While our second quarter results were soft, our yearto- date returns remain competitive. More specifically, Ariel Fund's (Investor Class) +8.38% six-month return narrowly beat its benchmarks—the Russell 2500 Value Index (+8.15%), the Russell 2000 Value Index (+8.23%) and the Russell 2500 Index (+8.31%). Ariel Appreciation Fund (Investor Class) earned +8.55% versus +7.78% for the Russell Midcap Value Index and +7.97% for the Russell Midcap Index.
Aftershocks In our view, a recent Wall Street Journal headline perfectly summed up today's investment environment in five simple words—"Another Spring, Another Fall Back."2 Having lived through three springtime swoons in three years, we have gotten acclimated to what Barron's calls "the 'risk on/risk off' dynamic…[whereby] macro cues and policy whisperings dictat[e] a herd-like rush either toward or away from riskier assets."3 Given the market's second-quarter losses, risk was clearly "off" for much of the last three months after a considerably larger risk appetite reigned over the prior six months. Of course, this kind of investment schizophrenia runs completely counter to our long-term, patient approach. Moreover, as contrarian investors, we generally find our best values when most are running for the exits. This is not to suggest that we would ever throw caution to the wind and take on excessive risk. Instead, we believe that periods when investors are most risk averse is precisely when the potential for a margin of safety increases and danger actually wanes.
There is little question that the "risk off' trade is directly tied to an ever-growing chorus of worries in the global marketplace. Yes, Europe is a mess, and China's white-hot economy may be cooling down to red-hot status. Sure, our unemployment rate is frustratingly high and an election year heightens domestic policy uncertainty. And there is no question that the banking sector keeps shooting itself in the foot, which only drives investor skepticism and prolongs a long-awaited financial sector recovery. All of these factors and more keep producing what we are calling the "aftershocks" of the 2008 financial crisis. These reverberations spark the fear that ultimately takes the markets down. But herein lies the rub. As market strategist Byron Wien is known to say, "Disaster has a way of not happening."4
Against this backdrop of market anxiety, we remain bullish about the prospects for the U.S. For one, the culprit that started the mess—housing—is not just stabilizing but actually showing signs of a recovery. As many know, The Wall Street Journal recently reported, "Inventories of single-family homes fell…[24% from one year ago…[[T]he largest annual drop in at least 30 years…["5 Of course a housing rebound directly affects unemployment with Macroeconomic Advisors estimating that "a healthy pace of 1.5 million new homes a year would create about 50,000 jobs a month and lower the unemployment rate by 1.5 percentage points."6 Meanwhile, working consumers are in much better shape than a few years ago given lower debt levels and higher savings rates. More than any other time in history, companies are flush with cash, and their cost cuts have created unprecedented profits. Even U.S. banks, whose self-inflicted wounds were the deepest of any industry, are now well-capitalized. Although it is early and only 20% of Fortune 500 companies have reported, so far earnings are hanging in there—albeit with less exuberant expectations—despite tough yearover- year comparisons. Not to mention, all of the negative headlines are already priced in, which puts us squarely in the lonely camp of what Barron's dubs the "bad news bulls."
After "Math" Beyond the aforementioned indicators, our bullishness is most influenced by the financial conditions of our small- and mid-sized portfolio holdings and the significant improvements we have witnessed since the worst of the financial crisis. Across industries and companies, we have watched management teams not just stabilize but improve their businesses as a direct result of the tribulations they have encountered in recent years. To that point, political candidates often ask: Are you better off today than you were 4 years ago? In the case of our companies, the answer is unequivocally yes.
For example, Interpublic Group of Cos., Inc. (NYSE:IPG) has the distinction of being one of the world's largest advertising conglomerates. When confronted with economic challenges, companies can and often do quickly scale back marketing and advertising to save money. And yet, IPG not only grew but was able to show margin expansion over the last four years—a period when tepid economic growth was a headwind. All the while, the company also managed to buy back half a billion dollars of dilutive convertible debt. In so doing, Debt/EBITDA substantially improved from 2.81x to 1.92x, which ultimately provided the company access to more favorable debt markets. This level of debt reduction, along with the company's repurchase of 52 million shares, has cut its diluted share count from 553 million to 438 million shares—a 20% decrease in shares outstanding. It is worth noting that even after this hefty $700 million spend, the company still had the ability to issue its first dividend in nearly a decade.
