Quarter Ended September 30, 2016
Equity markets shook off the malaise that took hold at the end of the second quarter—remember Brexit?—to post a strong quarter all around. Returns were especially good in domestic small caps and international stocks. While the S&P 500 Index advanced +3.85%; the Russell 2000 Index jumped +9.05%; and the MSCI EAFE Index rose +6.43%. The third quarter was the best period for the MSCI EAFE Index in nearly three years, and the best for the Russell 2000 Index in almost two years. We do not believe much changed to drive this result: we simply think people recognized the economy is sound and interest rates remain low—a good environment for equities. This quarter, Ariel Fund gained +9.77%, ahead of the Russell 2500 Value Index’s +6.18% gain, as well as the +8.87% rise of the Russell 2000 Value Index.
Some of our holdings rose nicely during the quarter. Cutting tools maker Kennametal Inc. (KMT, Financial) jumped +32.19% as its modernization efforts started to gain traction. To a large extent this means more automation, which increases efficiency and slashes costs. The company is also focusing on its more profitable, large customers and shedding smaller ones. We see these moves as an essential part of making its moat wider and better; we think the financial benefits will be significant and long lasting. Also, thermal printer maker Zebra Technologies Corp. (ZBRA, Financial) rose +38.94% due to a strong quarter. After adjusting for a tax benefit, its earnings per share were $1.34, crushing the $1.05 expectation. The company held its flat full year guidance. Wall Street had not previously believed in the company’s turnaround, but is clearly waking up. We think these numbers are just the beginning of the company’s good news.
Other holdings fell back a bit. Jam, peanut butter and coffee company J.M. Smucker Co. (SJM, Financial) retreated -10.64% due to a recent acquisition that has not met expectations. In 2015, the company moved into pet food as a part of its “center of the store” strategy with the purchase of Big Heart Pet Brands. That unit did not deliver the revenues or profits analysts expected. We believe the shortfall is mainly due to pet food cost deflation and a price war from its chief competitors. We think the management team will get things moving in the right direction and are content to own the stock at a cheaper multiple in the meantime. In addition, natural resources firm Contango Oil & Gas Co. (MCF, Financial) dropped -16.50% due to a significant earnings miss. Analysts were expecting the company to lose $0.33 per share, but Contango lost $0.67. Revenues were down significantly versus the previous year, largely due to the slide in the price of oil. Despite the miss, the company has managed to reduce its debt balance to $111 million—a 4% decrease—this year. We think the company is better positioned than most of its peers, and as such believe the stock is positioned to outperform going forward.
In the third quarter, we did not initiate nor eliminate any positions in Ariel Fund.
Looking ahead, we are optimistic. That is, most of our companies have been doing well. Management teams are making rational decisions, revenues and profits look good, and the holdings in need of changes are making them. Plus we think fundamentals, broadly, are sound. True, concerns about valuation are growing, and we agree some areas of the market have questionable valuations. So we have steered clear of those areas as well as specific stocks priced for perfection. In short, we believe our own portfolios are in good shape.
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 9/30/16, Kennametal Inc. constituted 4.1% of Ariel Fund; Zebra Technologies Corp 4.2%; J.M. Smucker Co. 2.3%; and Contango Oil & Gas Co. 1.0%. 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.
