Ariel Investments Annual Report (John Rogers)
For the one-year period ending September 30, 2011, Ariel Fund declined -14.11% versus a loss of -4.70% for the Russell 2500 Value Index. During the same period, Ariel Appreciation Fund declined -7.86% compared to the Russell Midcap Value Index, which lost -2.36%. Meanwhile, the S&P 500 Index gained +1.14% over the one-year period, highlighting the same theme we saw during the third quarter: small and mid-sized companies experienced sharper declines than large companies. Top detractors for both funds were in the financial sector, which has been under seige— specifically, Jones Lang LaSalle Inc. (JLL) and Lazard Ltd (LAZ) lost -39.78% and -38.92%, respectively. The consumer sector contributed positively to both funds with Nordstrom, Inc. (JWN) returning +25.26% and J.M. Smucker Co. (SJM) increasing +23.56%. Additionally, Ariel Appreciation Fund benefitted from its holding in global health care company Baxter Intl Inc. (BAX), which increased +20.40% this past fiscal year.
With growing sovereign debt concerns and European banks potentially exposed to big losses, there was universal pain—from U.S. equities to international stocks to high-flying commodities like gold—nothing was spared from the wreckage. If that was not enough, a dangerous political standoff related to the U.S. debt ceiling followed by America’s historic downgrade from AAA to AA+ conveniently added fuel to the fire. As The Wall Street Journal perfectly summed, “During the third quarter, markets were tossed to and fro on a daily—even hourly—basis by the latest news from Washington or European capitals.”2 But this time, the culprits were not the companies but their countries.
The Ariel View—A Time to Buy
During times of great uncertainty, people are overly influenced by headlines and pundits, rumor and chatter. Facts often take a back seat to speculation. These days, the sheer grandness of the notion of global deleveraging stops many investors in their tracks. The fear is palpable. But as we sort through the macroeconomic noise in order to synthesize our extensive research inputs, we embrace a fundamental thesis espoused by Warren Buffett: “Markets are stronger than governments—you can’t stop them.”3 While some professional investors are working to parse the debt issue into a thousand pieces, we recognize that much is unknowable when it comes to governments and therefore remain focused on well-defined micro issues—more specifically, individual companies and their prospects in varying market conditions. Despite the gloomy backdrop, it is here that the news is so encouraging. As Barron’s recently noted, “…American corporations rarely have been in better shape, with generally robust profits and balance sheets flush with more than $1 trillion in cash.”4 Heartened by their expanding coffers, our portfolio executives are mostly bullish about their own corporate growth prospects although still pessimistic about the broader business environment. Fortunately, we have seen this movie before. Negative sentiment and hence low expectations, joined with sturdy companies, are often a recipe for success.
“Negative sentiment and hence low expectations, joined with sturdy companies, are often a recipe for success.”
When uncertainty devolves to chaos and then panic, when companies manage to eke out profits in a middling economy, when as one Wall Street strategist observes, “the expectations bar is on the floor,” it is a time to buy.5 The problem is that most investors do not view negative returns and extreme volatility opportunistically. As Barron’s recently noted, “As oftquoted as Buffett is—few people have the guts to actually do what he says. Whenever people have a chance to be greedy when others are fearful…they tend to be too terrified to do anything…it is precisely because of volatility that long-term investors should summon their inner Buffett and buy quality stocks or add to positions…”6 As self-proclaimed Buffett wannabees, we have been doing just that! Accordingly, we have initiated positions in a number of industry leaders that were dramatically oversold during the quarter.
“Whenever people have a chance to be greedy when others are fearful…they tend to be too terrified to do anything …it is precisely because of volatility that long-term investors should summon their inner Buffett and buy quality stocks or add to positions…”
In Ariel Fund, we aggressively added to a number of our poorest performers on weakness. Be assured that our accumulation of additional shares was not a kneejerk reaction, but a function of our deep knowledge of the intrinsic worth of our holdings. We also initiated positions in health care components manufacturer Symmetry Medical Inc. (SMA); private equity leader KKR & Co. L.P. (KKR); animal testing specialist, Charles River Laboratories Intl Inc. (CRL); as well as circuit protection device manufacturer Littelfuse, Inc. (LFUS), a company we have owned previously in Ariel Fund, Ariel Appreciation Fund and other portfolios. To take advantage of these more compelling values, we eliminated our holdings in Anixter Intl Inc. (AXE), HCC Insurance Holdings, Inc. (HCC) and PrivateBancorp, Inc. (PVTB).
