Dear Fellow Shareholder: For the quarter ended June 30, 2011, Ariel Fund gave back some recent gains, falling -2.52%. During the same period, the Russell 2500 Value Index lost -1.47%, while the broader Russell 2500 Index dropped -0.59%. Meanwhile, the broad market as measured by the S&P 500 Index was virtually flat with its +0.10% gain. While the stock market moved in fits and starts for most of the quarter—with a seven-week decline offset by a late surge—the Fund was most negatively impacted by weakness in the consumer discretionary and financial services names.
Despite these recent losses, we remain enthusiastic about the quality and composition of the underlying portfolio and view our stocks as having taken somewhat of a breather after such a stellar run. As you know, Ariel Fund has been on a tear on the heels of the financial crisis, having surged +233.87% cumulatively since the March 9, 2009 market bottom through June 30th versus +150.03% for the Russell 2500 Value Index, +153.64% for the Russell 2500 Index and +104.73% for the S&P 500 Index. While we are pleased with this rebound, as patient investors, we remain fixated on the long-term. As such, we believe the nearly 25-year, top quintile performance record of Ariel Fund speaks volumes for our style of patient investing.
For the quarter ended June 30, 2011, Ariel Appreciation Fund managed a +0.99% return which was ahead of the -0.69% decline of the Russell Midcap Value Index as well as the +0.42% gain of the Russell Midcap Index. Strong performance among our consumer discretionary and producer durables stocks as well as our sole technology name Dell Inc. (DELL, Financial) offset weakness in the financials area. We believe continued strength in the Fund is a testament to our willingness to go against the grain as aggressive buyers during the worst of the financial crisis. For the three years ending June 30th— which includes the dramatic decline and rebound—Ariel Appreciation Fund has averaged +12.35% versus +6.35% for the Russell Midcap Value Index, +6.46% for the Russell Midcap Index and +3.34% for the S&P 500 Index. Furthermore, we are especially pleased with the long-term rankings of Ariel Appreciation Fund. For the trailing three years, it ranks in the top 1%; for the five years, it ranks in the top 5%; for the past 10 years and trailing 15 years, it ranks in the top deciles within its Lipper Multi-Cap Core category.
The Limits of Lessons
There is a saying among basketball coaches: “you can’t teach height!” This oversimplification of a common trait of most successful basketball players got us thinking about key aspects of the investment management business that cannot be taught. While there is little question giants constantly hone their craft by reading and learning, in the world of money management there are some things that simply cannot be gleaned from study. The true greats—Warren Buffett, Peter Lynch and Sir John Templeton among others—possess some winning characteristics often found in short supply in the investing world. Having closely followed their careers over the years, we think without three essential and yet unteachable traits— vision, courage and determination—there is little possibility of long-term investment success.
Vision
Albert Einstein once declared: "Imagination is more important than knowledge."3 According to his biographer, Walter Isaacson, "As a young student he never did well with rote learning. And later, as a theorist, his success came not from the brute strength of his mental processing power but from his imagination and creativity." Like Einstein's quantum physics, many oversimplify investing as a pure numbers game. By contrast, we view stock picking as a creative endeavor—one in which the art trumps the science. As such, we are convinced the greatest investors possess a distinct vision. They see the world from a unique vantage point not unlike the varied creative expression that comes from painters, actors and writers. For example, in movie making you can give two great directors the same script and the end products will likely yield two very different films. Such is the case with skilled portfolio managers. They operate in the same world, can choose from the same pool of stocks, have access to the same public information, and yet the most talented have portfolios that are not reminiscent of any other you have ever seen. But alas, there is no creativity school. Yes, a school can help foster creativity or help cultivate imagination but if neither is there to begin with, nothing can be done.
Alexander Hamilton reputedly once said, “Those who stand for nothing fall for anything.” For this very reason, creative investors embrace their visions as guiding stars. They must endure the chaos, noise and volatility of Wall Street. Moreover, while many investors are often uncomfortable standing alone, the notables are resigned to the fact that their bold, contrarian viewpoints will indeed cause them to zig when others zag. And on occasion—like late-celebrated artists ahead of their times—they too can be early and their perspectives can go unrealized for some time. Apropos of these points, investing great Warren Buffett noted: “I didn’t learn it in school or anything [but] it never bothered me if people disagreed with what I thought, as long as I felt I knew the facts.”
Courage
Winston Churchill once said, “Success is not final, failure is not fatal: It is the courage to continue that counts.” There is no teaching courage, however, you either have it or you don’t. Moreover, there is no way to know if someone is courageous until it matters most. It is easy to get lulled into thinking courage is common because there are many noteworthy instances of late—from Middle East uprisings, to modern-day war heroes, to the unbelievably selfless acts demonstrated by 9/11 rescuers—but true acts of courage are actually quite rare.
The same increasingly rare moments of courage matter when it comes to investing. Case in point— while physical harm and financial loss are indeed very different, they actually trigger similar fight or flight responses. Of course, no one actually dies due to a bad day in the stock market, but the emotional response to losing money can make some feel a life or death situation is at hand. As Jason Zweig details in his book Your Money and Your Brain, "a financial loss or shortfall is a painful punishment that arouses an almost primitive fear…losing money can ignite the same fundamental fears you would feel if you encountered a charging tiger, got caught in a burning forest, or stood on the crumbling edge of a cliff."
Thus it is human nature to fear investment losses, and while even professional investors are not immune, the most talented have the ability to acknowledge and conquer their fears. Most important of all, when the investing masses opt for flight, the greats know it is time to fight. The skillful draw courage from deep knowledge and experience and in so doing they are able to overpower a primitive response with higher reason.
Determination
Many profess to be passionate, but few truly are. In fact, as with the word “love,” we believe passion is so overused in our modern lexicon that its meaning has been watered down. For this reason, we believe the truly extraordinary investor is not just passionate but determined and, again, there is no lesson plan for determination. The great investor is always seeking, always learnng and never, ever satisfied. Such investors are relentless—eating, sleeping and breathing their portfolios. And even though determined investors must accept inevitable periods of underperformance, they are always focused on improvement. Our determination manifests itself in the form of rigorous balance sheet work, an endless search for independent verifications as well as obsessive reading to learn more and get better. Against this backdrop, we question, re-affirm and even refute our own investment theses regularly. The determined investor knows “[u]ltimately, it is the struggle that keeps us alive.”
Portfolio Comings and Goings
During the quarter, we added Simpson Manufacturing Co., Inc. (SSD, Financial) and Contango Oil & Gas Co. (MCF, Financial) to Ariel Fund. We bought Simpson, a manufacturer and marketer of building products, based on its 70% market share in the U.S. connector market. We purchased natural gas producer Contango based on its lean operations and proven capital allocation skill. The company also maintains no debt and substantial cash amounts on its balance sheet, providing stability to its operations. In addition, we exited CBS Corp. (CBS) as its market capitalization reached the upper limits for Ariel Fund.
