Ariel Appreciation Fund seeks long-term capital appreciation by investing primarily in common stocks of companies with market capitalizations between $2.5 billion and $15 billion measured at the time of purchase. The Fund invests in undervalued companies that show strong potential for growth. To capture anticipated growth, the Fund holds investments for a relatively long period of time – generally five years.
Our Approach to Investing
Our investment philosophy depends upon three interrelated tenets: patience, focus, and independent thinking, which drive our contrarian approach. Our divergence from conventional wisdom allows us to add value by taking advantage of the market’s few and small pockets of inefficiency.
A Patient View
“Time is the friend of the wonderful company, the enemy of the mediocre.” — Warren Buffett
Compels us to wait for the perfect pitch—differentiated companies with strong cash flows, low debt, high quality products or services, significant barriers to entry and low reinvestment requirements.
Permits us to use the market’s short-term thinking to our advantage since our longer term approach allows us to be opportunistic as price dislocations arise.
Enables us to take our time to research a name and wait as long as necessary for it to possess the margin of safety we require.
Leads us to build extensive third party networks that inform our stock picking.
A Focused Approach
“Invest within your circle of competence.” — Warren Buffett
Allows us to build expertise and accumulate deep knowledge.
Augments our conviction, especially during crunch time when it matters most.
Enables us to learn from our mistakes and make fewer of them.
Leads us to isolate the key issues of importance to a company in the midst of the market noise.
Results in our portfolio concentration in a limited number of names and a limited number of industries.
Allows us to build and cultivate our third–party sources more effectively.
We don’t own a little bit of everything because we can’t know everything—we choose to go deep instead of broad.
A Team of Independent Thinkers
“If you buy the same stocks as everyone else, you get the same results.” — Sir John Templeton
Encourages us to buy out of favor, misunderstood and ignored stocks.
Compels us to buy when others are selling and to sell when others are buying.
Leads us to perform our own original, proprietary research.
Persuades us to be benchmark agnostic with very different industry weightings.
Permits us to take advantage of market psychology.
Period: Q1 2013
Portfolio date: 31 Mar 2013
No. of stocks: 42
Portfolio value: $1,511,319,000
|Stock||% of portfolio||Shares||Recent activity||Reported Price*|
|hist||IPG - Interpublic Group||4.68||5,430,730||Add 7.70%||$13.03|
|hist||LAZ - Lazard Ltd.||4.20||1,859,520||Reduce 2.39%||$34.13|
|hist||TMO - Thermo Fisher Scientific||3.96||782,754||$76.49|
|hist||NTRS - Northern Trust Corp.||3.70||1,025,500||$54.56|
|hist||AFL - AFLAC Inc.||3.47||1,007,000||Add 29.07%||$52.02|
|hist||VIA.B - Viacom Inc.||3.27||801,800||Reduce 6.51%||$61.57|
|hist||STJ - St Jude Medical||3.24||1,211,200||Add 23.34%||$40.44|
|hist||FAF - First Amer'n Corp.||3.21||1,900,200||Reduce 14.40%||$25.57|
|hist||IGT - International Game Technology||3.17||2,899,890||Add 6.11%||$16.50|
|hist||BX - The Blackstone Group||3.15||2,408,700||Reduce 8.16%||$19.78|
|hist||TW - Towers Watson & Co.||3.14||684,200||Add 40.67%||$69.32|
|hist||JLL - Jones Lang Lasalle Inc.||3.02||458,500||Reduce 10.52%||$99.41|
|hist||HSP - Hospira Inc.||3.01||1,387,100||Add 56.91%||$32.83|
|hist||CBS - CBS Corp.||2.96||956,900||$46.69|
|hist||ZMH - Zimmer Holdings||2.96||593,900||Reduce 6.68%||$75.22|
|hist||BEN - Franklin Resources||2.95||295,400||$150.81|
|hist||KKR - KKR & Co. L.P.||2.87||2,246,455||$19.32|
|hist||WU - Western Union Co.||2.82||2,829,000||Add 42.81%||$15.04|
|hist||JNS - Janus Capital Group||2.71||4,362,775||$9.40|
|hist||ISCA - International Speedway||2.61||1,208,956||Add 7.70%||$32.68|