As far as Ariel Appreciation Fund, we traded out of long-time holding consumer products manufacturer Clorox Co. (CLX) as well as business data provider Dun & Bradstreet Corp. (DNB) in order to initiate a position in oversold financial names like KKR, which we believed to be a screaming buy as its shares fell from $16 to $10 between July and August. Similarly, we bought shares in alternative investment manager, Blackstone Group L.P. (BX) as its stock plummeted from $18 to $12. We also began buying diversified health care products company Hospira, Inc. (HSP), which has been held in Ariel Fund and other portfolios. Admittedly, Hospira has been the one new mid cap name to come out of the gate with a significant earnings disappointment and trade down since our purchase. Like most value managers, we know we can be early when establishing a position. And yet, we remain open to any and all lessons that can be learned when our initial analysis misses.
While we did not expect to be presented with another major league buying opportunity so soon after the ’08 financial debacle, this summer’s equivalent of a stock market curve ball feels like a fat pitch. In fact, the early results are encouraging. Thus far, we have made up a significant amount of ground since the market bottomed on October 3rd through yesterday, October 27th, as this letter went to press. Between Ariel Fund and Ariel Appreciation Fund, 22 holdings have rebounded +30% or more from their lows; 18 stocks have jumped +20 to +29%; and 10 issues are up +10 to +19%. In fact, as depicted below, our year-to-date returns no longer look as alarming as the losses reported for the nine-month snapshot ended September 30, 2011.
The Greek poet Homer once said, “Adversity has the effect of eliciting talents which in prosperous circumstances would have lain dormant.” In recent years, stock market investing has been a testament to adversity. For some, this kind of hardship discourages and defeats. For us, it enlightens and emboldens. Our mettle continues to be tested, but we do believe we are getting better with time. While we are encouraged by recent results, we are keeping our eyes on the prize and remain convinced that the greatest rewards for patient investors are realized over the long-term. 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@example.com.
John W. Rogers
Chairman and CEO
Jr. Mellody Hobson
Company Spotlight Nordstrom (JWN)
Founded in 1901 as a shoe store in Seattle, Nordstrom is a leading specialty fashion retailer that offers a selection of apparel, shoes, cosmetics and accessories for women, men and children. With 213 stores in 29 states, the company is often pigeon-holed as another traditional department store. And yet, its growing online presence and value-oriented Rack brand has broadened its appeal to evolving shopping preferences. Despite a challenged consumer, Nordstrom continues to shine, differentiating itself through superior customer service and operating efficiency.
Not Your Average Department Store The emergence of discount chains, specialty retail stores and online retailers has called the traditional department store format into question. But while others waned, Nordstrom evolved, carved out a rewarding niche and took share from floundering competitors. The company developed its online store years ago, readying itself in advance of the competition. It broadened and simultaneously diversified its brand appeal with Nordstrom Rack, offering its cash-strapped customers value. Most importantly, the company re-doubled its customer service efforts, recognizing that no matter the macroeconomic environment or evolving consumer preferences, the rewards go to those who put the customer first.
The Customer is Always Right The Nordstrom brand has always been known for world class customer service, but its more recent investments in technology have taken its reputation to a new level. Some customers prefer the high-touch, in-store experience. Others have moved their window shopping online via their mobile phones and tablets. Regardless of the medium, Nordstrom’s ability to service its customers is second to none. Its inventory is now seamlessly sourced which allows customers to receive products quickly from as many as three sourcing options–physical stores, distribution centers or even directly from the manufacturer. And now, with free Wi-Fi in every store and free shipping for online purchases, it has further differentiated itself from its traditional peers, while matching the strength of its online competition.
Rising to the Top In challenging economic times, the wheat gets separated from the chaff. In 2011, amidst persistently high unemployment and wavering consumer confidence, Nordstrom continues to grow same store sales, expand operating margins, beat consensus earnings estimates and return capital to shareholders. For example, in the most recent quarter, same store sales grew 7.3%, operating margins expanded 0.60%, diluted earnings per share exceeded expectations by $0.06 and the company bought back $300 million of common stock. When great companies truly possess competitive advantages, the evidence is apparent on the balance sheet.