While we did not exit any positions in Ariel Appreciation Fund, we purchased shares of Newell Rubbermaid Inc. (NWL, Financial) whose Rubbermaid storage products, Sharpie pens and Graco strollers are well-known to consumers. We also initiated a position in Chesapeake Energy Corp. (CHK, Financial), which is the largest independent provider of natural gas in the United States. As always, we appreciate the opportunity to serve you and welcome any questions or comments you might have. You can also contact us directly at [email protected].
Sincerely,
John W. Rogers, Jr.
Chairman and CEO
Mellody Hobson
President
Simpson Manufacturing Co. (SSD)
Simpson Manufacturing Co. is a leading manufacturer of wood-to-wood, wood-to-concrete and wood-tomasonry connectors, fasteners and fastening systems. These products improve the structural integrity of all types of buildings especially in areas prone to natural disasters. Current Chairman Barclay Simpson took over the CEO position from his father in 1947. He shifted the company's focus from fans and vents to the connector products business in the 1950s. Under Barclay's leadership, Simpson has established a dominant position in the industry with nearly 70% market share in the U.S. Its shares are held in Ariel Fund and Ariel Discovery Fund.
Construction Activity Weakness
The residential and commercial construction market remains near trough levels of activity in North America. Annual new home build rates in the U.S. have fallen nearly 75% from peak levels in the mid- 2000s. The commercial construction business in North America has also continued to suffer over the past few years. Not surprisingly, depressed building activity has caused a temporary decline in revenue and the stock price. We believe a construction recovery is inevitable. Likewise, we are more optimistic on the timing of the recovery than most.
Trusted Brand
The Simpson Strong-Tie brand is well-recognized in the construction industry and is synonymous with highly engineered, reliable building products. Indeed, in some geographies, building standards specifically identify Simpson products as required to meet code. Connectors and fastening systems are a small part of total cost in home or office building construction, but are critical to structural integrity. Thus, architects and builders are willing to pay premium prices for the comfort of having the best connectors and fastening systems, those made by Simpson.
International Expansion
International expansion is a source of significant growth for Simpson in coming years. Simpson has already successfully diversified its revenue from less than 6% from outside the U.S. in 2000 to over 20% in 2010. As the rest of the world comes to recognize the importance of structural safety, we expect builders to look to U.S. building codes as a guideline. With 13 manufacturing and operations facilities around the world and distribution to over 40 countries, Simpson stands to benefit strongly.
Intriguing Valuation
With dark clouds hanging over the stock, Simpson remains an intriguing investment. The market values the company as if building activity will never rebound. By contrast, we believe activity levels are currently near their lows and will improve over the next few years. Even at current levels, Simpson is a profitable company with a strong balance sheet. As these levels increase, we expect significant improvements in Simpson's profitability. As of June 30, 2011, shares traded at $29.87, a 29% discount to our steadily growing private market value of $41.81.
Lazard Ltd. (LAZ, Financial)
Founded in 1848, Lazard Ltd. (LAZ) is a boutique investment bank focused on providing strategic advisory, asset management and restructuring services to corporations and governments. It is the world's largest, independent financial advisory firm whose position strengthened coming out of the economic downturn as it took market share from its major competitors. Particularly, Lazard has developed an unmatched presence globally by attracting the industry's top talent and executing strategic transactions in 27 countries. Its shares are held in Ariel Fund and Ariel Appreciation Fund.
Independence
The core of the company's success is the simplicity of its business model. Unlike its bulge-bracket and Big Four accounting competitors, Lazard operates without the conflicts created by a trading desk, commercial bank or auditing division. This product focus creates a key competitive advantage as companies seek to minimize potential conflicts of interest in soliciting strategic advice and valuation. After the downturn of 2008, the increase in bankruptcies and forced re-valuations at the request of regulators provided significant business opportunities for Lazard to demonstrate its ability to provide trusted, sound expertise. As a result, Lazard advised on Kraft's acquisition of Cadbury, Coca-Cola's acquisition of Coca Cola Enterprises North America and an impressive percentage of the large transactions reported thus far in 2011.
Best-In-Class
Lazard operates in 40 major cities throughout Europe, North America, Asia, Australia and South America. In order to leverage its unique model and global presence, the Company has expanded its investment in financial advisory, developing a deep corps of senior bankers with substantial sector relationships and experience. As a result, nearly one-third of Lazard's business is derived from Europe.
Moreover, for many years Lazard was largely understood by the market as an investment banking firm, relying primarily on advisory and restructuring revenues. However, Lazard is engaged in another one of the most profitable business operations in financial services: asset management. The company has managed to secure inflows despite a weak capital market environment through its popular emerging and international market products. Its asset management division now generates nearly half of the firm's revenues and recently hit a record-high of assets under management at $155 billion last quarter.
Slow Return of M&A Activity
Despite Lazard's solid backlog of M&A transactions, announced global M&A activity has declined from the slight rebound seen in the fourth quarter of 2010. Typically, three factors are expected to have high correlation with M&A activity growth: 1) high CEO confidence, 2) attractive financing, and 3) appealing valuations. Encouraged by over $3 trillion on corporate balance sheets, we believe the beginning of a prolonged M&A growth period is at hand. We, therefore, have continued to acquire Lazard shares at these compelling values.
As of June 30, 2011, shares traded at $37.10, a 33% discount to our private market value of $55.00.
Quality Still a Bargain
Dear Fellow Shareholder: For the quarter ended June 30, 2011, Ariel Focus Fund outperformed its benchmark and the broader market increasing +1.01% versus a decline of -0.51% for the Russell 1000 Value Index and +0.10% for the S&P 500 Index. Although the Fund and the broader market have enjoyed strong performance over the last 12 months, we believe current valuations remain attractive, particularly among larger, high-quality companies. As such, our near-term outlook remains cautiously optimistic. The Fund ended the quarter trading at just 11x forward earnings estimates, a very reasonable level, particularly given the low interest rate environment.
Our two biggest contributors were Dell Inc. (DELL), which rose +14.89% and Johnson & Johnson (JNJ), which climbed +13.25%. Dell has been a strong performer this year increasing +23.03% through the end of the second quarter. The company has benefited from the generally strong corporate spending on technology products. As it happens, this same trend has also been a boost to International Business Machines Corp. (IBM) and Accenture plc (ACN). Leading into 2011, Dell's share price reflected extremely low expectations. The stock closed out 2010 trading at around 10.5x forward earnings and less than 5x enterprise value to EBITDA. This valuation level reflected a number of the company's challenges, particularly in its core PC business.
Dell's recent efforts to broaden its scope and quality in services, as well as the consumer business, have paid off. Of particular note is that the consumer business has swung to profitability despite a fiercely competitive environment. At Ariel, we track the average sell-side rating on stocks in our portfolio to gauge market sentiment. Currently, Dell is the second-least recommended stock in the portfolio. This year it has paid to be an independent thinker on Dell.
