Ariel Investments Portfolio Manager David Maley discusses the research process for the Ariel's Deep Value Strategy. Read the full Q&A below.
Investing in small/micro-cap stocks is more risky and volatile than investing in large-cap stocks. The intrinsic value of the stocks in which we invest may never be recognized by the broader market.
Question: Describe the research process that you follow.
Answer: We typically identify potential investment opportunities through our screening process, where we apply a variety of quantitative metrics. For example, we may look for companies trading at less than tangible book value, or near their net cash balance. Once we have identified a potential investment, we learn as much as possible about the company by reading financial statements and other reports, talking with management and other informed individuals, and building a valuation model.
Question: As you begin to research an investment, what do you hope to learn? What is top of mind for you?
Answer: When evaluating a company, we place a considerable amount of emphasis on management and directors. In our niche of very small stocks, strong leadership can make all the difference.
Question: What are some of the key metrics you look for in a company? How do metrics vs. qualitative characteristics factor into your process (art vs. science)?
Answer: We look for four characteristics in our investments: (1) size, (2) low price-to-book ratio, (3) fortress balance sheet, and (4) strong corporate governance and high insider ownership. Our research process revolves around identifying investment opportunities that meet these four attributes. As you can see, it is a combination of qualitative and quantitative analysis.
Question: Do macro-economic factors affect your investment process? For example, do rising interest rates play into your thought process?
Answer: Our bottom-up, stock-by-stock selection process seeks to identify mis-pricings rather than predict outcomes based on macro-economic or other themes. So, while rising interest rates will likely benefit many of our cash-rich, debt-free holdings, these were purchased due to mis-pricings we believed existed regardless of the interest rate environment.
Question: What will immediately make you eliminate a company from consideration?
Answer: The proxy statement is the first financial statement we read. Poorly incentivized and over-compensated managers can immediately curtail our interest in a company. We refer to this as our “governance smell test.”
Question: Since you often buy stocks when they’re under a cloud, how do you distinguish between a great bargain versus a potential mistake?
Answer: Relying on our thoughtful and consistent process helps our team avoid mistakes. All managers make occasional mistakes, but the biggest mistake you can make is to change your process. We believe that by being consistent in identifying undervalued companies with properly incentivized leaders and pristine balance sheets, we will find bargains rather than value traps.
Question: How would you distinguish Ariel’s research process from other investment firms? What makes Ariel’s research process different?
Answer: There are two main distinguishing factors. First, Ariel has one of the most collaborative investment processes. We are encouraged to both work together on investment ideas and to voice dissenting opinions. Second, our firm has a consistent history of being contrarian. We are disciplined to stick with our roots, which we believe will reward the long-term investor.
Question: Is there a beginning or an end to the research process?
Answer: The research process only ends if a company is acquired and therefore is no longer publicly traded. We consistently monitor our portfolio companies, including those we have exited. A stock which reached full value may again become undervalued.