|hist||CYN - City National Corp.||2.33||597,900||Add 48.14%||$58.91|
|hist||ITW - Illinois Tool Works||2.32||574,250||Add 66.96%||$60.94|
|hist||SWK - Stanley Black & Decker Inc.||2.16||403,299||Add 41.16%||$80.97|
|hist||SNA - Snap-On Inc.||2.15||392,100||$82.70|
|hist||GCI - Gannett Co.||2.07||1,428,300||Reduce 11.02%||$21.87|
|hist||MSG - Madison Square Garden Inc.||1.90||499,700||Reduce 22.66%||$57.60|
|hist||COH - Coach Inc.||1.89||571,100||Buy||$49.99|
|hist||BIO - Bio-Rad Laboratories Inc.||1.86||223,625||$126.00|
|hist||OMC - Omnicom Group||1.75||448,700||$58.90|
|hist||NWL - Newell Rubbermaid Co.||1.71||988,700||$26.10|
|hist||MCF - Contango Oil & Gas Co.||1.56||586,482||$40.09|
|hist||DV - DeVRY Inc.||1.55||739,435||Reduce 10.84%||$31.75|
|hist||BID - Sotheby's||1.49||601,600||$37.41|
|hist||LIFE - Life Technologies Corp.||1.46||342,300||Reduce 35.73%||$64.63|
|hist||SJM - Smucker (J.M.)||1.44||219,475||$99.16|
|hist||TROW - T. Rowe Price Group||1.21||243,300||$74.87|
|hist||CBG - CBRE Group||1.12||669,050||Reduce 41.62%||$25.25|
|hist||JWN - Nordstrom||1.12||305,800||Add 40.47%||$55.23|
|hist||TIF - Tiffany & Co.||1.06||231,200||$69.54|
|hist||CCL - Carnival Corp.||1.05||463,550||Add 185.17%||$34.30|
|hist||ACN - Accenture||0.94||187,100||$75.97|
|hist||APOL - Apollo Group||0.77||672,300||$17.39|
* Reported Price is the price of the security on the portfolio date. This value is significant in that it indicates the portfolio manager's confidence in the stock at that price and suggests at least some level of undervaluation and/or margin of safety.
Sector % analysis
Articles & Commentaries
John Rogers, Ariel Investments chairman & CIO, talks about which stocks are hot and where to invest in the markets.
From our perspective, the story of the last half-decade continues to be investors’ love affair with bonds and extreme distrust of equities—despite the handsome returns stocks have generated of late. Although December results are not yet available, it is clear that 2012 will be the fifth straight year of outflows from U.S. stock funds— totaling approximately $300 billion in total over the full period. Meanwhile, investors have plowed more than triple that amount—over $1 trillion—into municipal and taxable bond funds. A superficial look at performance suggests why bonds have been so popular: their five-year total return is much higher than the various equity groups, and they have gained between +4% and +8% in each of the last five calendar years. Meanwhile, stock returns are lower—plus international as well as domestic small-caps have lost money in two of the past five years.
We think investors are unfortunately limiting their analysis to a surface-level view and are thus missing what is more important. After all, since the carnage of 2008, stocks have crushed bonds. On an annualized basis, large-caps have gained +14.58% and small-caps have increased +15.81%—more than double bonds at +6.12%. The total return gap is even greater: the Russell 2000 Index has essentially tripled the Barclays U.S. Aggregate Bond benchmark. In large part, we think investors are fleeing a crash that is receding in the rear-view mirror: the losses of 2008. As is true of driving, it is important in investing to spend most of your time looking out the windshield rather than at the road already traveled. From that perspective the so-called “flight to safety” looks reckless more than cautious to us. Domestic bonds have rarely if ever had worse prospects, broadly speaking. The 10-year Treasury yield is just +1.8%—about one-fourth the income such bonds have provided long-term and among the lowest on record. Meanwhile, the comparable earnings yield of the S&P 500 Index and Russell 2000 Index are +6.7% and +6.1%, respectively, which are within the normal ranges but a bit better than average long term. We would much rather own an asset with an attractive yield in-line with historical norms than an investment much worse than the typical range—and we think overdue for a painful reversion to the mean.