While our investment in Dell has required us to buck conventional wisdom in the PC community, our investments in larger health care companies have required us to disregard news headlines for the last three years. At quarter end, we owned Johnson & Johnson, Baxter Intl Inc. (BAX), Zimmer Holdings, Inc. (ZMH) and our latest purchase, Abbott Laboratories (ABT). News articles from 2009 highlighted contentious health care reform and runaway corporate health care costs. Headlines this year focus on debt limits and entitlement restructuring, usually including predictions of cuts in Medicare and Medicaid and resulting pressures on health care providers. We continue to believe largecap, high-quality companies are currently the cheapest area of the U.S. equity markets. Johnson & Johnson is the poster child of a class of stocks that have been inexpensive for a while now. Many of the former large growth darlings from the technology bubble era have suffered massive multiple compression over the last decade. While they were quite overvalued at the turn of the century, in most cases these businesses have grown nicely since then.
Johnson & Johnson is the poster child of a class of stocks that have been inexpensive for a while now. Many of the former large growth darlings from the technology bubble era have suffered massive multiple compression over the last decade. While they were quite overvalued at the turn of the century, in most cases these businesses have grown nicely since then. Johnson & Johnson is trading at the same price levels as in early 2002, yet earnings have more than doubled since then. Much of the stock's collapse in valuation has been warranted as it was bid up to high levels that were unsustainable in our view. Still, just as the market overshot optimistically 10 years ago, we think the same is now happening on the downside. Johnson & Johnson's business generates excellent returns on capital, enjoys high levels of profitability and rests upon a very strong balance sheet. The last couple of years have not been kind to Johnson & Johnson as all three of its segments have faced company-specific issues, including recalls ranging from Tylenol to surgical sutures. In spite of this, however, the businesses were still able to grow, which speaks to the robust nature of the overall franchise. This is what excites us. If you buy a high-quality franchise at an attractive price, it takes enormous stress to cause permanent capital impairment. The company has been able to absorb a number of body blows, a slew of negative headlines and declining market expectations concerning future growth.
At current prices, not a lot has to go right for Johnson & Johnson to perform well for us, and we think there is tremendous downside protection considering its competitive advantages. No one seems to care about dividends anymore, but we view the attractive, growing and well-covered dividend as a sound capital allocation policy for a company that clearly generates more cash than it needs to sustain the business or can deploy at attractive rates of return. Furthermore, with a 3.4% dividend yield, the company only needs to grow at a mid-single-digit level to match the historical average for U.S. stocks. We think the EPS growth will be even higher in the short-run as a result of operating leverage and top-line growth as revenues return from the various recalls. Longer-term we remain optimistic on emerging market growth opportunities, as well as the aging demographic situation in the developed world. Conventional wisdom tells us emerging market countries will be able to afford better health care products and services and will spend a higher share of growing GDP on health care. Many large companies like Johnson & Johnson already get more than 50% of their earnings outside of the United States.
Stocks negatively affecting performance in the second quarter were concentrated in the financial services industry. Goldman Sachs Group, Inc. (GS), which fell -15.87%, and Morgan Stanley (MS), which dropped -15.61%, were our two worst performing positions. It seems the brokerage industry has replaced the health care industry as the nation's most out-of-favor area. Headline risk is at an all-time high with the industry under daily attack in the general press. Both Goldman and Morgan Stanley's stock prices have been driven down to a level that is quite remarkable. As we go to print, Goldman Sachs is trading at a price either at or even slightly below book value, while Morgan Stanley is trading at a 20% discount to book. This means anyone can purchase these two leading investment banks at the prices reserved only for the firms' partners in the past. Goldman and Morgan Stanley employees have competed for decades for the right to buy their firm's stock at book. As a reference, Goldman Sachs has traded at an average of 2.2x book since going public in 1999, while Morgan Stanley has traded at an average of 2.7x book over the same period. Neither Goldman nor Morgan Stanley have ever traded below book other than for a brief period at the height of the financial crisis. Yet today, the Fund can buy these two leading 15 arielinvestments.com 16 800.292.7435 investment banks at or below book in the public market. We are taking advantage of what we think is a rare opportunity and adding to our positions.
A quick comment on the for-profit education industry: since quarter end, our two holdings in this sector have moved up sharply in response to news that the Department of Education regulations were not nearly as onerous as had been feared. We will have more to say on these companies next quarter, but we will note that Ariel's philosophy of investing in companies we like and know well when they are suffering from negative headlines seems to be working well in this instance.
Meanwhile, our investments in the energy sector were modest detractors from performance in the quarter as both Exxon Mobil Corp. (XOM) and new holding Chesapeake Energy Corp. (CHK) declined due to a drop in both the price of oil and natural gas.
Let us close with our outlook for the market. We remain upbeat as the vast majority of our portfolio companies continue to report earnings above Street expectations. At quarter end, we calculated that the portfolio was trading at only 11x our forward earnings estimate and at a 27% discount to our calculation of intrinsic value. Since quarter end, earnings reports for our companies have exceeded our expectations giving us confidence despite the television pundits, that the possibility of a "double-dip recession" is remote. Our valuation work continues to indicate that larger, high-quality companies like IBM, Exxon and Johnson & Johnson are relatively inexpensive relative to their intrinsic value and continue to offer an excellent opportunity.
Portfolio Comings and Goings
During the second quarter, we purchased U.S. natural gas producer Chesapeake Energy Corp. Recent asset sales to a number of strategic competitors bolstered our confidence. Also, we have a positive outlook on natural gas stemming from domestic efforts to reduce dependence on foreign oil and reduce carbon emissions. We also initiated a position in "big box" discount retailer Target Corp. (TGT, Financial) because the stock price was trading well below its intrinsic value. Target is well-positioned with a reputation for low prices but with higher quality merchandise than some of its discount competitors. Lastly, we did not exit any positions during the quarter.
We appreciate your consideration and the opportunity to serve you and welcome any questions or comments you might have. You can also contact us directly at [email protected].
Sincerely,
Charles K. Bobrinskoy
Co-Portfolio Manager
Timothy Fidler
Co-Portfolio Manager
Apollo Group (APOL, Financial)
Founded in 1973, Apollo Group is one of the world's largest for-profit educators, serving nearly 400,000 students globally. The company's flagship University of Phoenix brand was created with the working adult in mind, offering associate's, bachelor's, master's and doctoral degrees through both online and campus locations. Over the past 15 years, Apollo has experienced impressive growth, a testament to both the value of a University of Phoenix degree and the growing global demand for educational attainment amongst an underserved population. Yet, regulatory uncertainty continues to distract investors from this long term trend. Shares of Apollo are held in Ariel Appreciation Fund and Ariel Focus Fund.
The Times They are a Changing
Over 35 years ago, founder Dr. John Sperling had the foresight to connect the introduction of the first personal computer with an eventual sea change in higher education. As the economy shifted from manufacturing to service-oriented, the Baby Boom generation would eventually demand new skills, degrees and methods of instruction. Today, as our society faces a growing disconnect between newly created jobs and applicant qualifications, that vision is now a reality. Of the 133 million people in the U.S. labor force, 55% do not have a college degree. Clearly, to reach President Obama's ambitious goal of regaining global leadership in college education by 2020, the solution will require much more than budget-strained public colleges and capacity-constrained private universities. Best in class for-profit institutions like the University of Phoenix have the capacity, access and quality necessary to bridge the gap.
