John Rogers' Ariel Investments Q1 Commentary
Stocks went on a big tear in the first quarter of 2013, especially in the United States. Equities tend to perform well in the first quarter because individual investors and institutions put money to work as a part of standard practice. Still, this year was even better than most. The large-cap S&P 500 Index jumped +10.61% but not as high as the small-cap Russell 2000 Index's +12.39% leap. While global stocks look tame by comparison, the MSCI EAFE Index's +5.23% gain is very strong on an absolute basis. Moreover, most key U.S. indices hit all-time records. Going into the quarter, the all-time highs for the Dow, S&P 500, and Russell 2000 were 14,164, 1565, and 868, respectively. The Indexes ended the quarter at 14,578, 1569, and 951—all above the previous highs. Sentiment clearly has moved decisively toward stocks. According to TrimTabs Investment research, nearly $78 billion flowed into U.S. stock mutual funds and ETFs just in January, an all-time record month. Similarly, Investors Intelligence reports that roughly four out of every five investors is bullish. While some of that sentiment is likely performance-chasing, we think the hangover of pessimism from the 2007-2009 financial crisis is finally fading and people are realizing that the economy is strengthening and growing. In the first quarter of 2013, Ariel Fund returned +15.76%, topping the Russell 2500 Value Index and the Russell 2000 Value Index, which rose +13.35% and +11.63%, respectively.
We had several stocks with strong returns in the first quarter. Private equity firm KKR & Co. L.P. (KKR) rose +31.84% due to strong fundamentals. Specifically, the company reported fourth quarter 2012 earnings of $0.48 per share versus consensus of $0.21. Its assets under management increased 28% over the past 12 months—up 14% from just the previous quarter. Returns on its private equity portfolio powered the increases, appreciating 24% in 2012—considerably higher than the S&P 500 Index. Originally our thesis held the stock was a bargain because it reflected its fee-based businesses but not carried interest. That inefficiency no longer exists, but now the crowd seems well behind the curve on the company's growth potential. We believe a broad distaste for many types of financial services firms remains in the wake of the Great Recession; in our view, this emotional backlash creates significant opportunities. In addition, leading gaming machine manufacturer WMS Industries Inc. (WMS), cashed in for a +41.09% gain as it agreed to a buyout. We purchased the stock in the last quarter of 2012 at around $16 per share; as part of our work, we calculated a strategic buyer would likely pay around $32 per share in an acquisition. At the time neither we nor anyone we know of anticipated an offer in the near-term; the calculation is a part of our discipline. On January 31, 2013, it was announced Scientific Games Corp. (SGMS) would purchase the company for $26.00 per share in an all-cash bid. We believe this result confirms our process. That is, we estimate an intrinsic value for our holdings, buying when shares trade at a significant discount to that calculation. Thus, even if a transaction occurs below our best estimate, there is still room to profit even when a lower bid is accepted. We sold the stock in response to the bid, in the $24 to $25 range.
Only a handful of our holdings saw negative returns in the first quarter. Construction materials specialist Simpson Manufacturing Co., Inc. (SSD) returned -6.65% as short-term issues obscured the company's normalized earnings power. First, the company made four strategic acquisitions for a cost of roughly $115 million in 2010 and 2011. It did not take on debt in order to fund the takeovers and had more than $150 million in cash on the balance sheet afterwards. These purchases have crimped margins recently, largely due to lower research and development costs. Second, big box retailer Lowe's replaced one of Simpson's products with a lowercost competitor because negotiations over price broke down. We took this as a good signal: Simpson would not slash prices when housing construction remained slow. The housing market is recovering fast, and housing construction is advancing in sync, which we believe will boost Simpson's earnings back toward normalized levels. Also, natural gas exploration company Contango Oil & Gas Co. (MCF) fell -5.36% as the appetite for mergers and acquisitions in the industry lessened. Specifically, Chesapeake Energy Corp. (CHK), a holding in some of our other portfolios, priced a joint venture at prices roughly 35% lower than recent transaction values for similar land. The deal implied low prices for deals across the space, hitting Contango's stock. Many believe the company's sale is imminent, and while it is reasonable to assume it could be, we do not believe management would sell its unencumbered assets on the cheap when they can afford to wait. As patient investors, that is what we would do, and we count their team as fellow travelers.
In the first quarter, we initiated a position in Western Union Co. (WU), a current holding in Ariel Appreciation Fund and Ariel Focus Fund. Western Union is the global leader in money transfer and payment services. With over 500,000 locations that serve 200 countries, the company's scale and network advantages create high barriers to entry and attractive economics. Even though money transfer volumes are recovering from the global recession, the stock trades at a historically low valuation. We view Western Union as an excellent, wide-moat franchise, with meaningful growth prospects, excellent free cash flow generation and sustainable competitive advantages that position it well for an evolutionary shift towards mobile payments. We eliminated our position in WMS Industries Inc. on the good news that Scientific Games Corp. announced its intent to acquire WMS.
As dyed-in-the-wool contrarians, we generally incline toward bullishness when the crowd is bearish and become optimistic when pessimism reigns. That said, we are not knee-jerk reactionaries who merely adopt the less popular stance to be ornery or because we think conventional wisdom is always wrong. Rather, we simply believe that all too often wellmeaning investors follow the recent trend rather than look forward. So we know when markets hit highs coinciding with rampant bullishness, that often signals trouble ahead. Currently, however, that is not our stance. After all, the economy is growing, with GDP well over $15 trillion—up from just $10 trillion in 2000. Plus, since late 2009 we have seen positive GDP growth in each of the past 14 quarters. Most importantly, that broad information confirms what we hear from management teams: they have cleaned up their balance sheets, demand is solid if occasionally volatile, and they seek growth—about which they are optimistic. In many bull runs, the crowd optimistically runs ahead of good economic news; this time it is playing catch-up. For that reason, we remain bullish.
This commentary candidly discusses a number of individual companies. These opinions are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
As of 3/31/13, KKR & Co. L.P. comprised 3.9% of Ariel Fund; WMS Industries Inc. 0.0%; Scientific Games Corp. 0.0%; Simpson Manufacturing Co., Inc. 2.3%; Contango Oil & Gas Co. 2.3%; Chesapeake Energy Corp. 0.0% and Western Union Co. 2.6%. Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of Ariel Fund.
The Russell 2500™ Value Index measures the performance of the small to mid-cap value segment of the U.S. equity universe. It includes those Russell 2500 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000® Value Index measures the performance of the smallcap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.
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