John Rogers Ariel Investments Letter
Dear Fellow Shareholder: This was a disappointing quarter for Ariel Discovery Fund, as our return of +2.47% lagged the +7.59% return of the Russell 2000 Value Index and the +5.24% gain of the S&P 500 Index. Year-to-date, Ariel Discovery Fund has returned +19.67%, as compared to +23.07% for the Russell 2000 Value and +19.79% for the S&P 500 Index. We continue to trail the benchmark since inception due to a tough launch, but even with this tough quarter our two-year annual return of +27.18% is respectable compared to the Russell 2000 Value Index and the S&P 500 Index.
Top performers during the quarter were Furmanite Corporation (NYSE:FRM), which gained +47.98%; Emergent Biosolutions Inc (NYSE:EBS), up +32.11%; and Gulf Island Fabrication, Inc. (NASDAQ:GIFI), which returned +28.51%. On the downside were Vical Incorporated (NASDAQ:VICL), losing -60.38%; JAKKS Pacific, Inc. (NASDAQ:JAKK), down -40.71% before it was sold, and Pendrell Corporation (NASDAQ:PCO), which fell by -25.67% (although it remains up +52.67% year-to- date). Vical is discussed in detail below.
Year-to-date, our biggest contributors were Furmanite, which gained +84.36%; ARC Document Solutions Inc (NYSE:ARC), up +79.30%; and Market Leader Inc (NASDAQ:LEDR), which rose by +68.40% before we sold it prior to the close of its acquisition by Trulia Inc (NYSE:TRLA). Vical has been our biggest loser year-to-date, falling by -57.39%. JAKKS dropped by -46.00%, and Rentech, Inc. (NASDAQ:RTK) was down by -24.71%.
As noted above, for the one-year period ending September 30, 2013, Ariel Discovery Fund gained +17.31% versus a gain of +27.04% for the Russell 2000 Value Index. Meanwhile, the S&P 500 Index gained +19.34% over the one-year period. The results were driven by individual stock results. Our two biggest contributors to performance were large holdings
Market Leader Inc (NASDAQ:LEDR), up +64.63%, and Madison Square Garden Co. (MSG), which gained +50.34%. Top detractors for the past year were Vical Incorporated (VICL), down -71.36%, and Imation Corp. (NYSE:IMN), which lost -26.65%.
Vical Incorporated (VICL)
We typically use these letters to discuss our approach to deep value investing, to outline the case for our favorite stocks, or to comment on trends in the market which we believe will affect our portfolio holdings. This quarter, however, we will share the story of a stock we have held for more than a decade which, at first glance, appears to have “blown up.” We want to explain why we have owned it, how our valuation work continues to indicate a bargain within our long-term discipline, and how we will evaluate the company going forward. Most importantly, we want to demonstrate why we think the company is on solid footing and continues to provide a great long-term investment opportunity. On Monday, August 12 th , after announcing that the Phase III trial of its Allovectin compound, a metastatic melanoma therapy, had failed, Vical stock dropped by 57%. Specifically, it did not meet either the primary endpoint of objective response rate or the secondary goal of overall survival. This result obviously disappointed the company, shareholders, and, most of all, cancer patients. Many had hoped this immunotherapy compound would revolutionize treatment for those battling this terrible disease. Although we would have preferred a better outcome on Allovectin, our thesis for Vical was not a simple bet on its success. In our analysis, the company’s infectious disease platform – with multiple promising products – was worth well more than the $240 million enterprise value of Vical just prior to the announcement. We continue to believe that is the case. All along, we knew a Phase III failure for Allovectin would lead to a s h or t- term hit to the stock, but we believed in the long-term, Vical was an undervalued infectious disease company. To us, Allovectin represented a free option on a cancer treatment with enormous upside potential. This option proved to be of no value, but our view on the rest of the company has not changed.
Due to the impending binary event surrounding Allovectin, we limited our position size. Indeed, we frequently reduced our weighting in the stock over the years when it traded higher. Just prior to the Allovectin announcement we had a weighting of roughly 3.5%, reflecting our view of extreme long-term undervaluation combined with near-term uncertainty. By comparison, our larger positions tend to be in the range of 5.0% to 6.0%, when we find severe dislocations but greater clarity.
We first bought Vical shares in late 2002 in our Ariel Micro-Cap Value Product as part of a “basket” of eight micro-cap biotechnology stocks combined to equal one normal position. A sustained market decline had left the industry in shambles, and we were able to buy the small positions in emerging companies for roughly half their net cash. True, we had limited insight into any specific early-stage compound’s approval, but we were able to own cheap assets—cash—and invest in science (difficult to value, but potentially quite valuable). As the market recovered in 2003, the stocks moved sharply higher, and we sold all except for Vical. We held Vical and later built it into a normal-sized position in both our Ariel Micro-Cap Value Product and eventually Ariel Discovery Fund. We realized its shares were priced like a one-product, early-stage biotech company.
In reality, Vical’s DNA delivery technology platform allowed it to build a deep, well- advanced pipeline of compounds whose potential outcomes are related but not identical. In addition, management did an outstanding job over time of partnering with larger pharmaceutical companies, enabling Vical to conserve cash and minimize dilution.
Success with Allovectin would have led to significant upside, but its failure has no bearing on the likelihood of success for Vical’s infectious disease candidates:
ASP00113 (formerly TransVax) – This is a therapeutic vaccine for cytomegalovirus (CMV) in transplant patients. Vical has partnered with Astellas, granting an exclusive license in exchange for up to $130 million in payments and double-digit royalties. Astellas recently launched a Phase III for stem cell transplant, and is expected to begin a Phase II for solid organ transplant later this year.
CyM Vectin – CMV vaccine for prevention of congenital infection. This could potentially be an opportunity of more than $2 billion for adolescent females. Vical is exploring partnerships for development of this promising compound.
Vaxfectin Adjuvant – This mixture is designed to increase immune responses when added to a vaccine. It has value either in Vical programs or as a technology for license or sale.
Herpes Simplex Program – This early stage program uses a Vaxfectin-formulated vaccine against HSV-2. The company expects to initiate a Phase I/II trial in late 2013.
– Vical also has a pandemic influenza rapid response technology, collaborations with Sanofi and Anges in angiogenesis, and two approved animal vaccines.
Given its current price of $1.25/share, the company’s enterprise value is a meager $38 million. To value Vical, we look at the company as a collection of assets held in cash ($70 million), product candidates, approved animal vaccines, and intellectual property in the form of its DNA technology platform. The company has one Phase III candidate being fully funded by a major global firm plus a number of potentially valuable assets. Thus we