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Portfolio > Portfolio Construction

Experience and Flexibility

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Experience: accept no substitute. In a world where the phantom valuations and effervescent ratings of mortgage-backed securities seem to be overshadowing all of the markets, it can be particularly reassuring to find a voice of quiet competence possessed by a money manager who founded his investment company in 1983, and has managed its flagship fund over its 21-year history to achieve solid total returns through many different market environments.

Flexibility has been a driving force in how John Rogers, Jr., 49, chairman and CEO of Chicago-based Ariel Capital Management, LLC, runs the Ariel Fund, and it enables Rogers and co-portfolio manager John Miller to “move back and forth between smaller- and the mid-cap names based upon where the best valuations are.”

That flexibility translates into 10-year annualized total returns of 12.92% versus 11.54% for its small-cap value peer group (through June 29), according to Standard & Poor’s, which gives the fund three stars overall as well as for the one-, three-, and five-year period; and four stars for its 10-year performance. Because of its smid-cap focus, there is no individual benchmark for this fund. Ariel uses the Russell 2500 Value Index, Russell 2500 Index, and the S&P 500 Index on its Web site.

What’s your investment style for the fund?

We look at ourselves as a value manager but I’ve noticed that a lot of the Buffett-like value managers get categorized by Morningstar as blend managers, partly because we all demand high-quality undervalued securities and they’re not as cheap as some of the lower-quality value companies. Often, Buffett-like managers like to invest in consumer companies where book value isn’t quite as relevant in valuing the business. If you invest in an old-fashioned machine-tool company or a heavy cyclical company, tangible assets and book value are very important, but if you’re investing in a branded [company, such as] McDonald’s–Warren Buffett made a lot of money investing in strong brands like Coca-Cola, with a strong brand, that was maybe undervalued at different times during its history; The Washington Post, American Express, etc., but those companies didn’t have a lot of book value. [For] Morningstar, as part of its criterion, my understanding is that book value has something to do with whether you end up in the value box or the blend box, so the way that we invest lends itself more to blend even though we see ourselves as true value managers.

How would that differ from GARP?

It’s a different mindset when you start–we’re not looking for companies where we’re paying a high price with expectations of growth continuing for several years into the future. Sometimes you can use that expected future growth rate to justify expensive multiples. We don’t look at it that way–we’re trying to find companies we think are cheap today. It’s probably not that big a difference from GARP, but at the same time I think it’s a totally different mindset. We’re often buying stocks where there’s a temporary problem that’s knocked the stock down where most of the analysts on Wall Street are either neglecting it or have sell recommendations on it, and so the stocks appear to be maybe more expensive also because they’ve maybe had temporary earnings disappointments. The reason our stocks aren’t GARP-y is because we’re not paying up for expected growth, we’re trying to buy great businesses, high quality businesses, while they’re under a temporary cloud, so it’s a different mindset from GARP managers.

How is the Ariel Fund different from other value funds?

The only difference, I think, is we’re not buying low quality, undervalued companies. I have a lot of friends in the business who do that very well. They get a company that does metal bending, manufacturing widgets somewhere in the upper Midwest and they’ll try and get that stock when it’s cheap and then sell it once it gets to full value over a six-month kind of a period. We’re not doing that. We’re trying to find a high-quality company that we can own for five-, 10-, 15-years or more, and grow with it over time, and I think that that sense of focus on quality and the focus on owning it for the long run is one of the things that distinguishes us from our peers.

The other part that distinguishes us from a lot of value managers is that we also stay within our circle of competence. We’ve borrowed that from Warren Buffett and Charlie Munger. We are only going to invest in the areas that we feel like we know best, and can add value and make good decisions when there’s a lot of stress around an industry or a specific company. When I look back at some of the mistakes we’ve made over the 25 years, it’s when we got outside of our circle of competence, didn’t quite understand that company or that industry as well as we should have, and then when things didn’t go so well, you didn’t have the courage of your convictions to buy more when you needed to. To summarize what makes us different it’s thinking longer-term, buying high-quality companies and staying within our circle of competence.


What’s your investment process?

The process really hasn’t shifted much over the years. I continue to read consistently all the business publications, all the newsletters, Morningstar publications, Outstanding Investor Digest, The Wall Street Transcript and of course, all the First Call reports and research reports from Wall Street, so every day I start reading and read throughout the day looking for ideas. I’ve been doing that since I was in college. I was the one guy on the basketball team at Princeton who had my Forbes, and my Fortune, for the long bus rides up to Dartmouth or Cornell (chuckling).

The process, for me, starts with reading. Our senior investment committee members each have a specific industry specialization or two, and then they are reading regularly within their industry. They keep track of all their companies ranked from top to bottom in terms of quality and so they’re searching for new ideas within their circle of competence, within their specialty. Either way: I might come up with an idea from my reading or one of the specialists from our investment committee who’s a seasoned veteran would find an idea within their sector, and once we identify an idea we talk about it at our weekly investment meeting and say: “Is this worth doing a full report on it?”

