Ariel Investments Vice Chairman and Head of Investment Group Charlie Bobrinskoy discusses the research process for the Ariel Value Strategy. Read the full Q&A below.
Ariel Focus Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment. Investing in equity stocks is risky and subject to the volatility of the markets. Investing in small/mid-cap stocks is more risky and volatile than investing in large-cap stocks. The intrinsic value of the stocks in which the Fund invests may never be recognized by the broader market.
Question: Describe the research process that you follow.
Answer: : 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.
Question: As you begin to research an investment, what do you hope to learn? What is top of mind for you?
Answer: : 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 long‑term sustainable competitive advantages.
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: : 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.
Question: Do macro-economic factors affect your investment process? For example, do rising interest rates play into your thought process?
Answer: : 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.
Question: What will immediately make you eliminate a company from consideration?
Answer: : 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.
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: : 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 short‑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 short‑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.
Question: How would you distinguish Ariel’s research process from other investment firms? What makes Ariel’s research process different?
Answer: : 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.
Question: Is there a beginning or an end to the research process?
Answer: : 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.
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.