John Rogers' Ariel Fund and Ariel Appreciate Fund Portfolio Manager Letter
The Fed Factor
On the heels of remarkable market strength in the first quarter, the second quarter witnessed the return of market volatility—largely propelled by incessant Fed watching as investors sought to discern Federal Reserve Chairman Ben Bernanke's views on the economy and ultimately his ongoing effort to spur growth by suppressing interest rates. Herein lies a unique conundrum—if the Fed deemed U.S. growth as sufficient to sustain a recovery (which would be good news), continued quantitative easing would be unnecessary (which many deem as bad news). As Barron's recently noted, "Never have financial markets been so fixated and dependent on monetary policies…"1
Bernanke sought to assuage concerns by telegraphing the Fed's intent to eventually "taper" the bond-buying with an eye toward ending the program when U.S. unemployment hits 6.5%. Although well-intentioned, his words were initially received with widespread concern—and the market sold off in reaction. While not surprising, the stocks most negatively impacted in our value portfolios were financial names deemed by others to be interest rate sensitive. As such, boutique investment bank Lazard Ltd (NYSE:LAZ) fell -5.08%, mortgage servicer First American Financial Corp. (NYSE:FAF) lost -13.35% and mutual fund company Janus Capital Group Inc. (NYSE:JNS) gave back -8.76%. While we carefully considered the near-term market dynamics pressuring each name, our ongoing research ultimately reconfirmed our long-term investment thesis in all cases. With Lazard, we are able to look beyond the negatively-impacted emerging markets stocks held by the firm's investment management business. We like the enduring economics of money management and treat this meaningful profit contributor as icing on the cake of the company's diversified investment banking operation. Rising mortgage rates drove down First American Financial's stock price as Wall Street investors feared an end to the refinancing boom. Over the near-term, we anticipate downward earnings revisions as refinancings come to a halt rather quickly and new home sales take time to ramp up. But looking further out, we know title insurance policies on new home purchases are twice as profitable as refinancings which will drive earnings at First American. Not to mention, with the stock trading at just 10x consensus earnings, our bullishness is only magnified by the stock's incredibly cheap valuation. Lastly, Janus—whose ongoing challenges have tested even our patience—represents the most contrarian name in our entire portfolio as measured by the large number of Wall Street analysts who have a sell rating on the stock. An undesirable trifecta of weak investment results, the negative impact from performance-based fees and net outflows largely isolated to three of its well-known mutual funds have created a perfect storm for this $162 billion asset manager. In our view, the bad news is more than priced in. By our calculation, performance fees have bottomed. Moreover, the company's balance sheet continues to strengthen and outflows should stabilize once returns improve.
Extra, extra—read all about it
In contrast to our financial names, one of our best performers during the quarter was a name many challenged in the not-so-distant past. As many know, although our media names fall squarely within our circle of competence as evidenced by our deep expertise in the industry, they represented some of our poorest performing and most controversial holdings during the worst of the financial crisis. During that tough period, we re-examined every position with a fresh perspective that required us to consider each stock from a lens of having never owned it. In the case of Gannett Co., Inc. (NYSE:GCI), despite its underperformance, we still saw tremendous value and, true to our contrarian leanings, doubled and tripled down on the holding as the price became more and more attractive—making the stock one of our largest positions. It is important to note, after taking some lumps, we eliminated other media names whose brands and franchises did not appear to be nearly as compelling over the long-term.
