Quarter Ended December 31, 2017
Many anticipated 2017 to be a sideways market, with the overall level of major indexes little changed by year end. Now with 2017 in the rear view mirror and a strong fourth quarter topping off a stellar twelve month run for equities, the bull market seems to have room to still run. Led by technology stocks, the large-cap S&P 500 Index surged +21.83% for the year, the small-cap Russell 2000 Index leapt +14.65% and the global MSCI EAFE Index advanced +25.03%. Strong corporate earnings, healthy economic growth and U.S. tax reform overcame escalating geopolitical tensions, devastating natural disasters, Washington gridlock, tighter monetary policy and burgeoning inflation. For the quarter, Ariel Fund advanced +7.87% during the quarter, substantially ahead of the gains delivered by the Russell 2500 Value Index and Russell 2500 Index, which earned +4.25% and +5.24%, respectively.
The positive results for Ariel Fund were largely driven by strong stock selection within the financial services sector, contributing +261 basis points to relative returns. Real estate expert JLL (JLL) was the top performer within the sector, delivering +20.89% gain for the quarter, on solid earnings, highlighted by organic growth, margin improvement, 20% reduction in net debt from the prior quarter and the announcement of a 13% increase in its annual dividend due to improved cash flow.
Looking broadly at our portfolio, helicopter operator Bristow Group, Inc. (BRS) was the best performing name, surging +44.06% during the quarter amidst a better than expected earnings report and increased fiscal 2018 guidance. Notable announcements included cost recoveries, capex deferrals, the sale of Bristow Academy and the issuance of a convertible senior notes offering. Management retains a cautious outlook as the offshore downturn has continued in spite of stabilizing oil prices. Overall, we believe the shares are undervalued and with the liquidity overhang satisfied, the company can now shift its focus to operating the business for long term success.
Another top contributor was specialty cutting tool insert maker Kennametal Inc. (KMT, Financial), advancing +20.55% on strong earnings driven by improved sales execution, cost reductions and increased productivity. New CEO Chris Rossi also delivered a well received 3-year strategic plan outlining further opportunities for margin improvement. We continue to believe Kennametal remains underpriced relative to its intrinsic value.
Alternatively, our limited exposure within the technology and energy sectors was a headwind. Within technology, weakness at distributor of enterprise electrical products, Anixter Intl, Inc. (AXE, Financial) impacted performance. Shares fell -10.59% due to concerns regarding the expanding industrial distribution offerings at Amazon.com, Inc. (AMZN, Financial). Despite the market’s recent focus, Amazon Business has been growing steadily since 2012. Most of the revenues for Anixter originate from projects. While price competition shrinks margins, the services performed are far from expendable, creating a layer of costs and expertise that Amazon would find difficult to replicate or improve upon. The projects themselves reach the distributors through powerful independent representatives, which creates more barriers to entry. In sum, we believe the Amazon announcement does not represent a substantive change in its narrative or Anixter’s business, but rather an increase in market attention given to these topics. We also think Anixter is poised to deliver strong earnings in 2018, as the company is likely to be a prime beneficiary of structural tax reform.
Nielsen Holdings, plc (NLSN, Financial) also underperformed during the quarter, declining -11.35% after announcing a negative guidance revision for the legacy Developed Buy business. Unsurprisingly, Nielsen cited continued challenges in the U.S. consumer goods environment. In the meantime, we view the core Watch business as solid, expect the new subscription analytics platform to eventually stabilize the Buy business in developed markets and find growth in emerging economies to be promising. At today’s valuation, the Watch business appears underappreciated and a turnaround in the Buy business is likely a free call option. At 14.1x cash EPS and a 35% discount to our estimate of private market value, the stock is trading at historical lows on both an EBITDA and free cash flow basis. We think the margin of safety1 at these levels is more than sufficient and are adding to our position on weakness.
Bar code manufacturer, Zebra Technologies Corp. (ZBRA, Financial) weighed on quarterly performance as well, trading down -4.40%. We believe the recent price decline runs counter to the company’s strong underlying business fundamentals. Moreover, we consider Zebra’s inventory tracking solution to be best in class and well positioned for growing global demand across retail, logistics and healthcare. At 14.2x forward cash EPS and a 21% discount to our estimate of private market value, we continue to think shares are undervalued.
We did not purchase any new holdings in Ariel Fund during the quarter, but we did exit our position in Graham Holdings Co. (GHC, Financial) as the stock price fully reflected our long-standing view of the sum of its parts. Since our initial purchase over 7 years ago, the company has successfully monetized several of its businesses, including The Washington Post, Cable ONE, broadcast television stations and most recently Kaplan Education. Including the spin-off of Cable ONE in 2015, our investment has generated an impressive +176% total return over our holding period.
Despite strong gains in 2017, we remain cautiously optimistic that the healthy pace of economic growth and a much lower corporate tax rate will boost earnings for many of our domestic holdings. And yet, with the S&P 500 Index trading at 19.4x forward earnings and the Russell 2500 Index trading at 19.6x forward earnings, we acknowledge valuations are getting frothy, but still remain well-below euphoric levels. Given our “slow and steady” approach, we are confident in our portfolio positioning, especially with our portfolios trading at a discount relative to the indices. Likewise, we continue to be intrigued by the international markets, given low levels of inflation in developed countries and the gradual normalization of monetary policy. At 15.6x forward earnings, the MSCI EAFE Index trades at a discount relative to its U.S. counterpart, offering a positive backdrop for savvy active managers.
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.
1Attempting to purchase with a margin of safety on price cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimations on our part, declining fundamentals or external forces.
