How did Ariel Investments’ flagship Ariel Fund, investor class, become the top-performing mid-cap core fund since the March 9, 2009, stock market bottom, according to Lipper, during a time when value investing, which is its calling, was out of favor and the fund charged an expense ratio slightly above 1%?
A new report, “From the Front Lines of the Financial Crisis,” plus a media briefing with Ariel’s CEO, John Rogers; investment head, Charles Bobrinskoy; and research director, Timothy Fidler, provides some answers, including lessons the Chicago-based $13 billion employee-owned firm learned from the crisis.
Here are some of the highlights:
A focus on balance sheets. During the financial crisis, ratings agencies were slow to downgrade corporate debt, and banks, worried about ability of companies to service their debt, often refused to refinance debt, according to Bobrinskoy. As a result, companies had to issue equity to raise funds to service their debt, he explained.
Even Tiffany, a company Ariel owned then and now, wasn’t able to refinance debt in 2009 due to fears of massive deleveraging. Then Warren Buffett agreed to buy the company’s debt, eventually buying $250 million worth.
“Debt levels will be important in the next downturn,” Bobrinskoy said, noting that they have been rising while many A-rated credits have been downgraded to BBB. He said studying debt covenants and following the credit default swap market — “they are betting on companies every day” — can help uncover balance sheet issues.
The importance of behavioral finance. “It’s one thing to study behavioral finance… it’s another thing to try to put it to work,” said Bobrinskoy, who like Fidler received his MBA from the University of Chicago Booth School of Business where Richard Thaler, one of the founding fathers of the discipline, teaches and where former Ariel board member Tobias Moskowitz, another adherent, also taught.
Bobrinskoy said that every member of his department did a self-assessment of their own biases and which ones they thought the firm as a whole was exhibiting, and they uncovered several: the endowment effect, which overvalues stocks the firm owns relative to those it doesn’t; anchoring estimates, whereby a firm is slow to incorporate new information about a company; and loss aversion — “all human beings put more weight on losses than gains” — which leads to a reluctance to sell stocks that have lost value.
Having a devil’s advocate. After realizing these and other biases, Ariel Investments added the job of devil’s advocate to each industry analysis group. “Their job is to argue the other side of a stock analysis, which can help uncover biases … and make sure that the analysis is taking account of new recommendations, reading sell recommendations as well as buy recommendations,” said Bobrinskoy.
Fidler added, “It’s easy to do it when it’s your job.”
Adding a moat rating. Ariel Investments also added a moat rating to its stock analysis, said President Mellody Hobson, who moderated the panel. Economic moats, a concept popularized by Warren Buffett and included in Morningstar’s stock analyses, indicate a company’s competitive advantage, which can include patents, a specific cost advantage and economic efficiency, to name a few.
Focusing on the long term. That’s natural for a value investor because they buy at a cheap price with the expectation that the price will rise. Ariel has a median annual turnover of 20%, which means it’s holding a stock for five years on average.
Central to that holding period is building relations with management. “When you talk with management every quarter for 10 years you get to know them really well,” Rogers said. Also key is a focus on ESG, specifically the S (social) and G (governance) factors, including diversity and inclusion. At the same time, the firm remains open to new ideas.
“If you want to be a 21st century company, you can’t behave like one in the 1940s,” said Fidler, noting that he was repeating one of Rogers’ dictums.
Among the firm’s long-term holdings are Tiffany; CBRE Group and JLL, both commercial real estate companies; and Royal Caribbean.
— Check out Warren Buffett’s 10 Nuggets of Investing Wisdom: 2019 on ThinkAdvisor.