Reaching For New Heights We view Nordstrom as an opportunity to own a bestin- class, differentiated retailer that not only has powered through the recent economic challenges, but also has room to run. Approaching previous peak operating levels, the company still has several promising growth opportunities that are not being recognized by the market—exposure to a recovering California economy, improving credit trends and continued growth in its online and Rack formats. As of September 30, 2011 shares traded at $45.68, a 13.4% discount to our steadily growing private market value of $52.75. Ariel Focus Fund: Pouncing on Pessimism Dear Fellow Shareholder: In the third quarter ended September 30, 2011, Ariel Focus Fund outperformed its primary benchmark and underperformed the broader market declining -15.73% versus a drop of -16.20% for the Russell 1000 Value Index and -13.87% for the S&P 500 Index. For the year-to-date ended September 30, 2011, Ariel Focus Fund slipped -11.04% versus declines of -11.24% and -8.68% for the Russell 1000 Value Index and the S&P 500 Index, respectively. For the one-year period ending September 30, 2011, Ariel Focus Fund declined -2.07% but was in line with the Russell 1000 Value Index, which lost -1.89% during the same period.
Over the past two years, our quarterly letters have emphasized three themes: high-quality, large-cap companies have been cheap; blue-chip technology companies such as International Business Machines Corp. (IBM) and Dell Inc. (DELL) have been oversold; and financial services companies, particularly the investment banks, have traded at historically low valuations. While the first two investment themes have driven strong performance in 2011, the third has not.
In 2011, high-quality, large-cap stocks have been among the best performers within the market as well as our portfolio. The most simple way to measure how quality is performing in the market is to compare the Dow Jones Industrial Average with other equity indices. In the first three quarters of 2011, the Dow fell only -5.74% versus -8.68% for the S&P 500 Index and -17.02% for the Russell 2000 Index. The top performers this year are those we think of as our highest quality names: IBM is up +20.69%, Baxter Intl Inc. (BAX) has climbed +12.78%, and Accenture plc (ACN) has gained +9.51%.
While our technology investments have not been drawing big headlines, they exhibit our preferred quality of compelling valuations and have positively contributed to 2011 performance. IBM may still evoke images of boring mainframe computer salesmen in some quarters, but the company has successfully remade itself into a leading enterprise software and services company with excellent global growth. Recently, IBM announced the appointment of seasoned veteran Virginia Rometty who is credited for bringing IBM into the upper echelons of the technology consulting business. Her appointment, effective January 2012, signals the company’s commitment to higher margin software solutions. Accenture, which we think is the leading information technology services company in the world, is finally getting the credit it deserves as measured by its expanding valuation premium. With the stock up over 9% this year, it is not as cheap now as it was two years ago. Although we have reduced our position, we are very comfortable holding at these prices. Our two most maligned technology holdings, Microsoft Corp. (MSFT) and Dell, have both outperformed the broad market this year. We have discussed our thesis on each at length in the past and will only pause to note that Microsoft is trading at around 8x forward earnings after backing out net cash on the balance sheet. Dell continues to trade at a breathtakingly low enterprise value to EBITDA of 3.9. Our technology companies may not have products for which consumers camp out in front of stores, but they have what we like: good consistent profits and cash flows, at very attractive valuations.
While our “quality is cheap” and “tech value” themes have worked this year, our thesis on the investment banking stocks has not. Shares of Goldman Sachs Group, Inc. (GS), Morgan Stanley (MS), Citigroup Inc. (C) and, to a lesser extent, JP Morgan Chase & Co. ( JPM), have all declined sharply. The poor performance of our financial services stocks has been a major negative contributor to Ariel Focus Fund this year. This is particularly disappointing to us given our favorable track record in this sector over the history of the fund.
“In 2011, high-quality, large-cap stocks have been among the best performers within the market as well as our portfolio.”
Media commentary around the poor performance of bank stocks in 2011 has tended to emphasize regulatory changes such as the Dodd-Frank Act, the Volker Rule and the Durbin Amendment. But in our view, Morgan Stanley and Goldman Sachs would not be trading at significant discounts to tangible book value even with a challenging regulatory environment if it were not for fears of a fiscal calamity in Europe. A probable Greek default and the threat of problems throughout the rest of Southern Europe have been well reported. At quarter-end our feeling was that the holders of Greek debt will eventually be forced to accept real losses and that many European banks are undercapitalized and will require an infusion of equity from their host governments. American investment banks will eventually take losses from their exposures to Europe but those eventual losses do not, in our opinion, justify Morgan Stanley trading at a 45% discount to tangible book value at quarter-end.
