All major indices closed out the third quarter at a loss, marking the first time Wall Street posted three consecutive quarters of declines since the aftermath of the global financial crisis. Persistently high inflation, escalating geopolitical tensions in Russia/Ukraine, energy-price shocks and aggressive central-bank tightening have weighed on consumer and business confidence. Recession watch has taken hold as many investors fear a Fed-induced hard landing. While Wall Street sits on edge and markets remain erratic, we are actively leaning into the moment by judiciously acquiring the downtrodden shares of quality companies whose value we believe should be realized over the long term. Against this backdrop, Ariel Fund traded -7.47% lower in the quarter, trailing the Russell 2500 Value Index’s loss of -4.50% and the -2.82% return of the Russell 2500 Index.
Leading provider of automated security solutions ADT, Inc. (ADT, Financial) advanced in the period. This quarter’s financial results continue to show that last year’s elevated investment in customer acquisition is paying off. Revenue and EBITDA came in ahead of consensus, and the company reported positive adjusted net income for the first time since its initial public offering. Additionally, the company announced another strategic partnership, this time with State Farm, the nation’s largest insurer. Longer term, we believe ADT’s industry-leading brand and national presence, coupled with these nascent partnerships with Google and State Farm, position it to be a prime beneficiary of growing demand for smart home technologies, including fully monitored residential security.
Regional banking services provider BOK Financial Corporation (BOKF, Financial) also traded higher, as reflation theme sin the marketplace raised interest rate expectations, boosting positive net-interest-margin trends. Additionally, the company continued to report solid loan growth along with tight expense controls, providing a tailwind for shares. Looking ahead, we believe BOKF’s strong underwriting standards, diversified business model (which includes banking and fee service businesses), and experienced management team continue to present a long-term opportunity.
Additionally, professional football club operator Manchester United Plc. (MANU, Financial) traded up on headlines that the Glazer Family is open to a full or partial sale of their stake. This iconic football club sports a global following north of 1 billion fans and plays in the English Premier League (EPL), the most watched professional sports league in the world. We expect MANU to continue to leverage its global brand to drive a larger revenue base enabling the acquisition of top talent to field competitive teams. We also believe MANU’s commercial opportunity for global partnerships, sponsorships and media rights remains robust. We view the near- and long-term outlook for MANU to be attractive.
Alternatively, leading manufacturer and distributor of floor covering products Mohawk Industries Inc. (MHK, Financial) detracted from relative returns in the quarter. MHK has consistently demonstrated its ability to deliver sales growth and generate strong cash flow despite significant inflation, rising interest rates, and geopolitical instability. However, this quarter was an inflection point as the slowing U.S. housing market began to change consumer discretionary spend. Higher natural gas prices and constrained supply in Europe presented another headwind. Given these factors, MHK guided to softening demand and increasing pressure on margins moving forward. Management initiated corrective actions across the enterprise including implementing further price increases, enhancing service levels and restructuring to reduce costs. In our view, MHK’s track record of success managing through economic cycles and healthy balance sheet have the company well-positioned to benefit from long-term growth in residential remodeling, new home construction and commercial projects. At current levels, MHK is trading at a -67% discount to our estimate of private market value.
Leading entertainment company Paramount Global (PARA, Financial) also traded lower on mixed earnings results. Strength in filmed entertainment and market share gains in streaming were partially offset by weakness in linear television. PARA’s decision to suspend services in Russia also negatively impacted earnings growth. Nonetheless, the company continues to display strong business fundamentals. PARA’s fresh array of global content is driving subscriber momentum worldwide across its direct-to-consumer platform with global subscriptions reaching nearly 64 million active users. Additionally, CBS was ranked the #1 network for the 20th consecutive quarter and Paramount Pictures opened five #1 films in a row, with Top Gun Maverick grossing over $1.3 billion to date. At today’s valuation, we believe PARA’s risk/reward is skewed sharply to the upside.
