Quarter Ended September 30, 2017
Overall, the third quarter continued the strong performance trend for equities year-to-date. The S&P 500 Index was positive for the eighth consecutive quarter. While the technology, energy, materials, and financials sectors all showed strength over the last three months, consumer sectors lagged. U.S. politics were center stage amid renewed efforts to repeal and replace the Affordable Care Act. Tax reform also dominated headlines, reviving last year’s so- called “Trump Trade,” which drove U.S. banks, industrial companies and small-cap stocks higher. This quarter, Ariel Fund rose +0.76%, lagging behind the Russell 2500 Value Index’s +3.83% rise as well as the +4.74% return of the Russell 2500 Index.
Our position in alternative asset management firm, KKR & Co. L.P. (KKR, Financial) was a top performer in the portfolio, returning +10.26% during the period. KKR reported a significant earnings surprise during the quarter, beating consensus estimates by more than $0.20. The company is one of only a small number of private equity firms that possess both the size and organizational structure to benefit from the continued high level of institutional interest in alternative assets. KKR has an extensive track record of strong, long-term performance, and we expect the company will continue to generate alpha for its clients.
Another stand-out performer in the portfolio was First American Financial Corp. (FAF, Financial), an industry leader in the title insurance and settlement services industry. It gained +12.72% during the quarter. Like KKR, FAF reported better-than-expected earnings for the quarter, as well as continued strength in its residential purchase and commercial business lines. During the period, the company experienced a strong pick-up in purchase volume, which was a positive surprise for investors. With nearly 30% market share and few competitors, First American Financial has distinct scale and relationship advantages in an industry that is becoming increasingly centralized and automated. A historically -depressed real estate environment provided an opportunity to own the stock at levels that reflect current housing demand, rather than at levels that, given a more normalized mortgage origination environment, would reflect the company’s lean cost structure and its resultant earnings power.
On the flip side, we had a few holdings that underperformed. Toy manufacturer, Mattel, Inc. (MAT, Financial) declined -27.44% during the period. Early in the quarter, the company reported disappointing earnings results. While company revenues were in-line with expectations, gross margins were disappointing. Another headwind to the stock was the mid- September announcement that Toys”R”Us was filing for bankruptcy, which sent shockwaves through the toy market. In our opinion, Toys”R”Us’ bankruptcy will have little long-term impact on Mattel. Toys“R”Us represents approximately 11% of Mattel’s total sales. In the short-term, the impact should be reflected in fourth quarter sales for Mattel, but those numbers will probably result from softness across the board, not from Toys“R”Us specifically. Likewise, we have strong conviction that the company’s global reach and proven consistency makes it the licensee of choice for brand owners seeking a toy-manufacturing partner.
Also detracting from performance was advertising agency, Interpublic Group of Cos., Inc. (IPG, Financial), which fell -14.72% during the period. In the second quarter, the company had reported disappointing earnings and revenue due to consumer products companies pulling back on advertising spending, and also to rising concerns that the future advertising spend will be meaningfully less than it was historically. Additionally, investors continue to be focused on potential issues surrounding advertising agencies’ lack of transparency and their failure to act in the best interest of their clients. This has potentially occurred in the form of rebates to ad agencies; upselling media inventory the agencies already own and bid rigging around video production. The concern around rebates has quieted down over the past few quarters. However, the discussion of potential issues of advertising agencies overcharging clients for media and bid rigging claims has strained the relationships between some advertising agencies and clients. These issues could lead to account reviews and pressure on fees. During IPG’s turnaround, the company was under intense pressure to be transparent with its clients and to clearly act in their best interests. Thus, we feel IPG is better positioned than its larger competitors to weather these concerns.
During the third quarter, we did not add any new positions or eliminate any existing positions.
We continue to be cautiously optimistic about the economy. We believe that company CEOs are generally optimistic about the future of the economy, particularly within small companies. While current valuations have compressed somewhat recently, we believe they remain elevated on an absolute basis. As of September month end, the S&P 500 traded at 18.4X forward earnings and the Russell 2500 traded at 18.9X forward earnings. While these figures are above average, in our view, they are still well-below dangerous levels. We continue to be disciplined in our approach and are confident in our portfolio positioning, which remains at a discount relative to the indexes.
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.