“Our technology companies may not have products for which consumers camp out in front of stores, but they have what we like: good consistent profits and cash flows, at very attractive valuations.”
This brings us to our outlook on the market. Over the past 18 months, we have been consistent to the point of repetitiveness in stating that quality, large-cap stocks represented the best risk/reward trade-off in U.S. equity markets. However, in this letter we note a change. In the past, one could purchase high-quality, large-cap stocks with high dividend yields, strong balance sheets and lower expected volatility, all at valuations below market averages. But with this year’s outperformance of high-quality stocks noted earlier, low-risk quality is no longer cheaper than the market as a whole. The stocks trading at the largest discounts to our estimates of intrinsic value have moved to the other side of the risk spectrum. Early this year, the market was assuming a solid economic recovery, bidding up companies with more cyclical businesses. Today, stock prices seem to be pricing in a significant chance of a double-dip recession and/or a European-led financial collapse. Companies with even modest economic risk or exposure to Europe’s financial system have gone, in our opinion, from in-favor and overpriced to out-of-favor and underpriced.
Our recent purchase of KKR & Co. L.P. (KKR), the asset management firm famous for its private equity business, illustrates this point. An investor in KKR stock receives an interest in three sources of value: the annual management fees paid by limited-partners (or the 2 in “2 and 20”), the carried interest in future profits earned by invested funds (the 20 in “2 and 20”) and the value of the firm’s capital invested in various operations across the firm.1 At the time we purchased KKR in the third quarter, we estimated the value of KKR’s future management fees plus the current value of the firm’s invested capital to be approximately equal to the current stock price. At those prices, we estimate that the market was ignoring the value of the future carried interest. Should we head into another bear market or recession, KKR’s stock will not perform well in the short term as it is certainly not a “defensive” stock. Nor are its profits “consistent” given the very lumpy nature of the realization of carried interest. However, with KKR trading at a roughly 40% discount to our estimate of its private market value at quarter-end, we believe we are being more than adequately compensated for any short-term volatility.
“Today, we think some of the best opportunities involve companies with manageable amounts of risk, but with dramatic upside potential.”
Today, we think some of the best opportunities involve companies with manageable amounts of risk, but with dramatic upside potential. Companies like Chesapeake Energy Corp. (CHK), KKR, Morgan Stanley and Goldman Sachs all face clearly identifiable challenges and excessive short-term stock price volatility. At quarter-end, all were trading at discounts of between 40% and 60% of private market value. Having large portions of our own personal assets invested in Ariel Focus Fund, we would never allow these companies to represent the majority of our holdings. But we do believe now is a time when taking some carefully monitored risk will be rewarded.
Portfolio Comings & Goings
During the quarter, we did not exit any positions, but we purchased three new holdings. We bought diversified health care products company Hospira, Inc. (HSP), which is currently a holding in Ariel Fund. As we mentioned, we purchased KKR, one of the largest and oldest private equity firms in the world, as well as former holding Berkshire Hathaway Inc. (BRK.B). Berkshire’s current stock price reflects several investor concerns that imply diminishing returns for investors—an overcapitalized insurance industry within a low interest rate environment, the inevitable departure of Warren Buffett and the sheer size constraints posed by the company’s portfolio. We see this as an opportunity to own the best-capitalized insurer in the world as well as a broad portfolio of well-managed companies whose aggregate value appears to us greater than today’s discounted valuation.
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 firstname.lastname@example.org.
Charles K. Bobrinskoy
Vice Chairman & Director of Research
Senior Vice President
Company Spotlight: KKR
KKR & Co. L.P. is a leading global investment firm with deep roots in the private equity industry. As of June 30, 2011, the firm had $61.9 billion in assets under management (AUM). Founded in 1976 and led by Henry Kravis and George Roberts, KKR has consistently been a leader in private equity having completed more than 185 private equity investments with a total transaction value exceeding $435 billion. Recently, the firm expanded its geographical presence and investment offerings to new areas including fixed income, capital markets, infrastructure and natural resources. Headquartered in New York City, the firm operates from fourteen offices around the world.