As we enter into 2013, the equity world around the globe is generally the way we like it to be. Specifically, although the business fundamentals look solid, the animal spirits, headlines, and valuations suggest a significant amount of fear. More importantly, the most-cited sources of anxiety are only tangentially linked to an active, focused portfolio of stocks—the half-solved Fiscal Cliff issue, the European debt crisis, and even the New Normal. Such macroeconomic matters only mildly hurt strong companies’ long-term fundamentals but can really hit stock valuations—creating ample opportunities for contrarian investors, in our view. Although many asset managers insist on rank-ordering their favorite asset classes, we can report that all of our portfolio managers, from micro-cap to all-cap, from domestic stocks to international fare, are finding plenty of attractive opportunities. Even though equities have already had three very good absolute return years in the last four, we continue to think 2013 will be a normal or even better-than-normal year for most of our asset classes based on prospective growth rates and overall valuations. As always, we strive to outperform with our highly-active, always-patient, contrarian investing style.
John Rogers, Ariel Investments chairman, CEO & CIO, reveals his top stock bets and explains why a "slow and steady" strategy works best in an uncertain political environment.
The investing question at top of mind for us these days is: why do people feel so bad in such a good market? One partial explanation is people simply do not realize how well the stock market has performed lately. As of September 30, 2012, the domestic large-cap S&P 500 Index has gained +16.44% year-to-date and +30.20% for the trailing 12 months. Small caps have done similarly well with the Russell 2000 Index up +14.23% in 2012 and +31.91% for the one-year period. Even stocks from abroad, where the macroeconomic fears of the day are headquartered, have strong returns: the MSCI EAFE Index has gains of +10.59% and +14.33% for the year-to-date and 12-month periods. Moreover, looking long-term the so-called “lost decade” label is history: all three of the previously-mentioned benchmarks are up more than 8% annually over the past 10 years.
The explanation you hear again and again is the stock market is really volatile right now. The key problem with this explanation is that the stock market has recently been more placid than usual. The gold standard for volatility is the VIX Index. Over the past decade its average has been 21.3 with a median score of 18.6. In 2012, however, the VIX has averaged 18.1 and on September 30th, it fell to 15.7. The market has been relatively tame.
The other prevailing explanation is there is “too much uncertainty.” The laundry list of uncertain things experts toss out includes the U.S. Presidential election, the state of the U.S. economy, the so-called “fiscal cliff,” the European debt crisis, and even the potential for a Chinese recession. This explanation seems a stretch to us. First and foremost, these are the kinds of things economists think about, not individual investors. But for just a moment, let us suppose people really do understand the entire financial system in all its complexity. If so, then they would seem to fear a gloomy uncertainty even more than a dismal near-certainty. That is, investors continue to shift money to bonds and the outlook for bonds is awful. Given record-high debt levels and record-low yields, this is not a big topic of debate—experts agree the comeuppance is very likely to come sooner or later.
We have a different explanation for the current mood: investors have an acute case of what behavioral economists call “prospect theory.” The simple version of this phenomenon is: investors hate losses more than they love similar gains. A typical rule of thumb is most people are twice as upset with the loss of $1,000 as they are pleased by the gain of $1,000. Generally speaking, it causes people to be more risk-averse than strict logic would dictate. Our evidence follows. Over the past 36 months, stocks have posted gains in 23 months— averaging a +3.84% gain in those months; bonds have had positive returns in 28 of those 36 months, with a +0.80% average. If investors were really looking at those gains, stocks are the clear choice. But the flows do not follow those gains: active stock funds have seen outflows in 32 of the last 35 months, while bond funds have seen inflows in 34 of the past 35 months. Why? In those 13 months where stocks lost money they lost an average of -3.64%, but bonds only lost -0.54% on average in the eight months where they slipped. Investors seem to look right past the recent gains and focus on losses, so they have avoided stocks and piled into bonds. Did investors benefit from their behavior? Not at all. Over the three-year period in question, the S&P 500 Index gained a cumulative +45.07%—more than double the +19.73% gain of the Barclays Aggregate Bond Index.
