fixed income securities in that at the time of the purchase of a bond, the amount of income and the timing of the payments are known. Risks of bonds include credit risk and interest rate risk, both of which may affect a bond's investment value by resulting in lower bond prices or an eventual decrease in income.
As of 09/30/12, Gannett Co., Inc. comprised 4.7% of Ariel Fund; First American Financial Corp. 3.9%; International Game Technology 4.0%; DeVry Inc. 4.0%; Life Technologies Corp. 2.1% and Stanley Black & Decker, Inc. 0.0%. Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of Ariel Fund.
One of Ariel Fund's benchmarks has been changed from the Russell 2500 Index to the Russell 2000 Value Index as the Adviser believes the new index is more indicative of the market capitalization and style profile of the fund. The Russell 2500™ Value Index measures the performance of the small to midcap value segment of the U.S. equity universe. It includes those Russell 2500 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000® Value Index measures the performance of the small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.
Investors should consider carefully the investment objectives, risks, and charges and expenses before investing. For a current prospectus or summary prospectus which contains this and other information about the funds offered by Ariel Investment Trust, call us at 800- 292-7435 or visit our web site, arielinvestments.com. Please read the prospectus or summary prospectus carefully before investing. Distributed by Ariel Distributors, LLC, a wholly-owned subsidiary of Ariel Investments, LLC.
Investing in small and mid-cap stocks is more risky and more volatile than investing in large cap stocks. Ariel Fund often invests a significant portion of its assets in companies within the financial services and consumer discretionary sectors and its performance may suffer if these sectors underperform the overall stock market. Performance data quoted represents past performance. Past performance does not guarantee future results. All performance assumes the reinvestment of dividends and capital gains. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the period ended September 30, 2012, the average annual total returns of Ariel Fund (Investor Class) for the one-, five- and ten-year periods were +35.48%, +0.36% and +6.61%, respectively. Ariel Fund's Investor Class shares had an annual expense ratio of 1.04% for the year ended September 30, 2011. Performance data current to the most recent month-end for Ariel Fund may be obtained by visiting our web site, arielinvestments.com.
Guru Discussed: John Rogers: Current Portfolio, Stock Picks
Stocks Discussed: GCI, FAF, IGT, LIFE, SWK, DV,