Ariel Investments Portfolio Manager Charlie Bobrinskoy details his investment philosophy as portfolio manager for Ariel Focus Fund.
Ariel Focus Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment. Investing in small- and mid-cap stocks is more risky and volatile than investing in large-cap stocks. Investing in equity stocks is risky and subject to the volatility of the markets. The intrinsic value of the stocks in which Ariel Focus Fund invests may never be recognized by the broader market. Past performance does not guarantee future results.
Question: What makes Ariel Focus Fund different compared to the rest of Ariel’s traditional value mutual funds?
Answer: Ariel Focus Fund is an all-cap fund. We can invest anywhere, from the smallest to the largest companies. Because small-cap stocks have outperformed large-cap stocks going into this year, we were finding most of our opportunities in larger companies. It is nice to have the flexibility to “go anywhere.”
It is probably fair to say that Ariel Focus Fund is the most conservatively managed of Ariel’s domestic funds. Ariel Focus Fund generally has the lowest beta of the domestic funds in Ariel’s traditional value strategy. I have invested a lot of my own and my family’s money in Ariel Focus Fund, which means I am investing alongside our shareholders.
Ariel Focus Fund has always been managed with a keen eye on price/earnings (P/E) ratio as a key determinant of value. This is one reason Ariel Focus Fund usually shows up as the most “value-oriented” of any of Ariel’s traditional value funds, as measured by Morningstar™ Style Boxes.
Question: How many stocks do you own in Ariel Focus Fund at any given time, and why do you stay at that number of holdings?
Answer: I currently own 29 stocks in Ariel Focus Fund (as of July 31, 2018). The number of holdings has generally varied from the mid-20s to no more than 30. As the name implies, Ariel Focus Fund was conceived as a concentrated fund investing in our best ideas.
Question: How do you determine if a company is undervalued? What factors do you consider?
Answer: For every investment at Ariel, we calculate a private market value (PMV), which we define as the price an informed rational investor would pay to own an entire company. We use three different inputs to determine this PMV: A traditional discounted cash flow analysis, a change of control valuation in a merger scenario and a full and fair public trading price—that is, where the stock could trade once the short-term issues have been resolved. We then compare the stock price with the PMV and seek to purchase stocks trading at a 40% discount.
Question: How do you know when it’s time to sell?
Answer: I typically sell when the stock price reaches our calculation of PMV or when I feel I have better alternative investment opportunities.
Question: Why do you typically seek a 40% discount to PMV? Is that higher or lower than other funds in your peer group?
Answer: Because we are only investing in a relatively small number of stocks, we can afford to be picky. We can wait for a “fat pitch” before pulling the trigger on a new name.
Question: Can you describe how Ariel uses moat ratings in the portfolio management process?
Answer: Economic “moats” are the barriers to entry that prevent competitors from selling similar products at lower prices. For example, we believe Lockheed Martin has a wide moat because, once the US Defense Department selected Lockheed to produce the F-35 fighter, it was almost impossible for another company to take that contract away. Western Union has a global network of locations that would be extremely difficult to replicate. We rate all portfolio companies as having either Wide, Narrow or Zero economic moats. We also rate the trend of that moat over time as increasing, stable or decreasing. The best companies have wide moats that are getting wider, but this is rare.
Question: How do you use a Devil’s Advocate to help with controversial names?
Answer: Each portfolio company is assigned a Devil’s Advocate analyst whose specific job is to present the bear case on each holding. A Devil’s Advocate is designed to counter endowment bias, the natural tendency to overvalue that which you own versus that which you do not.
Question: Why do you think a company’s balance sheet is important?
Answer: We see financial leverage as one of the most powerful, yet least understood forces in investing. A company’s debt leverage has an enormous effect on its relative performance. During the Great Recession, we learned that companies with too much debt can be forced to issue equity at the absolute worst time. Leveraged companies tend to perform badly when interest rates increase. At Ariel, we believe interest rates are going to go up a lot over the next three to five years. Companies with stronger balance sheets are poised to outperform during this time period.
Question: How would you describe your approach to value investing? Do you identify more with Warren Buffett or Benjamin Graham? Or, are you somewhere in between?
Answer: I think it is fair to say I am somewhere in between Warren Buffett and Benjamin Graham. I do not own the “cigar butt” deep value stocks that made Graham famous, but my portfolio also looks a bit more contrarian than does that of Warren Buffett. A significant amount of academic research shows value beats growth and low P/E beats high P/E. Buffett seems more willing to own high P/E stocks than I am.
Question: Given your experience in the industry, what advice would you give to investors? What is the most common mistake investors tend to make?
Answer: Unfortunately, most investors make the mistake of going with the crowd. Investors buy after the market has gone up and sell after the market has gone down. The opposite strategy is by far the better one. My second piece of advice is to limit debt leverage in almost all areas of your life. It is fine to obtain a mortgage in order to pay for a house, but it is almost never good to carry a balance on your credit card. And never borrow money to buy stocks; margin accounts can destroy your life savings. Finally, remain cautious about making direct investments in private companies, particularly in startups. Most new companies fail, especially restaurants!
Question: Why did you decide to become an investment manager?
Answer: I have always been fascinated with investment markets. Contrary to what some people think, real wealth gets created in the U.S. capital markets. I would argue that the U.S. capital markets are the critical factor that allows money to flow from those who have money and need to earn a return to those who need money in order to make their productive ideas a reality. Venture capitalists could never fund startups without the prospect of public equity markets to provide an exit. Mortgage markets allow middle-class home buyers to borrow at very low interest rates in order to afford a home. I love making a living inside of these capital markets. They are a never ending source of fascination for me!
The opinions expressed 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. Click here to view the Glossary for definitions of terms used.
In this commentary, Charlie Bobrinskoy candidly discusses a number of individual companies. Particular stocks mentioned were portfolio holdings in Ariel Focus Fund as of the date of this communication. Click here for Ariel Focus Fund holdings current to the most recent quarter end period. Holdings mentioned do not constitute all holdings in the Fund. Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of Ariel Focus Fund.
An economic moat is a perceived competitive advantage that acts as a barrier to entry for other companies in the same industry. This perceived advantage cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimations, declining fundamentals or external forces.
A growth investment strategy seeks stocks that are deemed to have superior growth potential. Growth stocks offer an established track record and are perceived to be less risky than value stocks. A value investment strategy seeks undervalued stocks that show a strong potential for growth. The intrinsic value of the stocks in which a value strategy invests may be based on incorrect assumptions or estimations, may be affected by declining fundamentals or external forces, and may never be recognized by the broader market.
“P/E ratio” is a price‐to‐earnings ratio and represents a valuation ratio of a company’s share price to its per‐share earnings. In general, a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to companies with lower P/E ratios. P/E ratio comparisons are more applicable for companies in the same industry, against the stock market in general or against the company's own historical P/E ratio.