If it is, it’s typically going to take four, to five, to six weeks for a brand new idea to get totally vetted before the investment committee can make a final decision. During that four- to five-week period we’re doing what most managers are doing–we do a couple of things differently, but we’re going to go out and visit the company, we’re going to talk to competitors, customers, and peers. We’re going to find as many industry experts–people who have been in that industry for years–to help us understand the quality of that company, the quality of that management team and whatever changes that are occurring in the industry that would make that a more or less successful investment idea. We’re just going to try and surround it, and then at our weekly meetings we’re going to update each other on what we’re finding, and then recommend to the industry expert: other people to check, other bases to cover, other questions to address that maybe haven’t been addressed already so when that full report gets finished, hopefully it’s really going to have all the questions that we need to have addressed, addressed, and will help us make a better decision.

After we put together a full written research report with our own recommendations, and our own projections–we do our discounted cash-flow analysis to determine what the real value of the business is. We look at what comparable transactions are occurring in the industry; we look at the sum-of-the-parts; we look at everything to see from a valuation standpoint, from our own perspective, what the value is. At the end of that process after we’ve studied the written research report and looked at the valuation, we go around the table and each of the senior people on the investment committee votes whether the stock should be added to the portfolio or not, but as the lead portfolio manager I make the final decision of whether the stock should go in or not. But I do want to get independent input from my colleagues and my teammates before I make that final judgment.

During this process I’ll also be talking to my co-manager, John Miller, and getting his thoughts along the way on a new idea, and then each of us will try to be on as many of the conference calls and as many of the visits during that [vetting] process to make sure we are absorbing all of the information about that particular company and industry directly as well as the senior person who is responsible for it.

What’s your sell discipline?

Each company has to have, at least twice a year, a full blown updated research report but this industry is so dynamic and industries are changing so rapidly, most of the time we’re going to be updating our companies more frequently than that, and having frequent conference calls and conversations at our weekly meetings. If the senior person or myself or the co-portfolio manager–any of us can raise our hand and say let’s look at this company because there’s something happening here that’s starting to bother us, and worry us, and we see something happening in the industry. Then we’ll do that homework and determine if we feel like whatever the concerns we have are really valid and significant or maybe they are just short term in nature and not really meaningful. We’re going to analyze whether the management team has good answers to the concerns and problems that we’re discussing and see whether we believe in listening to the management–that they have a good, coherent response.

So much of the work we do, whether it’s buying or selling, is trying to make sure that we’re able to listen carefully to the management team and determine whether we believe in them and whether we believe that they believe in their story. An important part of the job is being a good investigative reporter and being able to listen carefully, look management in the eye and determine whether they are true believers and have conviction around their plan to build a great business, and if we lose confidence in that conviction and think their answers are not strong, and are all over the place and ever-changing, that can be a reason for us to sell the stock: lack of confidence in management and lack of confidence in the industry will be reasons to sell.

We’ll also start to lighten up positions if they no longer meet our valuation criteria, and no longer sell at a discount to the private market value analysis that we do–that can be a catalyst to sell–so it could be for fundamental reasons or for valuation reasons.

Which holdings have surprised by performing better than, or not as well as, expected?

One thesis that’s been working very well for us is companies that are in the consulting or outsourcing space–companies that can give advice to other companies about how to do things well, and in some cases actually take over responsibilities for a major corporation and allow the corporation to focus on what it does best. We have companies throughout the firm, like Accenture [ACN], [or] Pitney Bowes [PBI], that do outsourcing in the office environment–take over your back office and mail room; companies like Northern Trust [NTRS], that will take over your pension fund management, and manage all of your assets for you; to companies like Jones Lang LaSalle [JLL], that do real estate outsourcing and will take over your entire real estate portfolio, lease it out, maintain it and manage it, buy and sell properties for a large multi-national company around the world. A company like BearingPoint [BE], that does consulting primarily for the government but also helps a lot of corporations, and Hewitt [HEW], that does human resources consulting, a big, big job and they do it really, really well. That’s one big, broad theme, this outsourcing consulting area, that’s worked out extremely well for us.

Another one that’s worked out well for us within this theme of staying within your circle of competence is, we’ve owned mutual fund companies for a number of years. For most of the last 20-years, for example, we’ve owned T. Rowe Price [TROW], and we also own Franklin Resources [BEN] that owns Franklin Funds, and Janus [JNS] that has the Janus brand of growth funds. Those companies have done remarkably well over the last several years and have helped us to have a really good year this year–part of the reason we’re outperforming this year in Ariel Fund is because of companies like Janus. Mutual fund companies have done well as the market has rallied so strongly from the lows after the bubble burst. What’s nice about that story is it stayed within our circle of competence.