One Step Ahead
For over a year now, Apollo has been cast under a broad cloud of near term regulatory uncertainty. However, as the Department of Education formulated new rules to ensure high quality education at a low cost, the company stayed one step ahead, proactively improving all areas of an already successful business model – from marketing, to admissions, to financial aid, to student experience, to alumni relations. Today, as its competitors are still reacting to the new rules of the game, Apollo is already positioned as the brand of choice for the non-traditional students looking to improve their skills relative to an increasingly competitive job market.
Sheltered from the Storm
Amidst the storm, the Apollo management team not only strengthened the company's position strategically, but also financially. Chairman Sperling and co-CEO's Charles Edelstein and Greg Cappelli have the company performing well, generating impressive free cash flow and amassing a fortress-like balance sheet. Already in the first three quarters of this fiscal year, the company has generated approximately $3.96 per share in free cash flow, returned approximately $2.90 per share to its shareholders and built up a rock solid net cash position of approximately $8.96 per share.
Plenty of Room on Stage
As investors played the role of wallflowers, we actively pursued the opportunity to own a global leader in for-profit education. And yet, as the industry continues to adapt to the new regulations, the opportunity persists. Despite the stock's impressive performance, today's price reflects the challenges still facing the competition, rather than the long term demand for Apollo's best-in-class programs. As of June 30, 2011, shares traded at $43.68, a 32% discount to our private market value of $64.48.
A GIFT FROM THE WORLD OF INDEXING
Dear Fellow Shareholder: Ariel Discovery Fund's returns struggled during the second quarter of 2011, trailing its benchmark and the broad market. Despite solid and improving fundamentals for the majority of our small-cap companies, their stocks were weak and the Fund lost -8.33% for the quarter. This compares to -2.65% for the Russell 2000 Value Index and +0.10% for the S&P 500 Index. Since inception on January 31, 2011 the Fund has lost -5.30% compared to a gain of +3.71% for the Russell 2000 Value Index and +3.57% for the S&P 500 Index.
While this quarter's results were disappointing, we feel very positive about the portfolio. With very few exceptions, we are pleased with what we are seeing at the businesses we own. Thus the discount to our estimate of fair value across the portfolio has risen to 43%. Of course we cannot predict when performance will improve, but we do feel extremely confident in the long-term value of our holdings.
Top performers during the quarter included: Vical Inc. (VICL, Financial), up +39.19%; Shoe Carnival, Inc. (SCVL), gaining +7.49%; and InfoSpace, Inc. (INSP), which returned +5.31%. On the losing end were: Sigma Designs, Inc. (SIGM), losing -41.00%; Ballantyne Strong, Inc. (BTN), down -34.59%; and American Reprographics Co. (ARC), which fell -31.69%. Sigma Designs has had disappointing results and a lowered near-term outlook; the stock now trades at an extremely depressed multiple of its cash-rich book value. Ballantyne, on the other hand, has had weak stock performance despite what we believe is a powerful, ongoing growth story, so we have continued to add to the position as the stock has traded lower. A Gift from the World of Indexing In his seminal 1991 book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Seth Klarman devotes a section to indexing, which he labels "mindless investing."1 Of course, at Ariel, we believe strongly in the benefits of long-term, active management. Yet even proponents of indexing would agree that one of its side effects can be sharp price movements when components of an index are changed. As Klarman notes: Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers…Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers
In his seminal 1991 book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Seth Klarman devotes a section to indexing, which he labels "mindless investing."1 Of course, at Ariel, we believe strongly in the benefits of long-term, active management. Yet even proponents of indexing would agree that one of its side effects can be sharp price movements when components of an index are changed. As Klarman notes:
Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers…Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers
Klarman wrote Margin of Safety 20 years ago, when indexing was primarily focused on the S&P 500 Index. In today's world, the Russell Indices are among the many other indexes tracked by substantial pools of capital. Each June, Russell reconstitutes its indexes, leading to a large number of additions and deletions. When small-cap and micro-cap stocks move in or out of the Russell 3000 Index, it can lead to significant price dislocations in both directions. The grandest irony of the efficient markets hypothesis appears when those portfolios most dependent upon it—index funds—create the most glaring inefficiencies in today's stock market. As long-term value investors, we believe that we can use this short-term illiquidity to our advantage. Following is an example which worked in our favor:
PCTEL, Inc. (PCTI) is a developer of innovative antennas and scanning receivers. Its products are used to build and optimize wireless networks. The company has $68 million in cash, or nearly $4 per share, as well as a profitable and growing business. We believe the management team led by CEO Marty Singer is both talented and properly motivated by significant stock ownership. We are big fans of the company.
On Friday, June 10th, PCTEL stock closed at $6.40. Over the following weekend, Russell provided the initial list of index changes, which would become effective on Friday, June 24th. PCTEL was noted as a deletion from the Russell 3000 Index, meaning that roughly two million shares would need to be sold on that date by indexers. (Recall that indexers only care about tracking the index, not about valuation). For the previous 30 trading days, PCTEL had traded an average of just under 32,000 shares per day. The stock closed down -7.5% on Monday, June 13th, as investors and traders anticipated the massive pending sale. The stock continued to trade at depressed levels over the next two weeks.
As we were confident in the long-term value of PCTEL, this dislocation enticed us to add to our position. We bought shares at $5.99 on June 13th, followed by a purchase at $5.80 per share on June 15th—more than 9% below the June 10th close! We also placed orders at even lower prices in case the dislocation became even more pronounced, but these trades never went through. Finally, on the reconstitution day, nearly 3.2 million shares of PCTEL traded as the indexers liquidated their holdings. The stock closed at $5.95, down -7.5% from the June 10th close. On the following trading day, PCTEL stock closed at $6.40 per share—exactly its price before the announcement. Those who bought stock during the two-week period truly received a gift from the "efficient market" indexers.
Portfolio Comings and Goings
We eliminated two holdings from the portfolio during the quarter. TomoTherapy Inc. (TOMO) was sold prior to the close of its acquisition by Accuray (ARAY), a deal which had been announced in March. We also decided to sell our entire position in Republic Bancorp, Inc. (RBCAA) despite only owning the stock for a few months. While we were comfortable with the risks associated with Republic's tax services business 23 at our entry price below book value, the FDIC issued an order in early May accusing the bank of a variety of violations and assessing civil money penalties. We immediately decided to exit the stock given the heightened risk.
We added one new position during the quarter, bringing the number of companies in the Fund to 33 at quarter-end:
Contango Oil & Gas Co. (MCF)—Based in Houston, Contango is an independent exploration and production company with a focus on natural gas. Led by founder and CEO Ken Peak, who owns more than 15% of outstanding shares, Contango is an extremely low-cost producer whose efforts revolve around capital allocation while outsourcing virtually all other aspects of the process. This has led to dramatic growth in book value since the company's founding in 1999. With no debt, substantial cash and proved reserves which we believe are worth roughly the current share price, we believe Contango presents a compelling investment opportunity.