We think investors are doing themselves a disservice by looking forward and seeing the spectre of the unknown or looking in the rearview mirror at losses. And they seem to be either overthinking the situation or overreacting to fear. We think a more rational, disciplined approach is in order. First, rather than looking at short-term returns and concentrating on intermittent drops, investors should look at the longest and therefore most statistically meaningful return sets when considering their options. According to Ibbotson’s most recent Stocks,
Bonds, Bills and Inflation Yearbook, from the end of 1925 to the end of 2011, the annual gains of large company and small company stocks were +9.8% and +11.9%, respectively. Meanwhile, long-term corporate, long-term government and intermediate-term government bonds averaged +6.1% or lower for the same period. Second, we believe investors are well-served developing a prudent asset allocation policy—employing dollar-cost averaging to smooth out the inevitable bumps in the road and rebalancing every year or so if target weightings get out of whack. Otherwise, short-term fears can drive decisions that limit long-term gains.
In our meetings with clients, prospects, consultants, and investing peers, the theme that continues to come up again and again is the dramatic shift in risk tolerance over the last several years. After the tumult of the 2008-2009 financial crisis and amidst the uncertainty of the European debt crisis, it is clear that investors have become far more risk-averse than they were a few years back. The most obvious signs are the massive rush of billions into bonds despite their historically anemic yields and the new world order of “risk on/risk off” days...
As a contrarian investor, I like it when perceptions are disconnected from reality because it gives me an opportunity to buy quality stocks on sale.
Stocks rose broadly in June and thus far in 2012, but everyone seems to be focusing on the third straight spring swoon. For the month, the domestic large-cap S&P 500 Index gained +4.12%, the small-cap Russell 2000 Index returned +4.99% and the international MSCI EAFE Index surged +7.05%. Thus far in 2012, these indices have gained +9.49%, +8.53%, and +3.38%, respectively. But, as above, the attention remains on the second quarter’s negative returns and how they mirror those of 2011 and 2010.
Given the three-peat, we feel as though we have opined on this volatile investment environment extensively in recent years with little new to say. For example, last year, in July’s commentary, we counseled perspective by saying, “It only feels like a meltdown. . . . [V]ery few people enjoy watching stocks drop, but the current slump is just a correction—not even a bear market.” In July 2010, we predicted future volatility and contrasted the market’s mood with our own efforts:
We cannot claim to be Mr. Market’s therapist, but it would not surprise us if the sharp swings from glee to gloom continue. The market and economic events of the last three years have left investors skittish. On the one hand, there are headlines signaling huge macroeconomic issues on the horizon. On the other hand, many individual companies continue to grow—and faster than analysts expect. We plan to maintain our focus where it has always been: on identifying strong companies with good growth prospects, healthy financing, and committed management teams.
So far the macroeconomic specters lurking the past three years have yet to deliver the predicted road damage—which is the way things tend to go. The worst usually does not happen. In addition, the recent downturns—like their predecessors in 2011 and 2012—have not morphed into a ravaging bear as in 2008, so investors should keep the losses in perspective. Finally, we think rational investors, which we try resolutely to be, should focus their attention on the fundamentals of individual companies, because in turbulent markets, buying opportunities often proliferate.
We think wire and cable distributor Anixter Intl. Inc. (AXE) serves as an excellent example of recent market
behavior. Its stock slid –21.52% in the past three months due to the short-term drop in copper prices as well as
fears that Anixter’s customers would pull back. As the world began to fret over a global macroeconomic contraction, copper dropped from $3.85 per ounce at the beginning of the quarter to $3.23 during the quarter—and then rose back to $3.46. Copper is the major input for about 10% of the company’s overall sales, so its price does matter. One might think lower copper prices would be a boon to Anixter, when in fact the company must pass along the commodity savings to its customers quickly. At best, the company’s margins hold steady. So lower copper prices lead to lower revenues and thus lower gross profits. Second, when copper prices flex quickly, Anixter may make purchases at a high price and then have to sell at lower prices. These issues are well understood but, in our opinion, exaggerated in short-term stock price swings. The fundamental problems that cause such a drop in value did not happen: the company did not lose a CEO, take on an unwarranted amount of debt, or even turn in an earnings report that portend future problems. From our perspective, Anixter’s stock is much cheaper than it was at the beginning of the quarter, even though its intrinsic value has changed only slightly—making it a potential opportunity from our perspective.
Ariel's John Rogers discusses recent opportunity in Madison Square Garden and International Speedway, as well as the firm's analytical adjustments in the wake of the financial crisis.