Highly Recognized Franchise
KKR is one of the most well-known and well-respected private equity firms in the world. This creates a competitive advantage in several ways. First, KKR gets the chance to review most companies considering a sale. Second, when buyers identify opportunities that are too large to complete alone, KKR is one of the most soughtafter investment partners. Lastly, KKR is able to attract seasoned talent which clearly helps its financial analysis as well as the firm’s ability to provide industry and operating expertise to its portfolio companies. The firm’s brand value is evidenced by the more than 185 investments and nearly $50 billion of equity deployed since its founding, as well as its track record of strong investment performance.
Scale and Expertise
KKR’s considerable capital pool allows for transactions not necessarily suitable for smaller competitors. Specifically, KKR’s scale allows it to participate in large transactions where competition is scarce. The firm is well diversified geographically and employs seasoned investment experts who take advantage of opportunities that arise particularly during periods of extreme market volatility. KKR’s valuable relationships with investment banks, advisory firms and industry executives place the firm in a position to receive the “first call” on potential investments. At June 30, the firm managed $47.0 billion in its private markets business and $14.9 billion in public markets. Noteworthy, $46.4 billion, or 75% of its AUM, generates fees to the firm. Lastly, KKR reported approximately $13.7 billion in uncalled commitments to its investment funds at June 30.
Seasoned Investment Management Team
KKR is led by a deep, tenured team of investment professionals with extensive experience. For example, its private equity investment committee averages over 30 years of industry experience per member for a total of nearly 250 years of experience. Managing directors average 22 years of industry experience.
As one of the largest private equity firms, KKR benefits from heightened levels of institutional interest in alternative assets, as well as low corporate valuations and near all-time low interest rates. With a patient and disciplined investment process, KKR is well-positioned to engage in strategic acquisitions at attractive transaction multiples and low borrowing costs. Furthermore, with a history of more than 35 years of generating returns that beat the S&P 500 Index, KKR should be buoyed by increased investor demand in alternatives. We are attracted to the firm’s recurring and predictable feerelated earnings along with the upside opportunity from its share of profits from its partnerships (“carried interest”). While acknowledging the firm’s inherent volatility in short-term operating results are largely due to mark-to-market values of its investments (including carried interest), we believe KKR should be able to deliver solid returns to investors over the long-term.
As of September 30, 2011, the stock traded at $10.40, a 42.5% discount to our estimated private market value.
Ariel Discovery Fund: Deep Values Abound
Dear Fellow Shareholder: This was a brutal quarter for stocks, and for the most part, results worsened the further one moved down the capitalization spectrum. As fears about European debt and a slowing U.S. economy took hold, investors fled from anything perceived as risky, leading to declines of more than -20% for most small-cap stock indexes.
Ariel Discovery Fund held up better than its benchmark during the quarter, losing -18.59% while the Russell 2000 Value Index was down -21.47%. While we are never happy about negative returns, we take some comfort in the fact that our deep value portfolio has held up relatively well in this environment. Since inception on January 31, 2011 the Fund has lost -22.90% compared to a decline of -18.56% for the Russell 2000 Value and -10.79% for the S&P 500 Index. Thus we have narrowed the underperformance gap that opened during the first few months of the Fund’s existence.
Even in this challenging market, a few stocks managed to produce modest gains during the quarter, led by Richardson Electronics, Ltd. (RELL), which gained +3.88%. We sold this position late in the quarter to take advantage of stocks we believed were at deeper discounts to intrinsic value. In addition, JAKKS Pacific, Inc. ( JAKK), which received an unsolicited takeover bid, gained +3.58%, and Sigma Designs, Inc. (SIGM) was up +2.62%. Of course, downside movers were more prevalent, as American Reprographics Co. (ARC) declined -52.48%, Avatar Holdings Inc. (AVTR) lost -46.22%, and SeaBright Holdings, Inc. (SBX), which we sold half-way through the quarter for tax purposes, was down -41.31%.
Performance Since Inception
Top detractors and contributors since inception were not dissimilar to those during the third quarter, with JAKKS Pacific and Richardson Electronics among the top contributors rising +9.46% and +7.65, respectively. Meanwhile, American Reprographics and Avatar Holdings were among the detractors falling -58.26% and -59.04%, respectively.
