John Rogers' Ariel Funds First Quarter Letter 'Good Sports'
Against this backdrop, the market has totally reversed course after the precipitous drop last Fall when fears of a double dip recession ensued following the U.S. debt downgrade and the 2.0 version of Europe's sovereign debt crisis. As Barron's wisely noted, "the first quarter's resounding rally was really just a repudiation of last year's recession fears…the 50 S&P 500 stocks that fared the worst in 2011 rebounded +23.8% in the first quarter, while the 50 that held up the best climbed just +10.5%…And the most heavily shorted posse jumped +18.1%, while the least-reviled group gained just +9.7%."1 In Ariel Fund, our most downtrodden financial services names have morphed into our very best performers—not surprising since these high-quality gems were dramatically oversold six months ago. In Ariel Appreciation Fund, the health care and financial stocks that were indiscriminately punished are now leading the pack with stellar returns. And although consumer stocks were the top performers in the Russell 2000 Value and Russell 2500 Value indices and the second best performing group in the Russell Midcap Value Index during the first quarter, our consumer names were our weakest contributors—mostly because they held up better during last year's market lows.
Recently, the Los Angeles Dodgers sold for an eyepopping $2 billion to a consortium including Magic Johnson. The final figure exceeded all expectations— more than double the price the Chicago Cubs fetched in 2009. At one point in time, that bid might have seemed like a huge stretch. But today it says a lot about the immense value of television rights. After all, the Dodgers auction came shortly after Matt Kemp appeared on the cover of Forbes in an article that connected his $160 million contract to a regional sports network deal likely to be worth $3.5 billion over 20 years. The relationship between money and sports has a storied history that is constantly shifting. Even though the business of sports inevitably attracts an abundance of attention given its larger-than-life athletes and wealthy owners, as value investors, we have been able to identify some unique investment opportunities (directly and indirectly related to sports) that play to our strengths and land squarely within our circle of competence. The key to our enthusiasm derives from the fact that sports sits in the sweet spot of technology, media and even real estate. While we have never professed any high-tech expertise, there is no question that recent breakthroughs have made sports more ubiquitous in the last few years. Television, cable and satellite mean more games are available than ever before. Not to mention, watching them in high definition (HD) vastly improves the product. At one time a simple score would suffice but with the proliferation of mobile devices like smart phones, tablets and laptops, devoted fans can now travel the world following their favorite teams live.
When we invest, we are constantly looking for businesses with wide moats that make it hard for new competition to break in. This is where we get excited since sports are somewhat insulated from the disruptive forces that have made some media cash cows less profitable. In television, the DVR has wreaked havoc on traditional advertising. Instead of watching commercial after commercial during our favorite shows, we fast forward through the ads with remote in hand. This phenomenon does not exist with sports because fans prefer to watch games live. Also, while many turn to the Internet to get free news and entertainment—people are willing to pay for sports. We buy pricey tickets to see games in person and are even willing to pay to watch athletes play on TV. For example, it is hard to see National Hockey League games without a pay television service. Similarly, with Monday Night Football on ESPN, viewers pay a charge on their cable or satellite TV bills. Escalating television sports contracts underscore this point. In December 2011, for instance, the National Football League signed a new 9-year deal with CBS Corp. (CBS), Fox and NBC that represents a 60% revenue increase over the current $4 billion annual take.
Herein lies the opportunity for our portfolios. As seasoned media investors, our deep knowledge of their revenue streams as well as their recent challenges puts us in a unique position to assess the opportunities at hand. This hard-learned media expertise has given us insight into the value of those assets that maintain or increase revenues in a world where the top line is often volatile and sometimes sliding. We are also employing the knowledge we have gained in real estate from companies such as Jones Lang LaSalle Inc. (JLL) and CBRE Group, Inc. (CBG). Real estate is an unusual asset because it can be tricky to estimate its current value, and also because savvy managers can wring far more value out of it than others can.
For all these reasons, we bought shares of one of the world's most famous sports venues last year—Madison Square Garden Co. (MSG). One part of our attraction was the fact that so few realize that it recently became a publicly traded company. Having been spun off from Cablevision Systems Corp. (CVC) in 2010, MSG includes the Garden, two regional sports networks, as well as the New York Knicks, the New York Rangers, and a variety of other venues and businesses. One of the main overhangs on the stock is the admittedly huge cost related to a massive upgrade of Madison Square Garden itself. With estimates running as high as $1 billion, the market is skeptical, but a
tour of the under-construction facilities more than convinced us the dollars represent money well spent. The facilities will be spectacular when all is said and done. We are further reassured about the expense when one considers that even in the worst economic downturn, fans continued to pay for premium tickets to live sporting events. Additionally, there is no better moat since the scale of the Garden simply cannot be duplicated in Manhattan today.
Even though it gained nearly +20% in the past quarter, we think it still trades at a 21% discount to intrinsic value today. CBS (CBS) and Gannett Co., Inc. (GCI) represent more of a back-door sports play. CBS, a holding in Ariel Appreciation Fund, currently has five of the top-10 rated shows in the country, the most of any network—as well as a topnotch sports franchise. Among other offerings, it currently hosts the NFL, PGA golf, the NCAA basketball tournament, and SEC (Southeastern Conference) college football. Moreover, the network has successfully made itself synonymous with watching these premier events on television. Even though it has gained more than 25% in the last quarter, we estimate it still trades at a double-digit discount to intrinsic value. While many continue to think Gannett, a holding in Ariel Fund and Ariel Appreciation Fund, is limited to USA Today, it is truly a diversified media company. A few of us recently attended their analyst day, where their small-town papers got a lot of play because Americans love their small-town sports and read the local paper to get the best coverage of these events. Additionally, the company's 23 television stations carry live sports. As a forward-thinking company, Gannett is working hard to monetize other parts of the sports craze. For instance, it recently devoted a chunk of its free cash flow to buy BaseballHQ.com, a fantasy sports website. Gannett trades at just 7x consensus 2012 earnings, which we think remains quite a bargain.
For us, the sports theme feels like a triple-play: the trend is clear in the social and entertainment world, remains unappreciated—and thus undervalued—in the investing world, and falls right in the center of our circle of competence.
Portfolio comings and goings We did not purchase any new holdings in Ariel Fund during the quarter, but we eliminated our position in Herman Miller, Inc. (MLHR) in order to pursue more compelling opportunities. In Ariel Appreciation Fund, we did not purchase any new holdings during the quarter, but we eliminated our position in Mattel, Inc. (MAT) in order to pursue more compelling opportunities.
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John W. Rogers, Jr.
Chairman and CEO