John Rogers' Ariel Funds Third Quarter 2013 Commentary
The third quarter of 2013 goes in the books as yet another strong one. Specifically, the global MSCI ACWI Index showed gains of +8.02%, while in the U.S. the S&P 500 Index rose +5.24%. That brings the year-to-date totals to +14.92% and +19.79%, respectively—a very strong year by any measure. As noted in The Wall Street Journal, quarterly gains have been strong for some time but without being abnormal. For the S&P 500 Index, 14 of the past 18 quarters have had positive returns, and the same is true of the MSCI ACWI Index. Such trajectories are not unusual. For instance, during the 1990s bull market and the 2002-2007 surge, the U.S. market actually had an even higher ratio of rising quarters. Altogether this pattern tells us the flip-side of the "slow recovery" coin has been a nice, long string of solid quarterly stock market gains and an economy that seems neither weak nor overheated. We experienced solid gains this quarter as Ariel Fund rose +8.78%, beating the Russell 2500 Value Index's +6.43% jump, as well as the +7.59% rise of the Russell 2000 Value Index.
Several of our holdings posted strong returns this quarter. Advertising firm Interpublic Group of Cos., Inc. (IPG) surged +18.63% as a competitor's merger provoked optimism. In late July, the American advertiser Omnicom Group Inc. (OMC), which we own in various portfolios, and the French firm Publicis announced a merger of equals. This mega-deal in the advertising world, which puts British giant WPP on notice, shook up the competitive landscape. For one, it seems likely to increase the odds that the relatively small Interpublic Group will become an acquisition target. Moreover, such mergers are generally a sign of strength in an industry, not a bearish signal. So we saw this industry event as a healthy sign for Interpublic, but, of course, we viewed the company's fortunes positively all along. In addition, auctioneer Sotheby's (BID) advanced +29.87% as the market became optimistic that activist investors might unlock value at the company. While we have long admired the business, a backstop to our valuation work has been the company's highly valuable real estate. Recently, a group of activist investors built up a double-digit stake in the company; the prevailing notion was the company might sell its land and lease it back. Others have postulated the company might be better off being private, like its top competitor, given the big cyclical swings in the auction world. We do not endorse any of these possibilities in particular but think the stock was undervalued given its earnings potential over the long-term.
A few of our holdings struggled in the third quarter. Real estate specialist Jones Lang LaSalle Inc. (JLL) fell -4.21% due to an earnings miss. Revenues came in near expectations, at $989 million—an increase of 7% year-over-year—versus the consensus of $995 million. Management suggested the bulk of the earnings miss came from higher-than-expected expenses. Adding to the Wall Street discontent was a lower forecast for the Americas in investment sales activity: growth of 10% to 15% rather than 15% to 20%. We see all these as minor, short-term issues and think the long-term picture is bright. People will always buy and sell corporate real estate, and the trend toward outsourcing real estate management is straightforward and rational. We plan to remain patient. Also, premier department store Nordstrom, Inc. (JWN) returned -5.74% due to slow sales and a scaled-back outlook. Its EPS of $0.93 actually exceeded the $0.88 consensus earnings expectation. Still, management noted the "softer than anticipated" sales trends and lowered its EPS guidance from the $3.65 to the $3.80 range to between $3.60 to $3.70. We strongly agree with management that the phenomenon is cyclical and short-term rather than a long-term issue. The company continues to stand out for its great brand, phenomenal customer service, energetic growth in its Nordstrom Rack stores, and so forth. Long-term we think most department stores are positioned to struggle, but Nordstrom is poised to thrive.
During the quarter, we initiated a position in U.S. Silica Holdings Inc. (SLCA), a supplier of industrial-grade sand to the oil and gas markets. Silica (the technical name for this sand) is critical in the process of hydraulic fracturing, and in our view, mastering the logistics and transportation of this commodity constitutes a durable competitive advantage. We believe the market is underestimating the likely pace of growth in U.S. Silica's revenue and earnings over the next several years (as demand continues to meaningfully increase), as well as the attractive cash flow characteristics of the company's business. We did not eliminate any positions from Ariel Fund this quarter.
At this point, we consider ourselves cautiously optimistic. While equities in the developed world are not especially expensive, the widespread bargainbasement prices from 2009 and even the summer of 2011 are no longer around. Warren Buffett himself has said so. Moreover, we have seen some signs of peak markets. On the September 23, 2013 cover of Time magazine was the Wall Street Bull sporting a party hat and surrounded by confetti—celebrating five years since the 2008 crash. A recent Barron's cover story from September 2, 2013 showed a smiling bull with the headline "The Bull's in Charge." Current television ads showcase couples discussing their financial plans; in many cases they do not fear falling markets but worry about missing out on gains. When it becomes conventional wisdom that a bull market is well-established and the crowd moves from nervous to hopeful, it can counterintuitively be a sign the rally is closer to the end than the beginning. Ultimately, however, as independent thinkers, we must focus on two things. First, we look primarily at fundamental business results, as well as future potential profits, not at sentiment gauges. Second, we are bottom-up investors who focus on individual businesses rather than examine entire economies. When you couple those two perspectives, we remain positive: looking at the limited set of businesses held in our portfolios, we like their stable foundations, as well as their future prospects, especially during the recovery but even if a slowdown occurs.
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 9/30/13, Interpublic Group of Cos., Inc. comprised 3.7% of Ariel Fund; Omnicom Group Inc. 0.0%; Sotheby's 1.8%; Jones Lang LaSalle Inc. 3.5%; Nordstrom, Inc. 0.7% and U.S. Silica Holdings Inc. 1.6%. 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. Russell® is a trademark of Russell Investment Group, which is the source and owner of the Russell Indexes' trademarks, service marks and copyrights.
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