Supported by relatively stable global growth, strong earnings fundamentals and U.S. tax reform, the current bull cycle weathered another quarter of volatility. Investor concerns around trade tensions, geopolitical issues, increasingly tight monetary conditions in the U.S. and rising inflationary pressures took center stage. As a result, the domestically focused U.S. small-cap Russell 2000 Value Index posted a +8.30% return, significantly outperforming its large-cap peer, the S&P 500 Index, which increased +3.43%. International equities struggled in the quarter as the MSCI EAFE Index declined -1.24%. For the quarter the Ariel Focus Fund traded +2.80% higher, which was significantly better than the Russell 1000 Value Index’s +1.18% gain, but trailed the S&P 500 Index’s +3.43% return.
Several stocks in the portfolio had strong returns in the quarter. Alternative asset manager, KKR & Co. L.P. (KKR) increased +23.36% over the period. KKR delivered an earnings beat and to attract new investors, the company announced that it would be converting to a corporation from a partnership, effective July 1, 2018. In our view, this change simplifies the structure, broadens investor appeal, and translates to possible inclusion in the major indexes.
Leading provider in specialty industrial services, Team, Inc. (TISI, Financial) also advanced considerably in the quarter, jumping +68.00% after posting year-over-year growth in revenues, adjusted EBITDA and free cash flow. Management believes the market is showing signs of improvement, as the Inspection and Heat Treating segment was stretched during the quarter due to growth in large project activity levels and expanded scopes. TISI is also rapidly deploying a new regional, cross-segment operating model that is expected to increase revenues, improve efficiency and decrease overall operating expenditures. The model should align responsibility for all services and products, promote cross selling and optimize resource allocations across locations to leverage the size and scale of the enterprise.
Energy company, Apache Corporation (APA, Financial) also benefitted quarterly performance, trading +22.22% higher on strong operational results and U.S. oil production that was above guidance. The outperformance in the United States was driven by a combination of shorter completion cycle times, improving efficiencies and excellent performance from new wells. The company’s international exposure to Brent oil pricing contributed to high margins, high cash returns and strong free cash flow. In our view, the performance was solid from an execution and cost-control standpoint, and we are encouraged that management sees continued momentum going forward. Additionally, a number of insiders purchased shares of APA during the quarter, highlighting confidence in the business outlook.
There were a few notable positions that detracted from our quarterly results. Branded food and beverage product company, J.M. Smucker Company (SJM, Financial) finished the period down -12.74%, after falling short of consensus expectations. Investors were also disappointed with the company’s full year 2019 guidance, which was mostly driven by higher than anticipated expenses. While we acknowledge increased marketing spend is necessary to support branded growth and Fiscal 2019 will be an investment year with lower than expected margins, we believe SJM has a portfolio of iconic, market leading brands that produce consistent returns. Additionally, SJM’s strong cash generation capabilities should continue to allow the company to deploy capital towards brand investment and business expansion initiatives, as well as return cash to shareholders.
Another underperformer in the quarter was Lockheed Martin Corporation (LMT, Financial). Shares traded -12.02% lower, as investors remain skeptical of a resolution to ongoing trade disputes. Peace talks between North Korea and the United States have also placed pressure on shares, as LMT is the world’s top supplier of missile defense systems. Nonetheless, the company continues to demonstrate strong organic top and bottom line earnings growth. At current levels, we believe LMT is trading at a significant discount relative to its intrinsic value.
Leading supplier of solutions for combustion, hybrid and electric vehicles, BorgWarner, Inc. (BWA, Financial) also weighed on performance, declining -13.78% in the quarter. Uncertainty around tariffs and concerns that we are at the peak of the automotive cycle have weighed on shares. Additionally, the CEO announced his retirement furthering investor skepticism. We continue to believe that BWA’s scale, global presence and leading edge technology properly position the company to deal with these potential issues. We expect the increased complexity required for auto manufacturers to meet higher fuel efficiency and lower emissions requirements worldwide to provide a tailwind to demand for BWA’s products. At current levels, the company is trading at 9.6x forward cash EPS and a 35% discount to our estimate of private market value.
During the quarter, we initiated a position in CBS Corporation (CBS, Financial), a leading entertainment company that is also held within Ariel Appreciation Fund. With its collection of valued media assets, growing retransmission fees for the right to carry the CBS signal, reverse compensation from its affiliates, video streaming deals, political advertising revenues, strong balance sheet, solid free cash flow generation and a seasoned management team focused on return on investment, we believe CBS is well positioned for continued growth. Conversely, we exited our position in MSG Networks, Inc. (MSGN, Financial) to pursue other opportunities.
Despite higher market volatility, we remain cautiously optimistic that steady economic and corporate earnings growth, as well as second order effects from U.S. tax reform will boost profitability for many of our domestic holdings. In the meantime, while cyclical pressures on inflation are building, we believe technological innovation continues to present a considerable headwind. Not to mention, history shows that stocks can still do well in a rising rate environment. And while meaningful to current market sentiment and conversation, it’s important to note that we view the uncertainties and risks around trade policy and geopolitics to be short term noise within the context of our long term investment horizon. Furthermore, we believe valuations have come down to attractive levels, particularly with the S&P 500 Index trading at 17.2x forward earnings and the Russell 2500 Index trading at 17.1x forward earnings, from 19.4x and 19.6x forward earnings, respectively, at the start of this year. Given our “slow and steady” approach, we remain confident in our portfolio positioning, especially with our domestic strategies 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, increasing consumer confidence and the gradual normalization of monetary policy. At 14.2x 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
