No matter how many times you reread Aesop’s famous fable, the plodding patience of the tortoise always bests the hare. That’s why when John W. Rogers Jr. founded Ariel Investments he decided the tortoise was the most emblematic of his methodical and slightly contrarian approach to long-term investing. Ariel Appreciation (CAAPX) is celebrating its 20th anniversary this year, but when we sat down with John and new portfolio manager Timothy Fidler, the two focused on their investment strategy and favorite themes--not the fund’s track record of success.
The fund’s amassed an impressive track record since its inception. What’s the secret to your success?
John: We are a value-oriented firm that has always focused on buying companies when they’re out of favor. For patient investors with a long time horizon, it pays to invest in the small and midsized companies that the market kind of hates.
What differentiates us from other value funds is that we concentrate on a few industries and relatively few names. We believe what Charlie Munger talks about every year at Berkshire Hathaway’s (NYSE: BRK.A) annual meeting; you want to stay within your circle of competence and become an expert in the industries and companies that populate your portfolio.
We often buy stocks when something isn’t quite right at a company--for example, it faces a temporary problem or a subsidiary causes trouble--but we think it will ultimately overcome these hurdles and become a higher-quality name. We’re willing to look out two to three years and bet that once things get back to normal these companies will be able to outperform.
Tim: We’re patient investors who expect to own stocks for three to five years. Over that period, management can have an enormous effect on the direction and value of a business. We spend an enormous amount of time getting to know each company’s management team and sizing up whether they’re good stewards of shareholder’s capital.
This approach has led you to some out-of-favor industries, such as media and commercial real estate. What’s the logic behind these moves?
John: Last year was the opportunity of a lifetime for value-oriented investors, though buying stocks at low prices didn’t work for a bit. You’d buy a stock, and it would go down; you’d buy more, and it got cheaper still. Credit markets froze, so any names with debt burdens got clobbered. And forced selling by hedge funds created drama when there really wasn’t any, so what was an $18 stock plummeted to $3. The market abandoned rationality.
Last March we became more aggressive in our purchases because we knew the economy would recover and wanted to add the names within our circle of competence that stood to benefit. We picked up some great stocks that we never thought would sink to bargain levels--for example, media giant CBS Corp (NYSE: CBS) and high-end retailer Nordstrom (NYSE: JWN).
In times of crisis focusing on your core competencies is essential to making good decisions; if you lack conviction, you’re more likely to be paralyzed by indecision. Because we knew our stories well, we were willing to buy when panic reigned.
But media companies are struggling, regardless of the recovery. How does that sector fit into your thinking on quality?
John: We spend a lot of time with Gannett’s (NYSE: GCI) management and believe in what they’re doing. But that business doesn’t have to return to its glory days. If it attracts a fair share of advertising revenue as the economy recovers, aggressive cost reductions and lower newsprint prices will enable Gannett’s earnings to surprise on the upside.
Analysts have been negative on the sector for so long and aren’t factoring in the benefits that will accrue from any improvement in the economy. Already a lot of the big retailers are advertising more aggressively on TV and in print. These days when I pick up my newspaper I see much more advertising. We’re hearing that advertising rates are improving not only from newspapers but also from several media companies that we talk to.
Buying quality stocks when there’s maximum pessimism has always made sense because once everyone gives up on a stock, groupthink takes over and share prices sink lower than they should--people lose sight of a possible recovery.
Do you have any favorite stocks?
John: CBS Corp is one of my favorites. The media giant should benefit from the economy’s inevitable recovery and an uptick in advertising. General Motors’ CEO is selling cars on TV, next year is an election year and advertising prices are on the mend. There’s a lot of positive momentum building, and companies will pay to put their products in front of the eyeballs that watch highly rated CBS shows like CSI, Survivor and The Amazing Race.
And investors often forget about CBS’ other businesses--for example, King World Productions, which distributes Oprah, Wheel of Fortune and Jeopardy. I often joke that I’m the only fund manager who’s been able to perform due diligence on two of these shows; I was a contestant on Wheel of Fortune in my youth, and I’ve appeared on Oprah several times. Showtime Networks is another important CBS franchise. And CBS operates 137 radio stations, boasts a valuable programming library and is one of the largest billboard owners in the US. The company also has a lot of exciting Internet opportunities on the horizon. CBS is one name that we’re going to stick with for the long run.
Tim: Hewitt Associates (NYSE: HEW) is the world’s leading outsourcer and human resources firm; it’s been around since 1940 and has a tremendous brand. The firm generates a high level of recurring revenue thanks to a client retention rate that exceeds 90 percent. And half of the Fortune 500 companies do business with Hewitt. Nevertheless, the market soured on the company because its business process outsourcing operations--a small-scale business--was losing money in a dramatic way. Negative sentiment brought the stock from the mid-$30s to the teens, at which point we decided to make our move.
If you look at the value of the consulting business, which only has three other competitors and a well-established market share, and then look at its outsourcing business, which had some pretty big competitors walk away from the market, you got the sense that the market had overreacted to a fixable problem in one business line.
We scrutinized the company’s balance sheet and found that Hewitt was one of the few names that had a net cash position and was actively buying back shares. Operating a consulting firm isn’t capital intensive, so the business generated high returns on capital and high margins.
We’ve owned shares of Accenture (NYSE: ACN) for almost 10 years, and I’ve covered the consulting space throughout my tenure at Ariel; when we took out our stake in Hewitt, we felt confident in our appraisal of where the company would be in the next five years.
And from a valuation perspective, Hewitt’s shares trade at 10 times free cash flow and 13 times earnings. Right now the stock’s above $41, and we rate its value somewhere in the mid-$50s. Not only is it cheap on a trading basis, but if you look at the assets and what acquiring firms have been willing to pay for similar businesses, you get a stock price that’s well into the $50s.
What’s your best advice for individual investors?
John: Stay the course. There’s a lot of skepticism about this rally, and I think people are tempted take profits and err on the side of caution. But I believe that this economic recovery is going to be much stronger than people anticipate, and the upside for a lot of the names that are tied to the recovery is much higher than people expect. Now’s the time to stick with equities for the long run.
Disclosure: No positions