Shares of premiere oil services company Core Laboratories NV (CLB, Financial) also underperformed in the quarter. The ongoing geopolitical conflict between Russia and Ukraine as well as associated European and U.S. sanctions continue to disrupt the business and create near-term uncertainty. Although headwinds persist, we believe the industry will realign global supply to meet strong demand for oil and natural gas. In our view, this asset light business will deliver modest growth in reservoir description. We also expect to see greater activity in fracturing rock, which should increase output in well completions and fuel longer term growth of the production enhancement sector. We have conviction in the management team’s long history of delivering strong operating results and robust free cash flow and returning capital to shareholders.
We initiated two new positions in the quarter. We purchased locally headquartered alternative asset manager GCM Grosvenor Inc. (GCMG, Financial). With its over 50-year history,GCM Grosvenor is a pioneer of fund-of-funds investing and provides clients with customized multi-manager portfolios or portfolios of direct investments and co-investments. The company differentiates itself by focusing on middle market and small and emerging investments where it believes it adds the most value for clients. Grosvenor’s competitive advantages also include its long history and expertise in managing across multiple alternative classes, its leadership in ESG and impact investment strategies, its track record of solid performance, and operational scale. The company has the potential to increase its market share, especially through its ESG and Impact strategies, and improve on its economics as it expands globally and gains new business through its secondary, co-investments and direct investments platforms.
We also bought shares of former position Generac Holdings, Inc. (GNRC, Financial), a leading global manufacturer of power generation equipment. The company has an unmatched distribution network and product portfolio and enjoys strong brand advantages. We believe this creates a wide moat for this niche business which commands a 75% market share in the North American residential market. Historically, growth has been limited due to a lack of awareness around the benefits of having a home standby generator, as well as its high price point. More recently, however, elevated power outage events, both weather-related and due to aging infrastructure, have tipped the scales of awareness in both the residential and commercial markets, which should result in a long-runway of market penetration-led growth, margin expansion and free cash flow generation. The stock was a pandemic darling but has since traded off substantially giving us an opportunity to acquire shares in this unique, high-quality business.
On the sell side, we exited our successful investment in leading electronic test and measurement business Keysight Technologies, Inc. (KEYS, Financial) on improved valuation to fund newinvestment opportunities.
Escalating geopolitical tensions, persistently high inflation, slowing economic growth and the potential for excessive Fed tightening continue to fuel recessionary fears. And yet, we view the probability of the most severe “hard landing,” or deep recession, to be less likely. Unemployment remains near historic lows and balance sheets of U.S. financial institutions and households are generally in good shape. We continue to be cautiously optimistic these factors will protect against a severe downtown. Meanwhile, values are abundant when the investment environment feels the most uncomfortable. With 39 years of experience, we are trained and battle-tested for these moments. We believe bear markets and oversold stocks create ripe buying opportunities for long-term, patient investors. We are diligently evaluating the collapsing prices of stocks on our watchlist versus our expectations of what these companies and their underlying business fundamentals should be valued at over the long-term. In times like these, we believe the worst-case scenario gets priced in giving us a margin of safety1 to buy and hold our favorite companies with confidence through the uncertainty until the market digests the volatility. Although our portfolios have sold off in recent months, in our view they are statistically cheap—trading at a significant discount to their private market values (PMV)2— or what some call intrinsic worth. In the past, portfolio dislocations of this magnitude have often served as a prelude to our most robust recoveries.
1Attempting to purchase a stock with a margin of safety does not protect investors from the loss of their investment, volatility associated with stocks, declining fundamentals, external forces, or our incorrect assumptions.
2Discount to Private Market Value ("PMV") represents the percentage discount at which the portfolio traded as compared to the portfolio holdings' PMV as determined by Ariel Investments. References to PMV are the time period: 12/31/07 – 09/30/22.
Performance data quoted represents past performance. Past performance does not guarantee future results. All performance assumes the reinvestment of dividends and capital gains, and represents returns of the Investor Class shares. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Performance data current to the most recent month-end for Ariel Fund may be obtained by visiting our website, arielinvestments.com. For the period ended September 30, 2022 the average annual returns of Ariel Fund (investor class) for the 1-, 5-, and 10-year periods were -25.05%, +3.80%, and +9.14%, respectively.
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.