At Ariel Investments, we like to bring in thought leaders regularly to share insights that might help us better understand the investing world. Recently, we were lucky enough to host Dr. Robert Aliber, Professor Emeritus of International Economics and Finance at the University of Chicago. Dr. Aliber’s work often focuses on macroeconomic developments. To that point, he has been especially attuned to financial bubbles. Indeed, if you have heard of Dr. Aliber, it was probably either from his appearance as a doomsayer for Iceland in Michael Lewis’s Boomerang or as the author who recently put forward the sixth edition of Manias, Panics, and Crashes—the first five being the work of Charles Kindleberger.
For the last three years in the late spring, the market has tanked on worries that trouble from abroad would crush the economic recovery—fears we have greeted with skepticism given the fresh, real-life perspectives of our management teams. At Ariel, we believe the European sovereign debt crisis will be mostly contained to the region and unlikely to do real damage outside the European banking industry. Against our contrarian bottom- up backdrop, we asked Dr. Aliber how his macroeconomic top-down view compared. We learned that Dr. Aliber thinks the European predicament is overblown, does not see it endangering the U.S. economy, and thinks a worse crisis is actually brewing in China.
As recent headlines suggest, the world’s economic worries remain centered on Greece. Should Greece have to exit the Eurozone, most dread what calamities might ensue. Dr. Aliber points out he went on record in 2010 in a short paper titled “The Devaluation of the Greek Euro.” His overarching point, then and now: the Greek economy is not competitive given its low tax revenues, high unemployment, and very large deficit. The only ways to address the problem are for Greece to become competitive through hard labor, a path in which it has shown no interest, or to devalue its currency. With the latter as the only viable option, Aliber believes Greece will shift to another currency, devalue it, and perhaps return to the Euro later. Since Greece is such a small player in the global economy, he does not think the event will be a cataclysm—and we agree.
Many pessimists acknowledge Greece’s small size but suggest it could initiate a crisis, causing contagion to spread to the rest of Europe and then America. After all, in 2008 the domino’s size did not matter as long as it tipped the next one—Lehman was not very large. Dr. Aliber sees the situation quite differently. Insolvency and illiquidity are two different problems, although they can appear to be similar when trouble looms. Ireland, for instance, suffered a liquidity crisis but the economy’s structure was sound and the country’s assets were real; contagion did not happen nor was it a large fear. Spain is routinely cited as the next domino, but Aliber notes its economy is vibrant. So long as there is enough liquidity, Spain and thus the rest of the Eurozone should be fine.
While today’s headlines focus on Europe’s problems, Dr. Aliber has greater concerns about China—specifically its housing. Where huge imbalances involve great sums of money, trouble can begin. Recently Aliber notes housing prices in the largest cities in China hovered between $500,000 and $600,000 even though annual incomes tend to range from $25,000 to $30,000. While prices are high, occupancy rates and rents are low; a situation he views as unsustainable. He says the slowing Australian and Brazilian economies and falling steel prices underscore weakness in the Chinese economy. He points to the so-called “luo guan,” or naked official, who has money, real estate and family abroad in preparation for a quick exit from the mother country if necessary.
hile some may believe a financial crisis in China might hit the U.S. hard, Dr. Aliber is not so sure. First and foremost, commodity prices would fall, which should be a good thing for the United States. On the other hand, China’s likely solution to a problem would be to increase exports, thereby skewing our already unbalanced trade further. And yet the very big picture still looks good. The U.S. housing crisis, he notes, is ending, and although unemployment is certainly a problem, it is fixable. He points out earnings have been solid the last few years and is not worried about a fall off. The metric to watch, he says, is corporate earnings to GDP. The long-run average is in the 7-8% range, peaking in the low double-digits in the late 1990s and bottoming in the early 1980s. At 9% or so today, he does not believe it will skid anytime soon.
John W. Rogers recommends shares of International Speedway (ISCA) and Gannett (GCI)...
The broad market’s docile recent returns—a -0.63% fall in April and a +4.76% twelve-month gain for the S&P 500 Index—belie its fits and starts. Within the past year the U.S. market has had streaks of four positive months in a row as well as five straight negative months. Increasingly the market seems to be binary in nature, fluctuating between risk on and risk off or from growing confidence to rising worry. As other investors focus on “the macro,” we feel as if we are doing something entirely different.
