John Rogers' Ariel Investments Monthly Commentary - November

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Dec 12, 2013
During the long 2002-2007 bull market, and especially in its final months, we received many questions and plenty of suggestions regarding our stance on energy stocks. As you know, energy stocks and commodities were red-hot during much of that cyclical, relatively low-quality stock surge, and we had little exposure to the area in our domestic stock portfolios. For a long time, we held a belief that energy companies were largely dependent on natural resource prices—which makes it difficult to build and defend the durable competitive advantage we seek. Besides, with the prices of those commodities and stocks so rich, there was not much value at hand. It is worth noting that as commodities became inflated, we spent an enormous amount of time studying the sector and its effect on our holdings.

Fast forward to 2013 and we have a number of energy companies in our portfolios. This is true because we shifted our perspective as well as our expertise. Indeed, our view on the space evolved as we started to discover potential opportunities that we can describe in two categories. First, we now think some energy companies can overcome their direct exposure to energy commodities through differentiated business models. Second, we believe some energy-related enterprises’ cash flows are far less volatile than natural resource prices. After we began finding opportunities, we also hired Anthony Walker, a research analyst with deep expertise in the energy sector. Now, among our domestic portfolios, we own a dozen energy and energy-related companies.

As above, the first category of holdings in this group are energy companies that have business models that we believe give them an advantage over peers and insulate them from price fluctuations. The most straightforward such example is Contango Oil & Gas Co. (MCF, Financial), which we own in our traditional mid-cap, small-to-mid cap, and small-cap portfolios, as well as in our deep value small cap portfolios. When we first purchased it in 2011, it focused exclusively on shallow-water Gulf of Mexico exploration and production, had an amazingly low-cost operation, virtually no debt, and thus very high cash flow. It was also quite disciplined in drilling only high opportunity locations. Since then the company has unfortunately seen its CEO and Founder, Ken Peak, depart for health reasons and later die. Moreover, it undertook a transformational acquisition, purchasing Crimson Exploration, which had become financially distressed. Its opportunities have now multiplied. And while its leverage has increased somewhat, the company continues to boast relatively low costs, minimal debt, and disciplined exploration. Across our domestic equity portfolios, we own several other companies whose profiles fit this mold. In our micro-cap and small-cap deep value portfolios, we own: Mitcham Industries, Inc. (MIND, Financial), a seismic exploration specialist; Bolt Technology Corp. (BOLT, Financial), a global leader in marine geophysical equipment; and Gulf Island Fabrication, Inc. (GIFI), which makes offshore drilling and production platforms and similar structures. Mitcham is also held in our traditional small cap value portfolio. In our focused all-cap portfolios, we own: Exxon Mobil Corp. (XOM), a very large and diversified integrated oil and gas company; Apache Corp. (APA, Financial), a traditional exploration and production company; and Chesapeake Energy Corp. (CHK, Financial), a natural gas specialist.

The second category of holdings do not appear in the energy sector in our reports, but we think they are very clearly energy-related entities. We will briefly describe two of these holdings, since they can be quite different from each other. First comes Bristow Group Inc. (BRS, Financial), which provides helicopter services to offshore energy rigs, and is a holding in our traditional mid-cap, small-to-mid cap, and small-cap portfolios. Although energy exploration and production can clearly fluctuate, Bristow offsets those shifts through long-term contracts lasting roughly three to five years. Furthermore, Bristow receives “monthly standing charges”—meaning it gets paid whether its helicopters fly or not—amounting to 70% of its operating income. Second is U.S. Silica Holdings Inc. (SLCA, Financial), which provides silica—industrial grade sand—chiefly to energy companies; we own it in Ariel Fund as well as our small cap separate account. When many look quickly at the company, they see a straightforward supplier of a pure commodity product, which therefore has no barrier to entry from competition. We believe, on the other hand, that Silica has a substantial competitive advantage due to its top-notch distribution network and its low costs. Two thirds of its customers are oil and gas producers and another third are industrial companies. In both cases, Silica’s customers need continual supplies of industrial sand or else they must idle their operations, costing a significant amount of time and money. In addition, Silica has 75% of its volume under contract, with an average weighted contract life of two years. In our view, Silica’s customers are highly unlikely to simply switch providers based on price. We have three other such holdings. We own two specialists in high-temperature and high-pressure pipe maintenance. In the deep value portfolios, we own Furmanite Corp. (FRM, Financial), and in both our traditional and deep value small-cap portfolios we own Team Inc. (TISI, Financial). Finally, in our focused all-cap portfolios we own National Oilwell Varco (NOV, Financial), which supplies equipment and components for oil and gas drilling.

Altogether, we think this narrative falls right in line with our long-standing investment culture. First and foremost, we are patient: we will wait months or years for potential opportunities to surface with attractive prices—and then we are happy to buy and hold them for a long time. Second, we are focused on companies we believe possess durable competitive advantages. Finally, and most importantly, we are independent thinkers. We avoid following the crowd and refuse to simply take conventional wisdom for granted (as in “$200 oil!!”). And we are constantly thinking over our old assumptions and views. That is, when we realize possibilities may exist for us where we did not find them before, we will work extraordinarily hard in order to identify them, understand them, and, potentially, invest in them on behalf of our valued clients. In other words, our learning culture mitigates the rigid thinking that may have kept us out of the sector based on past perceptions.



The opinions expressed 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.

This commentary discusses certain individual securities, which at the time it was written were held in certain portfolios Ariel manages. Portfolio holdings are subject to change. See current holdings information for Ariel’s portfolios at www.arielinvestments.com by clicking on a portfolio’s “Holdings” tab. The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients. It should not be assumed that investments in the securities identified, described and discussed were or will be profitable.

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