As always, we appreciate the opportunity to serve you and welcome any questions or comments you might have. You can also contact us directly at [email protected].
Sincerely,
David M. Maley
Lead Portfolio Manager
Despite these recent losses, we remain enthusiastic about the quality and composition of the underlying portfolio and view our stocks as having taken somewhat of a breather after such a stellar run. As you know, Ariel Fund has been on a tear on the heels of the financial crisis, having surged +233.87% cumulatively since the March 9, 2009 market bottom through June 30th versus +150.03% for the Russell 2500 Value Index, +153.64% for the Russell 2500 Index and +104.73% for the S&P 500 Index. While we are pleased with this rebound, as patient investors, we remain fixated on the long-term. As such, we believe the nearly 25-year, top quintile performance record of Ariel Fund speaks volumes for our style of patient investing.
For the quarter ended June 30, 2011, Ariel Appreciation Fund managed a +0.99% return which was ahead of the -0.69% decline of the Russell Midcap Value Index as well as the +0.42% gain of the Russell Midcap Index. Strong performance among our consumer discretionary and producer durables stocks as well as our sole technology name Dell Inc. (DELL, Financial) offset weakness in the financials area. We believe continued strength in the Fund is a testament to our willingness to go against the grain as aggressive buyers during the worst of the financial crisis. For the three years ending June 30th— which includes the dramatic decline and rebound—Ariel Appreciation Fund has averaged +12.35% versus +6.35% for the Russell Midcap Value Index, +6.46% for the Russell Midcap Index and +3.34% for the S&P 500 Index. Furthermore, we are especially pleased with the long-term rankings of Ariel Appreciation Fund. For the trailing three years, it ranks in the top 1%; for the five years, it ranks in the top 5%; for the past 10 years and trailing 15 years, it ranks in the top deciles within its Lipper Multi-Cap Core category.
The Limits of Lessons
There is a saying among basketball coaches: “you can’t teach height!” This oversimplification of a common trait of most successful basketball players got us thinking about key aspects of the investment management business that cannot be taught. While there is little question giants constantly hone their craft by reading and learning, in the world of money management there are some things that simply cannot be gleaned from study. The true greats—Warren Buffett, Peter Lynch and Sir John Templeton among others—possess some winning characteristics often found in short supply in the investing world. Having closely followed their careers over the years, we think without three essential and yet unteachable traits— vision, courage and determination—there is little possibility of long-term investment success.
Vision
Albert Einstein once declared: "Imagination is more important than knowledge."3 According to his biographer, Walter Isaacson, "As a young student he never did well with rote learning. And later, as a theorist, his success came not from the brute strength of his mental processing power but from his imagination and creativity." Like Einstein's quantum physics, many oversimplify investing as a pure numbers game. By contrast, we view stock picking as a creative endeavor—one in which the art trumps the science. As such, we are convinced the greatest investors possess a distinct vision. They see the world from a unique vantage point not unlike the varied creative expression that comes from painters, actors and writers. For example, in movie making you can give two great directors the same script and the end products will likely yield two very different films. Such is the case with skilled portfolio managers. They operate in the same world, can choose from the same pool of stocks, have access to the same public information, and yet the most talented have portfolios that are not reminiscent of any other you have ever seen. But alas, there is no creativity school. Yes, a school can help foster creativity or help cultivate imagination but if neither is there to begin with, nothing can be done.
Alexander Hamilton reputedly once said, “Those who stand for nothing fall for anything.” For this very reason, creative investors embrace their visions as guiding stars. They must endure the chaos, noise and volatility of Wall Street. Moreover, while many investors are often uncomfortable standing alone, the notables are resigned to the fact that their bold, contrarian viewpoints will indeed cause them to zig when others zag. And on occasion—like late-celebrated artists ahead of their times—they too can be early and their perspectives can go unrealized for some time. Apropos of these points, investing great Warren Buffett noted: “I didn’t learn it in school or anything [but] it never bothered me if people disagreed with what I thought, as long as I felt I knew the facts.”
Courage
Winston Churchill once said, “Success is not final, failure is not fatal: It is the courage to continue that counts.” There is no teaching courage, however, you either have it or you don’t. Moreover, there is no way to know if someone is courageous until it matters most. It is easy to get lulled into thinking courage is common because there are many noteworthy instances of late—from Middle East uprisings, to modern-day war heroes, to the unbelievably selfless acts demonstrated by 9/11 rescuers—but true acts of courage are actually quite rare.
The same increasingly rare moments of courage matter when it comes to investing. Case in point— while physical harm and financial loss are indeed very different, they actually trigger similar fight or flight responses. Of course, no one actually dies due to a bad day in the stock market, but the emotional response to losing money can make some feel a life or death situation is at hand. As Jason Zweig details in his book Your Money and Your Brain, "a financial loss or shortfall is a painful punishment that arouses an almost primitive fear…losing money can ignite the same fundamental fears you would feel if you encountered a charging tiger, got caught in a burning forest, or stood on the crumbling edge of a cliff."
Thus it is human nature to fear investment losses, and while even professional investors are not immune, the most talented have the ability to acknowledge and conquer their fears. Most important of all, when the investing masses opt for flight, the greats know it is time to fight. The skillful draw courage from deep knowledge and experience and in so doing they are able to overpower a primitive response with higher reason.
Determination
Many profess to be passionate, but few truly are. In fact, as with the word “love,” we believe passion is so overused in our modern lexicon that its meaning has been watered down. For this reason, we believe the truly extraordinary investor is not just passionate but determined and, again, there is no lesson plan for determination. The great investor is always seeking, always learnng and never, ever satisfied. Such investors are relentless—eating, sleeping and breathing their portfolios. And even though determined investors must accept inevitable periods of underperformance, they are always focused on improvement. Our determination manifests itself in the form of rigorous balance sheet work, an endless search for independent verifications as well as obsessive reading to learn more and get better. Against this backdrop, we question, re-affirm and even refute our own investment theses regularly. The determined investor knows “[u]ltimately, it is the struggle that keeps us alive.”
Portfolio Comings and Goings
During the quarter, we added Simpson Manufacturing Co., Inc. (SSD, Financial) and Contango Oil & Gas Co. (MCF, Financial) to Ariel Fund. We bought Simpson, a manufacturer and marketer of building products, based on its 70% market share in the U.S. connector market. We purchased natural gas producer Contango based on its lean operations and proven capital allocation skill. The company also maintains no debt and substantial cash amounts on its balance sheet, providing stability to its operations. In addition, we exited CBS Corp. (CBS) as its market capitalization reached the upper limits for Ariel Fund.
While we did not exit any positions in Ariel Appreciation Fund, we purchased shares of Newell Rubbermaid Inc. (NWL, Financial) whose Rubbermaid storage products, Sharpie pens and Graco strollers are well-known to consumers. We also initiated a position in Chesapeake Energy Corp. (CHK, Financial), which is the largest independent provider of natural gas in the United States. As always, we appreciate the opportunity to serve you and welcome any questions or comments you might have. You can also contact us directly at [email protected].