Janus Capital Group Inc. (NYSE:JNS) has tried even our patience over the years, but the company is on a much better path after taking some aggressive steps during the worst of the market meltdown. In 2009, the Janus board fired then-CEO Gary Black, replacing him in February 2010 with 13-year PIMCO veteran Dick Weil. In many ways, hiring someone from a world-renowned bond shop ran counter to this high-octane growthstock manager's brand. And yet, Weil arrived armed and ready to broaden the company's fixed income capabilities and expand its domestic and international equity offerings. As a result of these efforts, fixed income now represents $24 billion or 16% of assets under management (AUM), which is substantially up from 4% when he started, and value has grown from 10 to 12% of assets. Weil has also worked to extend the brand presence globally and also grow assets in the institutional arena. During this time, Janus's dividend jumped from 4 to 24 cents annually and debt was dramatically reduced from $1.1 billion at the time of the 2009 market low to $539 million today.
Last but not least, the transformation of one of our most controversial names, Gannett Co., Inc. (NYSE:GCI), has even surprised some of its most ardent critics. Despite wildly negative views of its admittedly decelerating newspaper publishing business, Gannett represented a diversified media company with a solid broadcasting division, a growing digital business and ownership in the popular CareerBuilder.com jobsite. During the worst of times, Gannett was highly profitable and throwing off tons of cash. In fact, its free cash flow has always been positive and this cash generation enabled the company to pay down debt and also refinance at much lower rates. More specifically, the company's debt has steadily trended down from $4.3 billion during the 2009 market low to $1.7 billion today. While cleaning up its balance sheet, Gannett increased its dividend, which now yields a rich 5.4%. Recently, the company also announced plans to buy back $300 million worth of stock in the next two years, which represents 9% of its shares outstanding. Even investment great Warren Buffett has come around to the possibilities at Gannett. Given our admiration for his investing prowess, this is a reassuring reversal. In 2009 when he was asked about the future of newspapers, he commented, "We would not buy them at any price." Today, Berkshire Hathaway Inc. (NYSE:BRK.B) not only owns Gannett shares but has also recently been on somewhat of a newspaper buying binge.
Ever After The aforementioned examples are reflective of other holdings across our small, small/mid and mid cap portfolios. One other noteworthy consideration is that despite markedly improved fundamentals, many of our companies—including IPG, Janus and Gannett—have not seen any meaningful change in their risk metrics. More specifically, a look at beta (as just one measure of risk) suggests that Wall Street has given little credit to the strengthened balance sheets, financial diversification and leaner operations of many companies. This disconnect further convinces us that great values are at hand.
We believe the silver lining of the worst financial crisis since the Great Depression is that our companies are stronger and better than before. As bottom-up stock pickers, we work overtime to find companies with sturdy balance sheets, strong cash flows and potent brands that will help them survive economic storms. After a tough 2008, we are more skeptical, more vigilant and more optimistic.
Portfolio Comings and Goings During the quarter, Ariel Fund initiated a position in International Speedway Corp. (NASDAQ:ISCA), the well-known promoter of motorsport events and activities in the U.S. We also purchased shares of Snap-on Inc. (NYSE:SNA), the leading manufacturer of tools and equipment for independent auto repair centers. We exited battery maker, Energizer Holdings, Inc. (ENR) as well as global security provider Brink's Co. (NYSE:BCO), in order to pursue more compelling opportunities.
In addition to adding Snap-on over the course of the last three months, Ariel Appreciation Fund bought shares of for-profit education leader Apollo Group, Inc. (NASDAQ:APOL) as well as global money and payment services company, Western Union Co. (NYSE:WU). We also re-initiated a position in Tiffany & Co. (NYSE:TIF) after the stock price came down significantly—a large overreaction in our view. On the sell side, we exited health care company Baxter Intl Inc. (NYSE:BAX) in order to pursue the aforementioned opportunities.
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]
John W. Rogers, Jr.
Chairman and CEO
1 Morningstar Direct
2 The Wall Street Journal, July 8, 2012, page 9.
4 The Wall Street Journal, July 21-22, 2012, page A11.
5 The Wall Street Journal, July 20, 2012, page A2.
6 Joel Prakken of Macroeconomic Advisors.