Deep Values Here, There and Everywhere
Three months ago, we noted that we believed the Fund’s portfolio was undervalued by 43% and expressed confidence in the long-term value of our holdings. As most of our companies continue to execute as expected, we are even more confident now that the discount stands at 51%. With the portfolio trading barely above book value and nearly one-third of its market value in net cash, we feel the risk/reward tradeoff for the Fund’s portfolio is extraordinarily attractive. While there is much discussion about the causes of the market decline and what forces are likely to make things better or worse in the short-term, we would rather spend time (and ink) illustrating just how attractive some of our holdings are.
Pervasive Software Inc. (PVSW) Based in Austin, Texas, Pervasive is a software company focused on both in-house and cloud-based data innovation. We believe its small size and the fact that the company has two related but separate businesses has led investors to ignore the deep value opportunity we see in Pervasive stock. Management, led by CEO John Farr and CTO Mike Hoskins, is talented and motivated by significant ownership. The company has produced more than 40 consecutive profitable quarters and has more than 40% of its $95 million market capitalization in cash with no debt. It trades at very low multiples of both asset value and revenues despite significant growth potential and an extremely attractive profile in a rapidly consolidating industry.
“…the risk/reward tradeoff for the Fund’s portfolio is extraordinarily attractive.”
Pervasive’s legacy database business, which currently accounts for about 60% of sales, is a consistent cash flow generator. Customers who embed this product in their software should continue to use Pervasive due to the cost of switching and their long-standing relationships. These cash flows are available for both R&D and share repurchase. CEO John Farr has proven to be an outstanding capital allocator, buying stock opportunistically when market conditions or other short-term factors lead to share price declines. While the balance sheet and this cash-generating business should provide some downside protection, the significant upside potential in Pervasive stock comes from its newer growth businesses which are focused on data analytics. These include Data Integrator, DataRush, DataSolutions and DataCloud. The rapid growth of these businesses is hidden by the larger legacy business, but the company has been recognized as an innovator by Gartner and IDC and has Intuit as a significant customer for its Data Integrator product. There have been several acquisitions of early-stage data integration and related companies at 6x to 10x times sales.
“…the significant upside potential in Pervasive stock comes from its newer growth businesses which are focused on data analytics.”
From a valuation standpoint, Pervasive currently trades at 1.2x book value, 2.4x tangible book value, and 2.4x cash. These are extremely low multiples for a growing software company, but an even more compelling case appears when we examine revenuebased multiples. On an EV/sales basis, the stock trades at 1.1x our estimate of 2011 sales. This would be modest even for the legacy business. The data analytics and other innovative lines deserve a much higher multiple. Even using the low end of the 6x to 10x times range mentioned above and conservatively valuing the legacy business at 1x sales, it would lead to a valuation of more than double the current share price.
First American Financial Corp. (FAF)
Dating back to 1889, First American is a leading provider of title insurance and settlement services to the residential and commercial real estate industries. First American now is focused on traditional title insurance after spinning off the data analytics business as a separate publicly-traded company known as CoreLogic Inc. (CLGX). During the significant downturn in the real estate industry, the company focused on right-sizing its business. The company has been successful in these efforts, maintaining profitability in the worst mortgage origination market conditions we have seen in a decade. We believe First American has tremendous upside with any recovery in mortgage originations and resulting increase in demand for title insurance and settlement services. Even without that recovery factored in, the stock trades at 60% of book value, barely over tangible book value and less than 11x forward cash earnings. Factoring in the eventual recovery we expect in the real estate market—even if delayed for years—we believe the stock has tremendous potential upside not reflected in the current stock price.
“First American has been successful in right-sizing its business, maintaining profitability in the worst mortgage origination market conditions we have seen in a decade.”
Portfolio Comings and Goings We added four new positions during the quarter, bringing the number of companies in the Fund to 34 at quarter-end.
Cowen Group, Inc. (COWN), a boutique investment bank, was transformed into a successful alternative investment manager when it was purchased by alternative asset manager Ramius LLC in 2009, who kept the Cowen name and banking business. Trading at roughly two-thirds of its tangible asset value, with a $10 billion profitable, growing asset management business, experienced management with significant ownership and potential growth should equity market conditions improve, we believe Cowen represents a compelling deep value opportunity.