Sincerely,
John W. Rogers, Jr.
Chairman and CEO
Mellody Hobson
President
Simpson Manufacturing Co. (SSD)
Simpson Manufacturing Co. is a leading manufacturer of wood-to-wood, wood-to-concrete and wood-tomasonry connectors, fasteners and fastening systems. These products improve the structural integrity of all types of buildings especially in areas prone to natural disasters. Current Chairman Barclay Simpson took over the CEO position from his father in 1947. He shifted the company's focus from fans and vents to the connector products business in the 1950s. Under Barclay's leadership, Simpson has established a dominant position in the industry with nearly 70% market share in the U.S. Its shares are held in Ariel Fund and Ariel Discovery Fund.
Construction Activity Weakness
The residential and commercial construction market remains near trough levels of activity in North America. Annual new home build rates in the U.S. have fallen nearly 75% from peak levels in the mid- 2000s. The commercial construction business in North America has also continued to suffer over the past few years. Not surprisingly, depressed building activity has caused a temporary decline in revenue and the stock price. We believe a construction recovery is inevitable. Likewise, we are more optimistic on the timing of the recovery than most.
Trusted Brand
The Simpson Strong-Tie brand is well-recognized in the construction industry and is synonymous with highly engineered, reliable building products. Indeed, in some geographies, building standards specifically identify Simpson products as required to meet code. Connectors and fastening systems are a small part of total cost in home or office building construction, but are critical to structural integrity. Thus, architects and builders are willing to pay premium prices for the comfort of having the best connectors and fastening systems, those made by Simpson.
International Expansion
International expansion is a source of significant growth for Simpson in coming years. Simpson has already successfully diversified its revenue from less than 6% from outside the U.S. in 2000 to over 20% in 2010. As the rest of the world comes to recognize the importance of structural safety, we expect builders to look to U.S. building codes as a guideline. With 13 manufacturing and operations facilities around the world and distribution to over 40 countries, Simpson stands to benefit strongly.
Intriguing Valuation
With dark clouds hanging over the stock, Simpson remains an intriguing investment. The market values the company as if building activity will never rebound. By contrast, we believe activity levels are currently near their lows and will improve over the next few years. Even at current levels, Simpson is a profitable company with a strong balance sheet. As these levels increase, we expect significant improvements in Simpson's profitability. As of June 30, 2011, shares traded at $29.87, a 29% discount to our steadily growing private market value of $41.81.
Lazard Ltd. (LAZ, Financial)
Founded in 1848, Lazard Ltd. (LAZ) is a boutique investment bank focused on providing strategic advisory, asset management and restructuring services to corporations and governments. It is the world's largest, independent financial advisory firm whose position strengthened coming out of the economic downturn as it took market share from its major competitors. Particularly, Lazard has developed an unmatched presence globally by attracting the industry's top talent and executing strategic transactions in 27 countries. Its shares are held in Ariel Fund and Ariel Appreciation Fund.
Independence
The core of the company's success is the simplicity of its business model. Unlike its bulge-bracket and Big Four accounting competitors, Lazard operates without the conflicts created by a trading desk, commercial bank or auditing division. This product focus creates a key competitive advantage as companies seek to minimize potential conflicts of interest in soliciting strategic advice and valuation. After the downturn of 2008, the increase in bankruptcies and forced re-valuations at the request of regulators provided significant business opportunities for Lazard to demonstrate its ability to provide trusted, sound expertise. As a result, Lazard advised on Kraft's acquisition of Cadbury, Coca-Cola's acquisition of Coca Cola Enterprises North America and an impressive percentage of the large transactions reported thus far in 2011.
Best-In-Class
Lazard operates in 40 major cities throughout Europe, North America, Asia, Australia and South America. In order to leverage its unique model and global presence, the Company has expanded its investment in financial advisory, developing a deep corps of senior bankers with substantial sector relationships and experience. As a result, nearly one-third of Lazard's business is derived from Europe.
Moreover, for many years Lazard was largely understood by the market as an investment banking firm, relying primarily on advisory and restructuring revenues. However, Lazard is engaged in another one of the most profitable business operations in financial services: asset management. The company has managed to secure inflows despite a weak capital market environment through its popular emerging and international market products. Its asset management division now generates nearly half of the firm's revenues and recently hit a record-high of assets under management at $155 billion last quarter.
Slow Return of M&A Activity
Despite Lazard's solid backlog of M&A transactions, announced global M&A activity has declined from the slight rebound seen in the fourth quarter of 2010. Typically, three factors are expected to have high correlation with M&A activity growth: 1) high CEO confidence, 2) attractive financing, and 3) appealing valuations. Encouraged by over $3 trillion on corporate balance sheets, we believe the beginning of a prolonged M&A growth period is at hand. We, therefore, have continued to acquire Lazard shares at these compelling values.
As of June 30, 2011, shares traded at $37.10, a 33% discount to our private market value of $55.00.
Quality Still a Bargain
Dear Fellow Shareholder: For the quarter ended June 30, 2011, Ariel Focus Fund outperformed its benchmark and the broader market increasing +1.01% versus a decline of -0.51% for the Russell 1000 Value Index and +0.10% for the S&P 500 Index. Although the Fund and the broader market have enjoyed strong performance over the last 12 months, we believe current valuations remain attractive, particularly among larger, high-quality companies. As such, our near-term outlook remains cautiously optimistic. The Fund ended the quarter trading at just 11x forward earnings estimates, a very reasonable level, particularly given the low interest rate environment.
Our two biggest contributors were Dell Inc. (DELL), which rose +14.89% and Johnson & Johnson (JNJ), which climbed +13.25%. Dell has been a strong performer this year increasing +23.03% through the end of the second quarter. The company has benefited from the generally strong corporate spending on technology products. As it happens, this same trend has also been a boost to International Business Machines Corp. (IBM) and Accenture plc (ACN). Leading into 2011, Dell's share price reflected extremely low expectations. The stock closed out 2010 trading at around 10.5x forward earnings and less than 5x enterprise value to EBITDA. This valuation level reflected a number of the company's challenges, particularly in its core PC business.
Dell's recent efforts to broaden its scope and quality in services, as well as the consumer business, have paid off. Of particular note is that the consumer business has swung to profitability despite a fiercely competitive environment. At Ariel, we track the average sell-side rating on stocks in our portfolio to gauge market sentiment. Currently, Dell is the second-least recommended stock in the portfolio. This year it has paid to be an independent thinker on Dell.
While our investment in Dell has required us to buck conventional wisdom in the PC community, our investments in larger health care companies have required us to disregard news headlines for the last three years. At quarter end, we owned Johnson & Johnson, Baxter Intl Inc. (BAX), Zimmer Holdings, Inc. (ZMH) and our latest purchase, Abbott Laboratories (ABT). News articles from 2009 highlighted contentious health care reform and runaway corporate health care costs. Headlines this year focus on debt limits and entitlement restructuring, usually including predictions of cuts in Medicare and Medicaid and resulting pressures on health care providers. We continue to believe largecap, high-quality companies are currently the cheapest area of the U.S. equity markets. Johnson & Johnson is the poster child of a class of stocks that have been inexpensive for a while now. Many of the former large growth darlings from the technology bubble era have suffered massive multiple compression over the last decade. While they were quite overvalued at the turn of the century, in most cases these businesses have grown nicely since then.