On June 13th, Gannett agreed to acquire Belo Corporation (NYSE:BLC) and its 20 television stations that reach more than 14 percent of U.S. television households in a $2.2 billion transaction. The New York Times dubbed it, "…the biggest local television station sale in more than a decade."2 The acquisition will nearly double Gannett's broadcast properties (from 23 to 43) and create the fourth-largest owner of major network affiliates reaching nearly one-third of all U.S. television households. Gannett will have 21 stations in the top 25 markets and will become the second largest owner of network-affiliated television stations. While normally skeptical and wary of acquisitions, we immediately saw the value of this transaction and future possibilities for Gannett Investors also applauded the deal as evidenced by the fact that Gannett's stock closed +34% higher on the day of the announcement while Belo shares increased +28%. The reason being, Belo will not only accelerate Gannett's transformation into a diversified media company with higher profitability and returns—it will also give Gannett more leverage when negotiating the valuable retransmission fees local television stations receive from cable and satellite operators in exchange for the right to carry those stations on their systems. Size matters when seeking higher retransmission fees with cable and satellite distributors and also when bargaining with the broadcast networks for their cut of that revenue. Retransmission revenues create a dual revenue stream for Gannett, similar to cable networks, while reducing cyclicality from what has historically been an advertising-only business model. And whereas advertising can be hard to forecast, contractual agreements make retransmission revenues predictable and sticky. Moreover, we anticipate a meaningful increase in these revenues once broadcast network compensation becomes more aligned with their ratings.
Despite primetime viewership declines, television still remains the most effective mass advertising platform precisely because it reaches so many people at once. In fact, broadcast television’s significantly larger primetime ratings and greater household coverage give it a distinct advantage over cable. Even though the number of adults under 24 who regularly watch television has declined, adults 65 and older continue to watch. Bernstein Research estimates that adults 65 and over watch 8 hours of television a day, twice as much as adults aged 18-24.
While acknowledging the inherent structural issues in print media, we welcome Gannett’s multimedia diversification through strategic investments and acquisitions. In publishing, Gannett is succeeding in converting its customers from print to a digital platform with an all-access content subscription model that has been a significant driver of recent revenue stability. It is worth noting that the company’s digital platforms attract 54.6 million unique users each month. Meanwhile, broadcast trends remain encouraging. Strong local advertising—specifically from auto dealers, increasing political campaign expenditures and accelerating retransmission revenues—have propelled the company’s strong operating performance. Finally, CareerBuilder’s future looks promising (Gannett owns 52.9%) as labor markets improve and it continues to gain market share from competitors. Gannett CEO Gracia Martore has also proven to be a visionary leader, patient investor and strong capital allocator. To the latter point, she aggressively strengthened the balance sheet by substantially reducing debt before allocating capital to share buybacks, dividends and strategic acquisitions.
Even though we still like small town community newspapers—last week, Warren Buffett purchased his 30th community paper since November 2011—we think Gannett’s real value lies in its ongoing evolution. Given the stock’s recent performance, Wall Street seems to agree.
Portfolio Comings and Goings
During the quarter, we initiated one position and exited two positions in Ariel Fund. We added MTS Systems Corp. (MTSC), which specializes in physical testing equipment. It occupies a key, important niche for manufacturing firms that are doing more and more virtual testing. In our view, companies are unlikely to abandon real-world physical tests; that stance is a contrarian one in a world where many believe virtual testing will eventually completely take over. In addition to significant potential growth, it boasts good operating margins, a sturdy balance sheet, and remains a very trusted brand. We sold Life Technologies Corp. (LIFE) on the news that Thermo Fisher Scientific Inc. (NYSE:TMO) had signed a definitive agreement to acquire it for $76 per share. We also liquidated the position in Zimmer Holdings, Inc. (ZMH) in order to pursue more compelling opportunities.
During the quarter, we did not purchase any new securities and exited two positions in Ariel Appreciation Fund. We eliminated Accenture plc (NYSE:ACN) when it reached a full valuation based on similarly full expectations. We also sold Life Technologies Corp. (LIFE).
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 Barron’s, June 17, 2013, page 7.
2 The New York Times, June 14, 2013, page B1.
Investing in small and mid-cap stocks is more risky and more volatile than investing in large cap stocks. Ariel Fund and Ariel Appreciation Fund concentrate a significant portion of their assets in the financial services and consumer discretionary sectors and their performance may suffer if these sectors underperform the overall stock market.
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 letter is not reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell a particular security. 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, Ariel Appreciation Fund or of the performance of the Funds. Click here for the most recent holdings for Ariel Fund and Ariel Appreciation Fund.
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