Tessera Technologies, Inc. (TSRA), based in San Jose, California, is a cash-rich, deep value opportunity with a profitable business and earnings that we believe are understated. The company develops and licenses technologies for next-generation electronic devices. With more than $10 per share in cash and a profitable business, the quarter-end price of $11.94 looks very cheap to us.
Littelfuse, Inc. (LFUS), based in Chicago, is a company that we have owned previously in Ariel Fund, Ariel Appreciation Fund and other portfolios. Littelfuse is a leading manufacturer of fuses and circuit-protection devices for use in the electronics, automotive and electrical markets. The company is in the final stages of transforming its manufacturing footprint, which should result in a significant increase in earnings power.
Mitcham Industries, Inc. (MIND), which we have owned in our micro-cap portfolio for some time, leases and sells seismic equipment to the oil and gas industry. Concern about declining spot oil prices, which have little effect on its customers’ long-term projects, have caused Mitcham stock to trade at barely over tangible book value and at less than 7x forward cash earnings.
We eliminated three holdings from the portfolio during the quarter. Richardson Electronics and Comtech Telecomm. Corp. (CMTL) were sold in order to buy other stocks, which we believed were at even greater discounts to fair value. SeaBright Holdings, as mentioned earlier, was sold for tax reasons and the proceeds were redeployed into other deeply discounted holdings.
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@example.com.
David M. Maley
Senior Vice President
Lead Portfolio Manager
Company Spotlight: Ballantyne Strong (BTN)
Ballantyne Strong is a manufacturer, distributor and servicer of digital cinema equipment. As the leading reseller for NEC digital projectors in the United States and China, the company distributes, installs and services cutting-edge projectors. Through the acquisition of MDI in 2007, the company became a leading manufacturer of cinema screens, with unique capabilities in specialty screens for 3D and IMAX formats. Additionally, the company has a growing service business featuring a state-of-the-art Network Operations Center. The company’s world-class reputation for service has enabled it to win service contracts even in scenarios where it does not supply the equipment.
Projecting into the future
For more than 70 years, Ballantyne Strong was a leading manufacturer and servicer of film projectors. In the mid-2000’s, the company’s visionary CEO, John Wilmers, recognized the world was transitioning to digital and re-positioned the company to be ready for it. For a company that had been defined by film prints since 1932, this was a major shift. Leveraging the company’s top-notch service capabilities, Wilmers transformed Ballantyne from a manufacturer of outdated equipment to a distributor of nextgeneration projectors. This strategy shift was prescient and well-timed: Today, the cinema industry is in the midst of a once-in-a-generation upgrade cycle. Digital projectors offer benefits to both movie studios and exhibitors, due to higher image quality and cheaper movie distribution. Although this upgrade cycle is expected to slow by 2015, the international opportunity is substantial and largely untapped. For example, movie theaters per capita in China lag far behind the West, but rapid construction of new theaters indicates the demand is there.
Although the digital upgrade cycle in the U.S. is well under way, it has not been a smooth ride. In the face of the 2008 credit crisis, national exhibitor chains had difficulty securing financing. Even now, in 2011, small exhibitors–regional chains and independent cinemas–are having difficulty borrowing for this capital investment. These headwinds have been bolstered by anemic box office results and persistent claims that improved home technology is reducing consumer demand for out-of-home movie experience. New 3D technology provided a boost to digital upgrades, as exhibitors had to upgrade some of their projectors and screens to accommodate some of the most popular movies. But this demand slowed as exhibitors realized that 3D capability was not necessary for all of their theaters.
Capital allocation is key
With $1.44 per share in cash, the company has excess capital to fund future growth and/or to return to shareholders. New CEO Gary Cavey has experience with acquisitions, and has his Board’s backing to pursue related growth opportunities. With the stock trading at a discount to tangible asset value despite solid profitability, one activist investor recently petitioned the company to execute a sizable share repurchase. At current prices such a move would be immediately accretive to both earnings per share and book value.
Riding off into the sunset
Having leveraged every resource at our disposal, our team has developed strong conviction that despite near-term headwinds the digital upgrade cycle is both powerful and inevitable. We also are convinced Ballantyne Strong is well-positioned. Although box office results are volatile, consumers continue to enjoy a movie experience they cannot get at home. Furthermore, the opportunities internationally have only just begun. As of September 30, 2011, shares traded at $3.08, a significant discount to our estimated private market value.