Investing in micro-, 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. Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, foreign currencies and taxes. The use of currency derivatives and exchange-traded funds (ETFs) may increase investment losses and expenses and create more volatility. Investments in emerging and developing markets present additional risks, such as difficulties in selling on a timely basis and at an acceptable price. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market. Ariel Focus Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.
Describe the research process that you follow.
Our research process follows four parts: idea generation, with stock ideas derived from multiple sources; assessing valuation, where we create our own private market value (PMV) estimates, verification, with our chief tool an extensive independent verification network, and a final decision, which results in us generally purchasing a few new companies annually.
Our research process is designed to find franchise-quality companies that are misunderstood and therefore mispriced by the market. We dig deeply into a company’s business model using 360-degree fundamental research in order to identify the best-in-class companies whose prospects can decouple from their industries, and then peel the onion to try to understand the source and sustainability of each company’s competitive advantage. Because we also pay close attention to risk management, we proactively assess not just the upside potential of an investment idea if things go right, but also the downside risks if things go wrong.
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.
As you begin to research an investment, what do you hope to learn? What is top of mind for you?
What I’m really looking for is a sustainable, competitive, economic advantage. That’s what this is all about. If you’re investing in companies that don’t have anything that allows them to earn an excess rate of return, they’re not going to be good investments in the long run. They may have short-term rallies, they may benefit from some short-term noise, but you’re looking for longâ€‘term sustainable competitive advantages.
When we start researching a company, we try to eliminate them from consideration as a means of avoiding businesses that come with risks that are too high to bear, including factors such as weak balance sheets, poor corporate governance, or low returns on invested capital relative to their weighted average cost of capital.
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.
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)?
I would describe it as both an art and a science. The mechanics of our investments process are that we start with a watch list of companies that we think are high-quality companies, and then we wait for some kind of short-term event. It might be a missed quarter, a regulatory problem, a trend in the industry that is producing a short-term headwind or a short-term macro factor like a strong dollar. If that hits the stock and makes the short-term outlook appear challenged, the stock may drop abruptly, although there has been no material change in the long-term value. The stock will jump to the top of our watch list, and we will update our valuation analysis. Our objective is to buy stocks that we think are trading at significant discount to their intrinsic values, and we are hoping to find a company with a long-term opportunity in the face of that short-term problem.
We use both quantitative and qualitative characteristics as part of our process. Quantitative metrics can include return on invested capital relative to weighted average and fixed charge coverage ratios, and our qualitative evaluation can include proprietary analyses of business model risk, which may incorporate assessments of risk factors such as product or customer concentrations.
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.
Do macro-economic factors affect your investment process? For example, do rising interest rates play into your thought process?
Macro-economic factors may have an impact on some of the stocks that we identify as potential candidates for investment, but they do not drive our investment process.
For example, there has been a rush toward perceived safer, defensive stocks that are less-cyclical stocks and a rush toward bond substitute stocks like REITs, MLPs, etc., as investors search for yield in a declining interest rate environment. The result has been that certain companies that are perceived to be more cyclical and less defensive have become very cheap, most particularly finance companies and industrials. The Focus Fund, which I manage, has been overweight those sectors for more than two years while underweight consumer staples, telecom stocks and utilities. This was a headwind in 2015, as investors continued to pile into these stocks perceived as safer and bond substitute stocks, but this changed in 2016. As the outlook for regulation has improved and interest rates have increased, investors are coming around to our way of thinking and noticing that many of these high-quality financial stocks represent real value, as do some of the higher-quality industrials and producer durables.
As global investors, we consider both macro and micro variables in our analysis, including the effects of currency or interest rates. That said, our investment decisions are driven primarily by our bottom-up analysis of the company’s long-term business prospects.
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.
What will immediately make you eliminate a company from consideration?
We will eliminate a company from consideration—and also sell a security from our portfolio—if we determine our investment thesis no longer has merit due to a major shift in the competitive landscape, a deterioration in company fundamentals, a loss of faith in management’s ability to execute the company’s strategy, or a combination of these.
Companies run by management teams who consistently make poor capital allocation decisions.
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.”
Since you often buy stocks when they’re under a cloud, how do you distinguish between a great bargain versus a potential mistake?
If you can find great long-term opportunities where there’s some kind of short-term problem, you can find a great long-term investment vehicle. But that can cause shortâ€‘term volatility, and so people need to know about Ariel. We’re a firm focused on the long-term. The investment may be volatile in the shortâ€‘term. I view investing as a philosophy and a process of finding what the market is undervaluing, but very much taking into account the risks involved in any individual security, and then putting them together in a portfolio that gives me a good combination of long-term value opportunity, but risk management. That’s what it’s all about.
Our investment discipline seeks to buy quality when it’s on sale, not junk at clearance prices. We only consider investing in businesses that have solid long term fundamental prospects, and we wait patiently to buy them when they are priced with a margin of safety. In this way, we can identify great bargains while generally avoiding value traps.
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.
How would you distinguish Ariel’s research process from other investment firms? What makes Ariel’s research process different?
What makes our research process different is that we are independent-thinking contrarians. Although our investment processes is collaborative, and we are encouraged to work together on investment ideas, we also are encouraged to voice dissenting ideas.
The strategy we employ fuses three unusual qualities: an emphasis on very small companies, deep value investing and a focused portfolio—generally investing in less than 30 stocks in any market cap. We talk about it as being superior ideas that Ariel finds across any market cap. While our competitors may occasionally use two of these approaches within the same product, I think it is exceedingly rare to find all three at once.
We invest to our convictions, not to benchmarks. This means that we are willing to own stocks, sectors, and geographies that other investors may avoid. Our patient investment approach allows us to take advantage of short term volatility.
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.
Is there a beginning or an end to the research process?
I would say no, in that we are always looking for the next great idea for our portfolio. Our patient, long-term approach searches for great buying opportunities that arise from Wall Street’s excessive short-term focus and the institutional neglect common with micro- and small-cap deep value stocks.
No. Research is a continuum. The world is constantly changing. Change provides opportunity. As active managers, we are constantly on the lookout for these opportunities.
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.
Attempting to purchase within a margin of safety on price cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimates on our part, declining fundamentals, nor external forces.
Bonds are fixed income securities in that at the time of the purchase of a bond, the amount of income and the timing of the payments are known. Risks of bonds include credit risk and interest rate risk, both of which may affect a bond’s investment value by resulting in lower bond prices or an eventual decrease in income. Treasury bonds are issued by the government of the United States. Payment of principal and interest is guaranteed by the full faith and credit of the U.S. government, and interest earned is exempt from state and local taxes. A REIT (real estate investment trust) is a security that invests in real estate. REITs receive special tax considerations, have potentially high yields, and offer a liquid method of investing in real estate. Risks include interest rate and overdevelopment risk. Utility stocks are known as defensive stocks because they historically provide higher-than-average returns in a declining market. In addition, utility companies may return dividends that are likely to offset declines in the company's stock prices. Risks of utility companies include the reduced potential for capital gain and the risk that the stocks may decline in value resulting in a loss. Consumer staple stocks are considered to be noncyclical in that the demand for the products made by these companies does not decrease in a recession. Consumer staple stocks have historically experienced lower volatility.