Investing in small- and mid-cap stocks is riskier and more volatile than investing in large-cap stocks. The intrinsic value of the stocks in which the Fund invests may never be recognized by the broader market. Ariel Fund is often concentrated in fewer sectors than its benchmarks, and its performance may suffer if these sectors underperform the overall stock market.
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, 2018, the average annual total returns of Ariel Fund (Investor Class) for the 1-, 5- and 10-year periods were +14.98% +11.41% and +12.23%, respectively. For the year ended September 30, 2017, the Fund’s Investor Class shares had an annual expense ratio of 1.01%.
Quarter Ended September 30, 2018
U.S. equity indexes hit record highs again this quarter. While we acknowledge the current cycle is getting long in the tooth, the positive narrative surrounding the market suggests the upward trend should continue for now. Strong corporate earnings fundamentals, traction from late-cycle stimulus, aggressive share buybacks and elevated levels of business and consumer confidence overcame trade tensions, geopolitical issues and tightening monetary conditions. For the quarter, Ariel Fund advanced +3.44%, outperforming the +2.67% return posted by its primary benchmark, the Russell 2500 Value Index but trailing the Russell 2500 Index’s +4.70% gain.
Several stocks in the portfolio had strong returns in the quarter. Bar code manufacturer, Zebra Technologies (ZBRA, Financial) traded up +23.44% during the quarter. Broad-based strength, both geographically and by product end market, drove the top and bottom line earnings beat. ZBRA also made significant progress reducing its financial leverage to the top end of its target range at 2.5x. Given the strength of the company’s results, ZBRA raised the full year outlook for sales growth and free cash flow. We view ZBRA as an industry leader with a strong management team. We think the company is well-positioned to benefit from secular global demand for asset tracking solutions across several industries and believe ZBRA remains underpriced relative to its intrinsic value.
Global cruise vacation company, Royal Caribbean Cruises Ltd. (RCL, Financial) also benefitted performance, jumping +26.09% in the quarter. Robust consumer demand and sustained strength in the company’s earnings growth continues to overcome headwinds from foreign exchange and fuel costs. Significant insider buying over the past month shows management shares our stance that there is upside from current levels. Furthermore, we expect new hardware, ship upgrades and technological innovation to bolster yields and earnings in 2019 and beyond.
Specialty cutting tool insert maker Kennametal Inc. (KMT, Financial) was another notable contributor, advancing +21.97% during the period. Fourth quarter and fiscal year end results highlighted solid execution on its 3- year strategic plan to improve economies of scale and profitability. Organic sales increased 10% in the quarter and margins expanded across each business segment. This momentum and price cost balance is expected to continue into 2019. KMT is a high conviction holding that continues to trade at a significant discount to our estimate of private market value.
Alternatively, several positions weighed on performance. Producer and supplier of sand, U.S. Silica Holdings, Inc. (SLCA, Financial) traded -26.48% lower due to investor concerns regarding the supply and demand mix for silica and noise around potential slowdowns in activity in the second half of 2019, due to rising labor costs, trucking congestion and outflow capacity. We believe the market is overestimating the volume and delivery time of silica coming to market and although there have been announcements for mines coming on line in West Texas, the competitors lack the capital required to begin production. SLCA is insulated from some of these issues due to their national footprint and close proximity of its mines to major rail lines and waterways. In addition, SLCA has received commitments from several customers to prepay for volume at attractive margins. Beyond supply concerns, investors continue to underappreciate the company’s industrial business relative to competitors. We believe the contributions from these less volatile return businesses such as the investment in SandBox and EP Minerals, and the company’s stable balance sheet has SLCA positioned for favorable risk/reward going forward. At current levels, SLCA is trading at a 63% discount to our estimate of private market value and we have been adding to our position on weakness.
Real estate expert Jones Lang LaSalle (JLL, Financial) also underperformed, trading -13.06% lower during the period. We believe this price action runs counter to its strong operational performance. JLL delivered a top and bottom line earnings beat in the quarter, highlighted by organic revenue growth across all of its business segments, progress on its digital agenda and technology transformation initiatives, record private equity assets under management and the extension of its credit facility maturity with improved pricing to support the company’s growth strategy. Despite a rising interest rate environment in the United States and intensifying global economic uncertainty, real estate fundamentals remain resilient in most markets. As such, we expect JLL to continue to benefit from accelerating trends of globalization, the outsourcing of real estate services and institutional demand for commercial real estate.
Leading global floor product manufacturer, Mohawk Industries, Inc. (MHK, Financial) was another notable detractor, falling -18.16% in the quarter on weaker than expected earnings. MHK is experiencing operating margin pressure due to raw material price and wage inflation, higher transportation costs, changes in product mix and lower than anticipated revenue due to delays in luxury vinyl tile sourcing. To address these issues, MHK introduced initiatives to improve pricing, increase sales in growing channels and reduce overall costs. We have confidence in this owner-operated management team and believe that the company’s pricing power, benefits from recent heavy capital spend and its strong balance sheet will overcome the headwinds. At current levels, MHK is trading at a -35% discount to our estimate of private market value.
We initiated positions in Affiliated Managers Group, Inc. (AMG, Financial) and Stericycle, Inc. (SRCL, Financial) during the quarter.
AMG purchases meaningful equity interests in small to mid-size boutique asset managers for a fixed percentage of revenues. While AMG maintains operational autonomy, it provides its affiliates with strategic, operational and technological support, as well as access to its global distribution network. We believe the market underestimates the strength of AMG’s franchise and its focus on alternative investments and global equities.
SRCL is a waste management service provider. Although the company boasts high net margin versus competitors, we believe it is trading at a significant discount due to some pricing pressures, an increase in capital spend for the implementation of an enterprise resource planning system and a levered balance sheet resulting from acquisition activity. Our contrarian call has the potential to be significantly rewarded as transformation initiatives bear fruit over the next several years.
We exited our position in leading provider of commercial credit data and analytics Dun & Bradstreet Corporation (DNB) which is being taken private at our estimate of private market value.
Additionally, we sold out of our position in global art auctioneer Sotheby’s (BID) to pursue more compelling opportunities.
We remain cautiously optimistic that a lightly regulated free market economic system in the United States will generate a healthy, growing economy and positive real returns over the long run. In the meantime, we expect many of our domestic holdings to benefit from steady economic and corporate earnings growth, as well as the second order effects from U.S. tax reform. While cyclical pressures on inflation are building, we believe tightening financial conditions, along with the expectation for further rate increases are largely priced into the markets. Not to mention, history shows that stocks can still do well in a rising rate environment. The bull-run, it seems, is here to stay for now. The drivers seem sustainable and investor sentiment is not yet euphoric. Short-term corrections and market volatility are expected in the near term – be it from profit taking, corporate earnings swings, elevated corporate debt leverage, trade policy or geopolitical factors. That said, we view these uncertainties and risks as short term noise within the context of our long term investment horizon. 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.
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.
