Quarter Ended June 30, 2017
It was another strong quarter for equities, one that was largely void of any major macroeconomic developments. First quarter earnings reported for the S&P 500 Index were up +15% year-over -year. Even more impressively, 78% of S&P 500 companies beat consensus EPS estimates. Additionally, last quarter’s revenue results had the biggest surprise to the upside since the fourth quarter of 2014. That said, Russell 2000 Index earnings were largely flat quarter-over-quarter. Overall earnings growth expectations for small-cap stocks have declined as valuations, particularly within financials, appear stretched. This quarter, Ariel Appreciation Fund rose +0.73%, trailing the Russell Midcap Value Index’s +1.37% rise as well as the +2.70% return of the Russell Midcap Index.
During the quarter, stocks in the portfolio performed quite well. Title insurer, First American Financial Corp. (FAF, Financial) gained +14.67% after beating EPS consensus estimates by $0.10. Better-than-expected commercial revenues and a material lowering of the loss provision rate helped the company grow revenue by 10% versus the same period one year ago. The firm has faced several headwinds due to the sluggish U.S. housing market, but there are notable signs of improvement for spring selling season which should benefit FAF. We remain confident the stock still has upside as the U.S. housing market resumes its gradual recovery.
Another strong contributor to performance was Northern Trust Corp. (NTRS, Financial), up +12.77% in the second quarter. The stock price was buoyed by improving net interest margins and a favorable rate environment. In the first quarter of this year, the firm’s total assets under management hit the $1 trillion mark for the first time, largely due to a +13% increase over the last 12 months in its wealth management segment as well as an +11% increase in its larger corporate and institutional services arm. The bank should continue to feel a tailwind from a more constructive rate environment going forward. It operates in a favorable industry with a diversified product offering and high barriers to entry. Moreover, throughout the tumultuous last economic downturn and current recovery, Northern has proven the quality of its franchise and the value of its conservative operating approach. We continue to find the stock attractive at these levels.
Some other holdings in the portfolio underperformed. Helicopter transport company supplier Bristow Group Inc. (BRS, Financial) declined -49.19% as continued oil price weakness and disappointing earnings weighed heavily on the stock. The company’s management team lowered guidance around profitability and accelerated necessary cost cutting. Despite this short-term weakness, management reiterated that it expected to see stronger results in the second half of the fiscal year as recent contract wins come online. Management also reaffirmed the firm’s commitment to maintaining total liquidity over $200 million, highlighting the successful renegotiation of the company’s short-term debt obligations late last year. We expect to see continued short-term volatility in the company’s quarterly earnings reports. While we recognize the company faces several headwinds, we do not believe it is facing any significant risk of insolvency. Continued weakness in the energy market will be a headwind to the company short-term. However, we believe the value of the helicopters that Bristow owns creates a potential margin of safety1, as the company’s assets exceed its current stock price.
Also detracting from performance was multinational media conglomerate Viacom, Inc. (VIAB, Financial), which saw its shares fall -27.59% during the period. The company reported adjusted EPS of $0.79 vs. consensus of $0.59, with revenues up +8% year-over-year. Despite the positive news, investors remain wary of the company’s ability to execute its strategic plan, as changing media consumption patterns and technology create more general concerns about the cable business model. Nevertheless, Viacom is the owner of valuable content including children’s programming and comedy, and a leading movie production franchise with more than 3,300 motion pictures in its library. Despite critics’ arguments that fundamentals will remain negative at those media network companies serving kids and teens and at those lacking live sports programming, we believe Viacom’s content will provide attractive economics regardless of the distribution medium.
We purchased one new position in Ariel Appreciation Fund in the second quarter of the year, and eliminated two others. We added U.S. Silica Holdings, Inc. (SLCA, Financial), a niche supplier of sand to the oil and gas market, primarily servicing the process of hydraulic fracturing. The company is the second-largest producer of silica in the United States and boasts a differentiated logistics and transportation network that makes it a key and preferred supplier among its customer base. In our view, the market underappreciates the strength of the company’s competitive position, the likely pace of its revenue and earnings as demand for sand continues to meaningfully increase, and the attractive cash flow characteristics of its business. We exited two of our consumer names during the quarter, Tiffany & Co. (TIF) and TEGNA, Inc. (TGNA). Our decision to exit Tiffany was based largely on valuation. The stock’s strong performance in recent months helped it reach our estimate of intrinsic value. We sold our remaining shares in TEGNA in anticipation of its spin-off of Cars.com Inc. (CARS). Likewise, we were uncomfortable with the debt load of the remaining legacy business.
As we look ahead, we remain cautiously optimistic about the economy. During our recent earnings calls, we noticed a shift from cost- cutting to top-line earnings growth, as well as increased optimism from company CEOs on the future of the economy, particularly within small companies. That said, we believe current valuations are difficult to overlook. As of June month-end, the S&P 500 Index traded at 18.5X forward earnings and the Russell 2000 Index traded at 19.3X forward earnings. While these figures are definitely above average, we do not yet consider them to be in dangerous territory. We remain disciplined with our approach and are confident in our portfolio positioning, which is at a deep discount relative to the indexes. Historical patterns have suggested this is a positive leading indicator for strong performance going forward.
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.
The Russell Midcap ® Value Index measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap Index companies with lower price-to -book ratios and lower forecasted growth values. The Russell Midcap® Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes or underlying data and no party may rely on any Russell Indexes and/or underlying data contained in this communication. No further distribution of Russell data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The S&P 500® Index is the most widely accepted barometer of large cap U.S. equities. It includes 500 leading companies.
As of 6/30/17, First American Financial Corp. constituted 4.0% of Ariel Appreciation Fund; Northern Trust Corp. 4.0%; Bristow Group Inc. 1.1%; Viacom, Inc. 2.3%; U.S. Silica Holdings, Inc. 1.8%; Tiffany & Co. 0.0%; TEGNA, Inc. 0.0%; and Cars.com 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 Appreciation Fund.
1 Attempting 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.
