Entering the fourth quarter of 2016, it appeared domestic stocks would have a solid year and international equities a lackluster, yet positive one. After a divergent quarter, we had a great year in the U.S. and a flat year abroad. For 2016, the large-cap S&P 500 Index gained +11.96%, the small-cap Russell 2000 Index leapt +21.31%, while the developed-market MSCI EAFE Index eked out a +1.00% gain. As many know, the big surge after the surprising U.S. Presidential Election became known as the “Trump Bump.” The disparity between large-caps’ single digit fourth quarter gains and small-caps’ big run stems from the President-Elect’s plan to slash corporate taxes. Perhaps more importantly, however, the gains suggest optimism the economic expansion will continue. Globally, pessimism has held sway for some time. Since a July 3, 2014 peak, the MSCI EAFE Index is down -9.23% cumulatively through December 31, 2016. This index is clearly in a bear market: down for two and a half years and at one point off -22.15% cumulatively. This quarter, Ariel Fund gained +7.75%, behind the Russell 2500 Value Index’s +9.34% gain but ahead of the +6.12% rise of the Russell 2500 Index.
Some holdings in the portfolio advanced considerably. Helicopter transportation company Bristow Group Inc. (BRS, Financial) ascended +46.83% after recently secured financing put Wall Street at ease. The Street had worried the company would become financially distressed like a top competitor given the oil industry’s woes. Instead, Bristow arranged $300 million in debt, secured by a portion of its own helicopter fleet. In addition, oil rose during the year and the quarter, giving the stock a mild boost as well. We think its shares are undervalued given the company’s significant assets and depressed earnings. In addition, asset-tracking specialist Zebra Technologies Corp. (ZBRA, Financial) jumped +23.20% on solid quarterly results and guidance. Its non -GAAP earnings per share were $1.43, ahead of the $1.41 consensus due to improved profitability. Management forecasted profits would keep improving. Two years ago this thermal-printing company acquired Motorola’s enterprise business, and the integration was rocky; now the acquisition is paying off and fundamentals are smooth.
Other holdings underperformed. Scientific research firm Charles River Laboratories Intl, Inc. (CRL, Financial) slid –8.58% due to contracting customer spending and a general downturn in health care stocks. Like other similar firms, Charles River expanded over the last 15 years to be able to handle peak medical research, but as drug companies scaled back, there was clearly overcapacity. The company’s drug discovery business is still a bit slack. That said, many health care stocks slid this quarter during a huge rotation to financials. We think the current issues are largely cyclical but the secular push toward solving medical problems through pharmaceuticals remains intact—a long-term tailwind for Charles River. Also, real estate company JLL (JLL, Financial) declined –10.89% on disappointing earnings. In early November the company reported quarterly earnings of $1.42, significantly below consensus of $2.00. Revenues were strong, but the impact of an acquisition, higher technology spending, a decline in incentive fees, and a significant write-down of receivables all hurt the bottom line. We think the quarter featured a rare confluence of one-time factors. To our minds, the long-term value of one of the top two global real estate players remains stable.
In the last quarter of the year, we added one new position in Ariel Fund. We purchased Keysight Technologies, Inc. (KEYS, Financial), a leading test and measurement business for electronics. The company’s long history dates back to its formation as the measurement business of Hewlett - Packard (HPE, Financial), which has resulted in deeply rooted relationships, leading market share, and a seat at the table during the development of new technologies. Recently spun-off from Agilent Technologies, Inc. (A, Financial), investors are discarding the shares due to a perceived lack of near-term growth prospects. We see this as an attractive long-term opportunity to own a niche market leader with excellent free cash flow generation. We think it is well-positioned to benefit from several longer-term tailwinds, including 5G wireless testing and growing demand for modular solutions, software-based testing and recurring services. We did not exit any positions during the quarter.
For the fourth year running, we enter a new year with largely the same view of domestic equities. The U.S. economy continues to make progress, and while growth is not as fast as some want, we remain content given our “slow and steady” philosophy. Full employment, modest inflation and low interest rates provide a good environment for growth but are unlikely to drive an overheated economy. And yet, we will be the first to admit, valuations are toward the higher end of normal, with the S&P 500 Index trading at more than 17.5x forward earnings. As a result, the international markets appear more intriguing given widespread concerns over rising international tension, Brexit, sovereign debt, and so forth. The MSCI EAFE Index trades cheaper than its U.S. counterpart, at just 15x forward earnings. Against this backdrop, we believe 2017 will be good for savvy active managers given reasonable growth but modestly elevated valuations.
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 12/31/16, Bristow Group Inc. constituted 2.7% of Ariel Fund; Zebra Technologies Corp 4.7%; Charles River Laboratories Intl, Inc. 2.6%; JLL 3.2%; Keysight Technologies, Inc. 1.9%; Hewlett-Packard 0.0%; and Agilent Technologies, Inc. 0.0%. 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.