If we compare investing to cooking, it feels as if most practitioners and Ariel are both trying to make a dish with eggs, but they are making soufflés and we are fixing hard-boiled eggs. In order for a soufflé to work, everything has to be just so. The oven must be at exactly the right temperature. The egg whites and yolks must be completely separated and beaten in a precise way. They must then be folded—but not mixed!—together. Finally, you have to bake the mixture in the right kind of dish for the correct amount of time. Done perfectly, you have a very tasty treat; if not, you often get a mess. We are trying to do something much more simple. We boil water, drop in an egg, wait the requisite eight or so minutes, and then chill the egg down. True, you can overcook or undercook with this recipe, but it is undeniably easier.
To return to the world of investing, here is what we see. Many are trying to get a very detailed picture of just how the world economy is doing in order to fine-tune their asset mix, sector mix and stock picks. Every day a crucial set of numbers seems to emerge. This April, the market-watchers waited anxiously to discover whether payrolls would increase by the estimated 205,000 or not—and the figure came in much lower. Those tuned in to the big picture were also eager to discover where U.S. growth would come in for the first quarter of 2012, as well as whether China would grow 7%, 8% or 9%. As it happened, U.S. growth disappointed the masses at 2.2%, while China’s 8.1% increase struck the crowd as a poor showing. All told, the news reports painted April as a month of disappointments—fast on the heels of a bundle of encouraging datapoints in March. Even when very bright people dedicate themselves completely to making accurate predictions about these matters, they find it very difficult. It is like chefs who keep trying to make soufflés even though they continually fall.
For our part, we are trying to make our task easier by narrowing the focus to a specific company and isolating the big issues. We are not trying to match up the economic picture with certain stocks, nor are we trying to master reams of details regarding the economy or each firm. Instead, we are trying to find companies that have strong franchises and powerful brands run by smart, experienced managers who will make sound capital allocation decisions. If we are able to do so with some consistency, we think our results will hold up well. That is, if we just try to boil eggs one after another, our clients will end up well-fed.
We will use two examples from the past month—a rising stock and a falling one—to illustrate what we are doing. Brink’s Co. (BCO) reported first quarter earnings of $0.35 per share versus consensus of $0.32, and the stock gained +6.41% in April. The press release was full of positive news including short-term growth rates, improved margins, an advantageous tax rate, and so forth. We homed in on two issues. We wanted to see continued growth in the business, especially in South America, as well as progress with the funding statues on the company’s U.S. pension plan. Brink’s delivered on both counts. One of our weaker stocks in April was Janus Capital Group Inc. (JNS), which declined -14.93%. Asset management stocks tend to amplify the market’s returns, so its decline in April’s drop was predictable. In order to satisfy its investor base, the company sliced and diced its portfolios’ performance, inflows and outflows, and other data in many ways. We do not focus on such minutiae; the company cannot, of course, control short-term performance, so we do not worry about it. If Janus retains its investment edge, long-term performance will be solid, ultimately driving assets under management upward. In the meantime it can make smart and even opportunistic capital allocation decisions. Indeed, during the first quarter, it repurchased $59.4 million in debt, bought back 263,600 shares of stock, and lifted its dividend by 20%. Those three actions were far more important to us than the short-term results which captured most investors’ attention.
All of this begs the question: are we playing an old-school game in a new-school world? That is, has our investment approach become outdated? We think not. Indeed, as long as shares represent ownership interests in individual companies and as long as we can purchase them at a discount to their intrinsic value, we believe our philosophy remains fully intact. To that point, we would argue that the market’s short-term focus and obsession with abstruse factoids makes our job easier and more relevant, not less so.
Over the short-term as well as the intermediate term, our rational emphasis on straightforward, reliable numbers was an effective antidote to the market’s emotional scramble. In the winter of 2009, many investors were furiously speculating how bad things might get: How far could the market fall? Would this period match the Great Depression? When would the carnage end? In the meantime, we homed in on two key datapoints for each of our stocks—the normalized earnings power of the business and the current market price. Examining these two metrics together, we concluded the market was pricing our stocks as if the gloomiest scenario was the most likely one—leading us to add to a number of our holdings opportunistically.
