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.