Ariel Investments Portfolio Manager Tim Fidler details his investment philosophy as co-portfolio manager for Ariel Appreciation Fund.
Investing in 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 Appreciation Fund invests may never be recognized by the broader market. Past performance does not guarantee future results.
Question: How would you describe your approach to value investing?
Answer: As portfolio managers, John W. Rogers, Jr. and I practice a classic, traditional, bottom-up value approach to investing that plays to our firm’s core beliefs of patience, focus and independent thinking. Our focus is on the quality and growth prospects of the underlying businesses. All of our fundamental analysis seeks to replicate the same thought process that a private owner would employ if she could own the entire business. Portfolio companies are selected for their long-term prospects, not trading considerations. We seek to hold differentiated, growing businesses with solid balance sheets and attractive returns on capital. We will own businesses that are defended by what Warren Buffett has described as economic moats1.
Furthermore, the only way to outperform the market is to be different than the market. Consequently, our portfolios will look very different than that of the benchmarks. Our portfolios are concentrated and will have pronounced differences in industry composition, as the type of company we seek tends to cluster in areas such as consumer discretionary, consumer staples, financial services, business services, and industrials. We require our companies to exhibit consistency and predictability over the long run, which limits our investments in areas such as deep cyclicals, utilities, and some areas of technology and basic materials.
Finally, having a willingness to be different than the crowd, or what we refer to as independent thinking, is critical. Most successful value investments require some emotional pain. Ariel has a tremendous research culture that encourages and rewards analysts to look for ideas others may eschew due to short-term issues or perceived career risk from investing in unpopular companies. The school of behavioral finance has greatly influenced our thinking at Ariel, and we try to articulate our investment theses by identifying what systematically flawed decision-making in the market is occurring in each situation.
Question: What’s the difference between Ariel Appreciation Fund and Ariel Fund?
Answer: The market capitalization of the companies in the funds and portfolio management are the primary differences. Ariel Appreciation Fund seeks to buy companies within a market capitalization range between $2 billion and $15 billion, whereas Ariel Fund’s range is $1 billion to $7.5 billion. As of March 31, 2018, the average weighted market cap of Appreciation Fund was $10.3 billion, while Ariel Fund had an average market cap of $5.5 billion.
Question: How do you and John W. Rogers, Jr. co-manage the fund?
Answer: John and I are the final decision-makers on all investment decisions for Ariel Appreciation Fund. Beyond the two formal weekly research and investment committee meetings, much of the interaction in our research department is conducted more informally. We will both participate in management meetings, conference presentations, company visits, and other interactions, reaching our decisions together. Ariel is not a trading culture, and there is more than enough time to work together to get the big decisions right. Furthermore, I have worked with John for more than 15 years, so while we may not be able to complete each other’s sentences, we are fully aligned on all points, processes and philosophy.
Question: What index do you use as your primary benchmark? Secondary? Why two? Do you care about benchmarks?
Answer: Our primary index is the Russell Mid Cap Value. We also compare ourselves to the Russell Mid Cap benchmark and the broader market as measured by the S&P 500. While we don’t manage to a benchmark and will have periods where we behave quite differently than the indices over an investment cycle, our goal is to outperform them over the long run.
Question: How many stocks do you own in Ariel Appreciation Fund at any given time, and is there a range you try to stay within?
Answer: We currently hold 43 stocks in Ariel Appreciation Fund (as of March 31, 2018). Our goal is to hold between 35 and 40 stocks at any given time. We feel that is the sweet spot of providing healthy diversification without diluting our stock-picking efforts.
Question: What do you consider when adding a new stock to Ariel Appreciation Fund? How many do you typically add each year?
Answer: Every new stock added to Ariel Appreciation Fund has to meet two basic tests:
- Is it a quality business by Ariel’s standards?
- Is there an opportunity for us to have a differentiated opinion about the business than that of the broad market?
Our expected holding period for each new investment is, on average, between four and five years, which means that in any given year, 20% to 25% of the portfolio is expected to turn over. If you run the math, 20% to 25% turnover on a portfolio holding approximately 40 companies yields between six and eight new names per year on average.
Question: How do you know when to sell a stock? What is your sell discipline?
Answer: The sell discipline is fairly simple. When all works well, we sell stocks when they approach our estimate of their intrinsic value. We aren’t looking to buy at $18 and sell at $22. We’re fairly patient. We’re looking to buy somewhere around $20 and sell somewhere around $35 a few years out. Once companies do hit our estimate of their intrinsic value, we begin selling. Other less favorable circumstances will incite us to sell a holding, such as a change in the competitive landscape or a loss of confidence in management’s ability to execute its plan. At that point, we’ll take our losses and redeploy the cash in what we think are better businesses and opportunities.
Question: How do you determine if a company is undervalued? What factors do you consider?
Answer: Every stock is evaluated on our conviction in the company-specific investment thesis and the price we are paying for that company. All potential investments have to pass initial tests on balance sheet strength and expected growth. In particular, businesses are required to have an investment-grade balance sheet as determined by our proprietary debt-rating process and exhibit an ability to grow earnings per share at least at a double-digit compound annual growth rate over our expected holding period.
In determining valuation, we use a combination of three different methods. The first is a classic discounted cash flow model, and the second considers asset value. We review recent transactions of similar businesses that have changed hands in either a strategic mergers-and-acquisitions transaction or a private market transaction such as a leveraged buyout. The third is what we call the full-and-fair value. This is a market trading value where we look at the full price that the market has been willing to pay for the business when it is firing on all cylinders. We then combine the three methods to arrive at an intrinsic value for the business or what we call “private market value” (PMV). In our process, we are looking to buy companies trading at a 40% discount to our PMV. We will also buy stocks trading at less than 13x expected cash earnings per share.