During the summer of 2011, the crowd became similarly convinced natural disasters and manmade crises would undo a recovery it had never fully embraced. Instead of attempting to determine the probability of a European debt implosion or the short-term impact of a flagging Japanese economy, we focused on the strong earnings of our holdings and the massive pile of cash that would insulate American companies from the dangers they encountered just a couple of years before. Our knowledge of the known kept us from worrying about the unknown.
The simple truth is the worst rarely happens. So when many assume it will, one can prevail by looking for dependable signposts of normalcy. Doing so does not demand vastly superior intelligence or information, but most find it too difficult to do—many find it emotionally draining to calmly believe all will be well when the masses are frantic. For that very reason, the rewards are considerable.
The question we find ourselves answering now is: after such a strong absolute and relative run, what gives us confidence going forward? To be sure, we do not expect the market to deliver annualized returns above 20% annually nor do we think our portfolios will compound at more than 30%. Yet we do believe equity markets will have typically strong historical returns and think our portfolios are capable of outperforming. Our confidence stems from the same thing that got us here: fundamentals are strong, yet valuations remain attractive. Profits are lofty on a historical basis, but largely due to cost-cutting in the Great Recession rather than prodigious recent economic growth. Reason suggests the best is yet to come because strong growth eventually follows a recession— and that should supercharge current profitability. In the meantime, the market continues to have sedate expectations. Over the past 85 years the average market P/E has been 16.4x; today it is only 15.3x. So the market and our portfolios may seem as if they have come a long way from the bottom, but they still have room to go. We continue to have our portfolio positioned to take advantage of the economic recovery, so if correct our optimistic, contrarian take should continue to play out.
Conventional wisdom says the nearly three years since the March 9, 2009 market bottom have been tough for active domestic stock managers. Investors have pulled $222 billion in assets from active mutual funds but invested $64 billion in diversified U.S. index funds. The standard explanation has two parts. First, most active managers provided too little downside protection in the 2007 to 2009 bear market. Second, they have lagged during the rebound. For instance, only 25% of funds in Morningstar’s large blend category have topped the S&P 500 Index over the past three years. Cynics say stock-pickers have not beat the market going up or down, so traditional long-only active management is, in their view, dead.
To paraphrase Mark Twain: reports of our death are greatly exaggerated. First, while outperformance in the mid blend and large blend universes has been unusually rare the past three years, more than half the small blend funds topped the Russell 2000 Index. Second, while we have not identified a simple, quantitative “magic bullet” separating leaders from laggards, we have seen an interesting pattern: many managers we track closely are leading the performance charts. In fact, we easily found a group of funds that almost universally outperformed— often with top-decile returns. We looked to the report prepared for our board three years ago in March 2009 describing our long-tenured funds’ closest peers. The true stock-pickers we identified before the three-year rally now contradict the view that highly active management no longer works.
Our board wants to see our closest peers, so we look for funds following the same philosophy we do. We use Warren Buffett’s strategy: focus on a small number of stocks, buy strong businesses trading at deep discounts, and hold for the long-term. We think smart people who employ this approach consistently are likely to outperform over time. To identify fellow travelers, we screen for funds with compact portfolios (70 stocks or fewer) and low turnover (less than 50% annually). We then use our judgment to weed out funds with a different approach—“relative value” funds, for instance. We also add back well-known Buffett followers omitted by our screen and include a small number of diversified funds run by industry thought leaders well-known as true stock-pickers.
In the 2009 board report, we listed 34 funds (including our own) in our large-, mid-, and small-cap peer universes. Today, 30 of them still exist with the same mandates (one shifted focus and three small funds shut down). Of that group, 25 of 30—more than 80%—landed in the top half of their Morningstar categories from March 1, 2009 through February 29, 2012. More impressively, 19 of 30, just over 60%, are top-quartile funds. Stunningly, 12 of these 30 funds landed in their categories’ top decile over the past three years.
Our point is simple. We did not select this group as those most likely to skyrocket in the next bull market. Nor did we select them using standard characteristics—sector weightings, beta, trailing performance, and so forth. Instead, we sought funds run by highly-active, benchmark-agnostic, bottom-up investors. With that in mind, we are pleased but not terribly surprised to report their dramatic successes of late. While many managers found it difficult to stand out, a small group who were seasoned, committed to value investing, and willing to demonstrate independent thinking substantially outperformed.