Quick Take: The Ariel Fund (ARGFX) typically holds a relatively small number of stocks, but lately, portfolio managers John Rogers Jr. and John Miller say their universe of potential investments has also become smaller. In part, that’s because shares of the small companies they focus on have become expensive.
At the same time, investments by fund shareholders have been picking up, the stock pickers say. As a result, the $3.1-billion fund now has about 13% of its assets in cash, according to Rogers. He says he typically would keep less than 5% in greenbacks.
When they put that money to work, Rogers and Miller look for undervalued shares of profitable, financially sound companies with strong industry positions and management teams. Recently, they’ve been finding values in financial services stocks, which accounted for 26% of the fund’s holdings at the end of the second quarter.
The fund was up 9% at the end of last month. That put it ahead of the average small-cap value fund, which gained 2.4%, and the Standard & Poor’s 500 index, which inched up 0.4%. For the five years ended in August, the fund returned 13.5% on average, while similar funds rose 12.8%, and the index dropped 2.1%.
The Full Interview:
S&P: What do you look for in buying stocks?
ROGERS: We’re focused on smaller companies that we can own for the long term. We want to buy these companies while they’re out of favor. That’s when we often find a high-quality franchise at a bargain price. We look for stocks selling at a discount of 40% or more to the company’s intrinsic value.
That’s our core approach. Underneath that, we like to make sure we’ve got a high-quality management team, a superb balance sheet, and a company with true barriers to entry. That makes the franchise really solid and allows for 10% or more growth in the future.
S&P: You limit the portfolio to 35-45 stocks. Why do you concentrate it?
ROGERS: We think that there are not that many great companies, and we think that the markets are so efficient that the only way to outperform is to follow a relatively small group of companies that you know better than your competition so you can make better decisions about those companies — when to buy and when to sell. This lets you get more significant contributions from your winners.
S&P: Can you cite a recent purchase that illustrates your approach to stock picking?
MILLER: In February we started a position in Argosy Gaming (AGY), an operator of riverboat casinos.
In terms of valuation, Argosy is a company that, when we initiated the position, was trading right around 13 times our forward 12-month earnings estimate, and it was at what we felt what a sophisticated buyer would pay for this franchise.
It’s in an industry where we feel we have a lot of expertise. We are currently a shareholder in Caesars Entertainment (CZR), which is being acquired by Harrah`s Entertainment (HET).
S&P: Could you name another new addition to the portfolio?
MILLER: We’re really paying a lot of attention to identifying opportunities in the financial services sector. It’s interesting how the market is just ignoring this area.
A good example would be S&T Bancorp (STBA), which we purchased within the last couple of months.
Here’s a company that’s trading right around 10 times forward 12-month earnings. As interest rates continue to rise, they’ve done a really terrific job in terms of matching the assets and liabilities on their balance sheet to offset any impact from rising interest rates.
S&P: The biggest chunk of the fund’s assets — 26% — were in financial services stocks on June 30. Do you have any favorites in that group?
MILLER: Markel Corp (MKL) is a large holding. It’s a terrific niche insurer. Their expertise is in smaller markets, like summer camps for kids and the horse industry.
It’s a very profitable company. We still think it’s significantly undervalued. The stock currently is trading at right around $300 per share. But we think this company is worth in excess of a much higher figure, whether its $350 per share, or higher.
S&P: What’s your cash position now compared to what it typically would be?
ROGERS: It’s about 13%. We would typically have less than 5% in cash.
S&P: Why are you holding more cash?
ROGERS: First, the overall market for small cap stocks, we feel, is expensive, so there are fewer bargains out there for us that meet our investment criteria.
Secondly, there’s been a lot of merger and acquisition activity over the last several years, and so many great small-cap companies have been bought by bigger companies that it’s narrowed the universe of high-quality, small-cap value stocks to invest in.
We have had new cash come in, too. It’s been a great year for us, and so more money has come in at the same time time we’re having some challenges in finding new ideas.
S&P: Has the cash inflow forced you to buy bigger companies than you normally would?
ROGERS: We have been buying larger companies, more mid-sized companies. Not because of any other reason than the fact that so many of our good names have been gobbled up by bigger competitors. So you end up finding that the universe of companies that meet your criteria is smaller. You find that the companies that fit are a little larger than they used to be.
S&P: The fund had $3.1 billion in assets at the end of August. It’s one of the larger small-cap funds. Are you thinking of closing it to new investors?
ROGERS: It’s something that’s on our radar screen, that we talk about at our board of directors meeting. But we don’t have any current plans to close it.
MILLER: We have such a long-term investment perspective and such low portfolio turnover that it allows us to manage more money effectively. Typically, our turnover has been 20%. In the last three years or so it’s been under 10%.
S&P: Your seventh-largest holding at the end of last month was Janus Capital Group Inc. (JNS), a company that’s seen more than its share of trouble over the last year. What makes it attractive to you?
ROGERS: We like companies that have strong brands, which Janus still does. We think they have a strong management team. And they still have a lot of analyst expertise. Their funds have started to show better performance. Some of the funds’ bad years are starting to wind down.
S&P: What’s your outlook for small-cap stocks?
MILLER: I think it’s a time to be very cautious. I think smaller companies have done so well relative to larger companies that you’re going to see better performance in mid-sized and larger companies going forward.
S&P: What about the overall market?
ROGERS: I would not be surprised to see a down year overall. The S&P 500 could be down 7%-10% at the end of the year. I wouldn’t be surprised if the Nasdaq was down 16%-17%.
I think higher interest rates and inflation rates will force price-to-earnings multiples down, and as you see P/E compression you’ll ultimately have a profound impact on the overall market.
Contact Bob Keane with questions or comments at: firstname.lastname@example.org.