Question: We’ve heard you say in interviews that Ariel Appreciation Fund is “concentrated yet diversified.” Can you explain that?
Answer: Despite running a concentrated portfolio, we have enough diversity in our holdings and industry weights to capture the traditional behavior of a diversified portfolio with regard to limiting outsized idiosyncratic risk resulting from any one position. In other words, while we may be out of sync with the market at any given point in the investment cycle, we will track the broad market performance trends so no one individual position alters the risk profile of the overall portfolio.
Question: Is the 40% discount you typically seek higher or lower than other mid-cap funds in your peer group? Why is that so?
Answer: Here at Ariel, we believe the market is largely a highly efficient discounting mechanism. Finding “sixty-cent” dollars in a highly efficient market is not an easy task and requires a concentrated portfolio to effectively pursue such a strategy. There simply aren’t that many mispriced stocks at most points in the investment cycle to run a fund with hundreds of companies and follow a disciplined value approach such as ours. Considering that concentrated funds are relatively uncommon among our mid-cap peers, we would suggest that the 40% discount required at Ariel is substantially higher than that of our peer group.
Question: How do you limit risk in your portfolio?
Answer: As I mentioned, we don’t manage to our benchmarks, so we don’t pay any attention whatsoever to things like tracking error and asset correlations. We do examine multi-factor risk models, but they are not a formal part of our risk management efforts. We are purely bottom-up investors. The way we feel we can best control our risk is by really digging in, understanding our businesses and understanding their prospects over time. We also have controls in terms of diversification, in that we do not have more than 10% of the portfolio in any one specific industry. Furthermore, all position sizes are limited to a cap of 6% at market value and we will not add to the position if it is above 5%.
We also have very strict balance sheet controls, which is what we feel separates good stocks from bad stocks, despite the quality of underlying business. Weak balance sheets can turn great businesses into bad stocks in a very rapid fashion. Furthermore, we are constantly assessing the quality of our companies’ competitive advantages, or economic moats, and rate all portfolio companies on this metric as it is a critical aspect of investing with a perceived margin of safety2.
Finally, our ESG analyst for our domestic research team works with the primary analyst and portfolio managers to assess the sustainability and ethical impact of portfolio companies and prospective investments. As such, we maintain a proprietary ESG Risk Assessment level for each of the core domestic holdings. We seek companies with a commitment to social awareness and corporate governance similar to how we search for sound financial strength and economic moats. We believe a dedication to social awareness and corporate governance drives better companies. There are three key mechanisms. First, ethical and sustainable business practices can create competitive advantages through cost savings, revenue enhancements, and innovation. Second, companies can mitigate future risks by addressing weak ESG standards. And finally, companies may enhance their brand or reputation as an industry leader in sustainability, thereby establishing consumer loyalty and bolstering recruiting efforts.
Question: Do global crises affect your fund?
Answer: To the extent they affect the overall market’s appetite for risk, they will impact the Fund. We do not have any specific investment theses tied to these global crises. From time to time, global geopolitical shocks such as war, terrorism or natural disasters are so severe that the pricing of all risk assets are affected, but thankfully these are somewhat infrequent.
Question: What brought you to Ariel?
Answer: I started my career as a ‘quant’ at Morgan Stanley & Co. The more quantitative modeling I did, the more convinced I was that the vast majority of asset pricing anomalies would be priced away though simple arbitrage over time as computing power and data became cheaper and more readily available. What would never be arbitraged away would be human behavior. Poor, systematic decision making by human beings will still be around long after I retire. At Ariel, I found a culture that is set up around that basic idea. It’s a perfect fit.
Beyond investment considerations, Ariel is a wonderfully unique place. John W. Rogers, Jr. is fond of saying “We don’t look like other Wall Street firms.” Our firm celebrates and promotes diversity, and is active across a host of other social endeavors such as developing early financial literacy in our schools and giving back to the communities in which we live. It’s easy to come to work and feel good about what your firm stands for.
Question: Explain the research department’s structure and organization.
Answer: Our research team is organized along industry lines. Every analyst, including me, is responsible for primary coverage on two or three industries. We also have devil’s advocate responsibilities on another two or three industries. Our domestic research team in Chicago is 11 people strong, including nine of us who have the formal responsibilities of covering individual stocks. In any given week, there are multiple research reports to discuss and debate covering anything from exploratory new idea research to reviewing stocks we have held for 20 years.
Question: Given your experience in the industry, what advice would you give to investors?
Answer: Stocks are ownership interests in real businesses. The values of most businesses change very slowly over time, despite the volatility of the prices that investors will pay for them at any given point in time. Use irrational volatility to your advantage.
1An 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.
2Attempting to purchase with a margin of safety on price cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimations on our part, declining fundamentals or external forces.
The opinions contained in this commentary were 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.
The Russell Midcap® Value Index measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap Index companies with lower price-to-book ratios and lower forecasted growth values. The Russell Midcap® Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Index represents approximately 27% of the total market capitalization of the Russell 1000 companies. Russell® is a trademark of Russell Investment Group, which is the source and owner of the Russell Indexes’ trademarks, service marks and copyrights. The S&P 500® Index is the most widely accepted barometer of large cap U.S. equities. It includes 500 leading companies.