Johnson & Johnson is the poster child of a class of stocks that have been inexpensive for a while now. Many of the former large growth darlings from the technology bubble era have suffered massive multiple compression over the last decade. While they were quite overvalued at the turn of the century, in most cases these businesses have grown nicely since then. Johnson & Johnson is trading at the same price levels as in early 2002, yet earnings have more than doubled since then. Much of the stock's collapse in valuation has been warranted as it was bid up to high levels that were unsustainable in our view. Still, just as the market overshot optimistically 10 years ago, we think the same is now happening on the downside. Johnson & Johnson's business generates excellent returns on capital, enjoys high levels of profitability and rests upon a very strong balance sheet. The last couple of years have not been kind to Johnson & Johnson as all three of its segments have faced company-specific issues, including recalls ranging from Tylenol to surgical sutures. In spite of this, however, the businesses were still able to grow, which speaks to the robust nature of the overall franchise. This is what excites us. If you buy a high-quality franchise at an attractive price, it takes enormous stress to cause permanent capital impairment. The company has been able to absorb a number of body blows, a slew of negative headlines and declining market expectations concerning future growth.
At current prices, not a lot has to go right for Johnson & Johnson to perform well for us, and we think there is tremendous downside protection considering its competitive advantages. No one seems to care about dividends anymore, but we view the attractive, growing and well-covered dividend as a sound capital allocation policy for a company that clearly generates more cash than it needs to sustain the business or can deploy at attractive rates of return. Furthermore, with a 3.4% dividend yield, the company only needs to grow at a mid-single-digit level to match the historical average for U.S. stocks. We think the EPS growth will be even higher in the short-run as a result of operating leverage and top-line growth as revenues return from the various recalls. Longer-term we remain optimistic on emerging market growth opportunities, as well as the aging demographic situation in the developed world. Conventional wisdom tells us emerging market countries will be able to afford better health care products and services and will spend a higher share of growing GDP on health care. Many large companies like Johnson & Johnson already get more than 50% of their earnings outside of the United States.
Stocks negatively affecting performance in the second quarter were concentrated in the financial services industry. Goldman Sachs Group, Inc. (GS), which fell -15.87%, and Morgan Stanley (MS), which dropped -15.61%, were our two worst performing positions. It seems the brokerage industry has replaced the health care industry as the nation's most out-of-favor area. Headline risk is at an all-time high with the industry under daily attack in the general press. Both Goldman and Morgan Stanley's stock prices have been driven down to a level that is quite remarkable. As we go to print, Goldman Sachs is trading at a price either at or even slightly below book value, while Morgan Stanley is trading at a 20% discount to book. This means anyone can purchase these two leading investment banks at the prices reserved only for the firms' partners in the past. Goldman and Morgan Stanley employees have competed for decades for the right to buy their firm's stock at book. As a reference, Goldman Sachs has traded at an average of 2.2x book since going public in 1999, while Morgan Stanley has traded at an average of 2.7x book over the same period. Neither Goldman nor Morgan Stanley have ever traded below book other than for a brief period at the height of the financial crisis. Yet today, the Fund can buy these two leading 15 arielinvestments.com 16 800.292.7435 investment banks at or below book in the public market. We are taking advantage of what we think is a rare opportunity and adding to our positions.
A quick comment on the for-profit education industry: since quarter end, our two holdings in this sector have moved up sharply in response to news that the Department of Education regulations were not nearly as onerous as had been feared. We will have more to say on these companies next quarter, but we will note that Ariel's philosophy of investing in companies we like and know well when they are suffering from negative headlines seems to be working well in this instance.
Meanwhile, our investments in the energy sector were modest detractors from performance in the quarter as both Exxon Mobil Corp. (XOM) and new holding Chesapeake Energy Corp. (CHK) declined due to a drop in both the price of oil and natural gas.
Let us close with our outlook for the market. We remain upbeat as the vast majority of our portfolio companies continue to report earnings above Street expectations. At quarter end, we calculated that the portfolio was trading at only 11x our forward earnings estimate and at a 27% discount to our calculation of intrinsic value. Since quarter end, earnings reports for our companies have exceeded our expectations giving us confidence despite the television pundits, that the possibility of a "double-dip recession" is remote. Our valuation work continues to indicate that larger, high-quality companies like IBM, Exxon and Johnson & Johnson are relatively inexpensive relative to their intrinsic value and continue to offer an excellent opportunity.
Portfolio Comings and Goings
During the second quarter, we purchased U.S. natural gas producer Chesapeake Energy Corp. Recent asset sales to a number of strategic competitors bolstered our confidence. Also, we have a positive outlook on natural gas stemming from domestic efforts to reduce dependence on foreign oil and reduce carbon emissions. We also initiated a position in "big box" discount retailer Target Corp. (TGT, Financial) because the stock price was trading well below its intrinsic value. Target is well-positioned with a reputation for low prices but with higher quality merchandise than some of its discount competitors. Lastly, we did not exit any positions during the quarter.
We appreciate your consideration and the opportunity to serve you and welcome any questions or comments you might have. You can also contact us directly at [email protected].
Sincerely,
Charles K. Bobrinskoy
Co-Portfolio Manager
Timothy Fidler
Co-Portfolio Manager
Apollo Group (APOL, Financial)
Founded in 1973, Apollo Group is one of the world's largest for-profit educators, serving nearly 400,000 students globally. The company's flagship University of Phoenix brand was created with the working adult in mind, offering associate's, bachelor's, master's and doctoral degrees through both online and campus locations. Over the past 15 years, Apollo has experienced impressive growth, a testament to both the value of a University of Phoenix degree and the growing global demand for educational attainment amongst an underserved population. Yet, regulatory uncertainty continues to distract investors from this long term trend. Shares of Apollo are held in Ariel Appreciation Fund and Ariel Focus Fund.
The Times They are a Changing
Over 35 years ago, founder Dr. John Sperling had the foresight to connect the introduction of the first personal computer with an eventual sea change in higher education. As the economy shifted from manufacturing to service-oriented, the Baby Boom generation would eventually demand new skills, degrees and methods of instruction. Today, as our society faces a growing disconnect between newly created jobs and applicant qualifications, that vision is now a reality. Of the 133 million people in the U.S. labor force, 55% do not have a college degree. Clearly, to reach President Obama's ambitious goal of regaining global leadership in college education by 2020, the solution will require much more than budget-strained public colleges and capacity-constrained private universities. Best in class for-profit institutions like the University of Phoenix have the capacity, access and quality necessary to bridge the gap.