The one area that continues to plague us this year, and for the last three years, has been our media names, and in particular our newspaper holdings. We have a lot of them throughout the firm; we’ve owned everything from The Tribune [TRB], to McClatchy [MNI], and Lee Enterprises [LEE], Journal Register [JRC], and it’s just been a sector that continues to disappoint. It seems like you think the worst is over, and then the next quarter the earnings and the revenue come in much less than expected; the negative reporting, and negative write-ups on Wall Street just get worse, and worse, and worse. We continue to be believers that these companies generate lots of cash flow. People are still reading newspapers. Even if my 17-year old doesn’t read the newspaper, you know there are a whole lot of people now living to be 80- or 90-years old who are still reading their newspaper every day. If you look at the combination–the eyeballs that are actually receiving the content either through the Internet or the traditional newspaper, you actually have more people receiving the content that’s being delivered by professional journalists at the major publications around the country. Local content still matters–people want to know what’s going on in their hometown, what’s happening with the local politics, local sports, in the community. Yahoo and Google really can’t generate that kind of high-quality content and deliver it the way the newspaper can either through the Web or through the traditional paper. As Sam Zell said after he bought The Tribune: “Relevant content still matters,” and it’s the job of these great newspaper companies to make sure that content is relevant to those local readers. That’s been the painful area for us.

So you think that this has a future?

I do. I think, as Mason Hawkins talked about, you can buy companies when there’s the maximum pessimism; you usually are buying at the bottom at a bargain price, and if that’s ever true these companies are going to be huge winners.

We have been looking at a couple of new areas and the primary one is companies that have some connection to the housing-related turmoil that’s been happening in the country. There’s been so much bad press about housing prices collapsing, and things going on in the subprime mortgage markets, so what we’ve tried to do is, instead of buying the actual homebuilders, we’ve bought companies we think can benefit from the recovery but are relatively lower risk than the homebuilders themselves. For example we’ve started to build a major position in USG, used to be called United States Gypsum, they are so big in wallboard and other important materials that are valuable as you’re constructing new homes. We’ve been buying Countrywide Financial [CFC] that is one of the major mortgage providers throughout the United States, and Countrywide has a great brand. These are names we’ve been buying throughout the firm in our smid-cap and our mid-cap portfolios–some more in the mid, some more in the smid.

We also have added to our existing holdings in that space too, adding to companies like Mohawk [MHK], that makes carpeting for the home, another good example of a name that would become a larger position now because of our confidence in this sector.

Your financial sector holdings have gone up in the last few years–do you have any worries about not just subprime mortgages, but the effect of CDOs, CMOs on any of the financial companies that you hold?

For the most part, most of our financial services companies are either insurance, the mutual fund companies that I suggested earlier, or banks that are really higher quality kind of banks. One area where we’ve had some negative exposure that worries us has been in H&R Block [HRB], that had a big subprime mortgage business, they’re in the process of selling it but they probably aren’t going to get the price that they would have gotten two or three years ago. We’ve been concerned that H&R Block is trying to do too many things: owing a bank, being in subprime mortgage, being in the brokerage business, and have lost some of their focus around their core tax business. That’s been the one financial services company that’s been the most problematic in this current environment that you mentioned. The other ones have been much higher quality names; they’ve given us confidence that things are fine.

Where would this fund fit in an individual’s portfolio?

The Ariel Fund is kind of a nice thing for someone who wants to be in the small- to mid-cap value area and then have faith that our portfolio management team will move back and forth between the smaller- and the mid-cap names based upon where the best valuations are. Because what will happen sometimes, which has happened more recently, is the small value indexes have been so hot for so long, there are not that many high-quality values left, and a lot of companies have been taken over in this period. We’re not just going to buy a small cap company just to buy it, if it doesn’t meet our strict criteria. There have been more opportunities in some of the mid-cap names that have been more neglected and still meet our high quality standards, so I like that flexibility to bounce between small and mid, and hopefully our customers don’t mind the fact that we can be a little bit between small and mid, and a little bit between blend and value. We’ve stayed right in the same part of the style boxes, basically, but we evolve a little bit right in the left-hand corner of the style boxes, between value and blend, and small and mid.

So you’ve given yourself the flexibility to take advantage of the better values?

That’s what I like about it–because that’s exactly what we’ve done.

What else do advisors need to know?

We have experienced managers in charge of [the fund]. I’ve been the lead portfolio manager now, on Ariel Fund, since 1986 when it was started. According to Lipper there are only a little more than 250 funds that go back that far, and a much smaller number that had the same lead portfolio manager. I think that that sense that we’re the sort of grizzled veterans who have been through a lot of up and down cycles is relevant. My deputy on the fund, John Miller, has been with us 17 years. You put the two of us together, that’s kind of a nice story and I’m really proud of the fact that out of the 280 some-odd funds that go back to 1986 we were ranked 15th as of last quarter, so that makes us feel good that at the end of the day, after all those ups and downs, and all the various cycles, that we would be in the top-20 of all the equity funds that go back to November of 1986, it gives us a lot of confidence here at the firm and makes us feel good. The nice thing too, is that since I started when I was 24, I’m not looking for an exit strategy. John and I are both in our 40s; I’ll be 50 next year–hopefully I can do this for quite a bit longer, and hopefully just get better through experience.

Do you own this fund in your personal portfolio?

Oh, it’s the biggest asset that I have in my personal portfolio, by far.

E-mail Senior Editor Kathleen M. McBride at [email protected].


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