One Step Ahead
For over a year now, Apollo has been cast under a broad cloud of near term regulatory uncertainty. However, as the Department of Education formulated new rules to ensure high quality education at a low cost, the company stayed one step ahead, proactively improving all areas of an already successful business model – from marketing, to admissions, to financial aid, to student experience, to alumni relations. Today, as its competitors are still reacting to the new rules of the game, Apollo is already positioned as the brand of choice for the non-traditional students looking to improve their skills relative to an increasingly competitive job market.
Sheltered from the Storm
Amidst the storm, the Apollo management team not only strengthened the company's position strategically, but also financially. Chairman Sperling and co-CEO's Charles Edelstein and Greg Cappelli have the company performing well, generating impressive free cash flow and amassing a fortress-like balance sheet. Already in the first three quarters of this fiscal year, the company has generated approximately $3.96 per share in free cash flow, returned approximately $2.90 per share to its shareholders and built up a rock solid net cash position of approximately $8.96 per share.
Plenty of Room on Stage
As investors played the role of wallflowers, we actively pursued the opportunity to own a global leader in for-profit education. And yet, as the industry continues to adapt to the new regulations, the opportunity persists. Despite the stock's impressive performance, today's price reflects the challenges still facing the competition, rather than the long term demand for Apollo's best-in-class programs. As of June 30, 2011, shares traded at $43.68, a 32% discount to our private market value of $64.48.
A GIFT FROM THE WORLD OF INDEXING
Dear Fellow Shareholder: Ariel Discovery Fund's returns struggled during the second quarter of 2011, trailing its benchmark and the broad market. Despite solid and improving fundamentals for the majority of our small-cap companies, their stocks were weak and the Fund lost -8.33% for the quarter. This compares to -2.65% for the Russell 2000 Value Index and +0.10% for the S&P 500 Index. Since inception on January 31, 2011 the Fund has lost -5.30% compared to a gain of +3.71% for the Russell 2000 Value Index and +3.57% for the S&P 500 Index.
While this quarter's results were disappointing, we feel very positive about the portfolio. With very few exceptions, we are pleased with what we are seeing at the businesses we own. Thus the discount to our estimate of fair value across the portfolio has risen to 43%. Of course we cannot predict when performance will improve, but we do feel extremely confident in the long-term value of our holdings.
Top performers during the quarter included: Vical Inc. (VICL, Financial), up +39.19%; Shoe Carnival, Inc. (SCVL), gaining +7.49%; and InfoSpace, Inc. (INSP), which returned +5.31%. On the losing end were: Sigma Designs, Inc. (SIGM), losing -41.00%; Ballantyne Strong, Inc. (BTN), down -34.59%; and American Reprographics Co. (ARC), which fell -31.69%. Sigma Designs has had disappointing results and a lowered near-term outlook; the stock now trades at an extremely depressed multiple of its cash-rich book value. Ballantyne, on the other hand, has had weak stock performance despite what we believe is a powerful, ongoing growth story, so we have continued to add to the position as the stock has traded lower. A Gift from the World of Indexing In his seminal 1991 book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Seth Klarman devotes a section to indexing, which he labels "mindless investing."1 Of course, at Ariel, we believe strongly in the benefits of long-term, active management. Yet even proponents of indexing would agree that one of its side effects can be sharp price movements when components of an index are changed. As Klarman notes: Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers…Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers
In his seminal 1991 book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Seth Klarman devotes a section to indexing, which he labels "mindless investing."1 Of course, at Ariel, we believe strongly in the benefits of long-term, active management. Yet even proponents of indexing would agree that one of its side effects can be sharp price movements when components of an index are changed. As Klarman notes:
Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers…Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers
Klarman wrote Margin of Safety 20 years ago, when indexing was primarily focused on the S&P 500 Index. In today's world, the Russell Indices are among the many other indexes tracked by substantial pools of capital. Each June, Russell reconstitutes its indexes, leading to a large number of additions and deletions. When small-cap and micro-cap stocks move in or out of the Russell 3000 Index, it can lead to significant price dislocations in both directions. The grandest irony of the efficient markets hypothesis appears when those portfolios most dependent upon it—index funds—create the most glaring inefficiencies in today's stock market. As long-term value investors, we believe that we can use this short-term illiquidity to our advantage. Following is an example which worked in our favor:
PCTEL, Inc. (PCTI) is a developer of innovative antennas and scanning receivers. Its products are used to build and optimize wireless networks. The company has $68 million in cash, or nearly $4 per share, as well as a profitable and growing business. We believe the management team led by CEO Marty Singer is both talented and properly motivated by significant stock ownership. We are big fans of the company.
On Friday, June 10th, PCTEL stock closed at $6.40. Over the following weekend, Russell provided the initial list of index changes, which would become effective on Friday, June 24th. PCTEL was noted as a deletion from the Russell 3000 Index, meaning that roughly two million shares would need to be sold on that date by indexers. (Recall that indexers only care about tracking the index, not about valuation). For the previous 30 trading days, PCTEL had traded an average of just under 32,000 shares per day. The stock closed down -7.5% on Monday, June 13th, as investors and traders anticipated the massive pending sale. The stock continued to trade at depressed levels over the next two weeks.
As we were confident in the long-term value of PCTEL, this dislocation enticed us to add to our position. We bought shares at $5.99 on June 13th, followed by a purchase at $5.80 per share on June 15th—more than 9% below the June 10th close! We also placed orders at even lower prices in case the dislocation became even more pronounced, but these trades never went through. Finally, on the reconstitution day, nearly 3.2 million shares of PCTEL traded as the indexers liquidated their holdings. The stock closed at $5.95, down -7.5% from the June 10th close. On the following trading day, PCTEL stock closed at $6.40 per share—exactly its price before the announcement. Those who bought stock during the two-week period truly received a gift from the "efficient market" indexers.
Portfolio Comings and Goings
We eliminated two holdings from the portfolio during the quarter. TomoTherapy Inc. (TOMO) was sold prior to the close of its acquisition by Accuray (ARAY), a deal which had been announced in March. We also decided to sell our entire position in Republic Bancorp, Inc. (RBCAA) despite only owning the stock for a few months. While we were comfortable with the risks associated with Republic's tax services business 23 at our entry price below book value, the FDIC issued an order in early May accusing the bank of a variety of violations and assessing civil money penalties. We immediately decided to exit the stock given the heightened risk.
We added one new position during the quarter, bringing the number of companies in the Fund to 33 at quarter-end:
Contango Oil & Gas Co. (MCF)—Based in Houston, Contango is an independent exploration and production company with a focus on natural gas. Led by founder and CEO Ken Peak, who owns more than 15% of outstanding shares, Contango is an extremely low-cost producer whose efforts revolve around capital allocation while outsourcing virtually all other aspects of the process. This has led to dramatic growth in book value since the company's founding in 1999. With no debt, substantial cash and proved reserves which we believe are worth roughly the current share price, we believe Contango presents a compelling investment opportunity.
As always, we appreciate the opportunity to serve you and welcome any questions or comments you might have. You can also contact us directly at [email protected].
Sincerely,
David M. Maley
Lead Portfolio Manager
