Ariel International, & Ariel Global Fund – Healthy Ideas
Dear Fellow Shareholder: As you know, stocks continued a massive global rally this quarter. So we are happy to report a quarter of strong absolute performance and solid relative results. During the quarter, Ariel International Fund gained +11.03%, versus the MSCI EAFE Index, which returned +11.61%. Additionally, Ariel Global Fund rose +8.49%, topping the MSCI ACWI Index, which advanced +8.02%.
For the one-year period ending September 30, 2013, Ariel International Fund returned +28.11% versus +24.29% for the MSCI EAFE Index. Over the same period, Ariel Global Fund advanced +28.84% compared to the MSCI ACWI Index, which gained +18.37%. For both funds, the top contributing sector was information technology, while the top detracting sector was telecommunication services. For Ariel International Fund, on a stock specific basis, top contributors were Nokia Corp. and Roche Holding AG, gaining +158.31% and +49.23%, respectively. Detractors included NTT DoComo, Inc. and Nintendo Co., Ltd., sliding -2.20% and -9.83%, respectively. Top contributors for Ariel Global Fund were Nokia Corp. and Gilead Sciences, Inc. returning +155.49% and +89.48%, respectively. Detractors included NTT DoComo, Inc., returning -5.47%, and Mobistar SA, falling -19.63%, respectively. Turning to philosophy and process, as we have mentioned before, we are true bottom-up stock pickers, but oftentimes market pressures bearing down on an area cause us to dive into that part of the market to find bargains. In our second-quarter 2013 letter, we explored how this tactic drove a significant weighting in Japanese stocks that worked very well and quite quickly. Mind you, we did not “bet” on Japan, but rather used the market’s pessimism toward its overall economy in order to initiate positions in thriving multinationals that happened to be headquartered in Japan.
In this quarter’s letter we will explore a more recent, similar move: our international and global portfolios now have significant overweightings (versus their benchmarks) in health care stocks. To some this positioning may represent a very different tactic—a sector stance versus a geographical one. To our minds the idea is very similar, however: Market pressures drove low prices for a large group of securities from which we hand-pick wonderful companies for our portfolios. It makes little difference to us whether negativity compresses stock prices in a country, region, sector, or industry; what matters is the gems such pressure creates.
We think the history of the health care sector over the last quarter-century has been shaped largely by heuristics, mental shortcuts used to make decision- making easier, as well as behavioral biases. In the 1990s, the health care sector was globally a darling of growth investors. Investors worldwide saw gradual revenue gains, wonderful margins, and massive cash flows and created a heuristic explanation for it. Specifically, investors reasoned, the population in the developed world was getting older, creating a vast, long-term demand for drugs, medical devices, etc. This story, which of course was rooted in reality, ultimately became overly simplistic: Health care is a growth sector, and therefore its stocks deserve to be priced at a premium to the market. Indeed, during the massive global rally from their January 31, 1992 inception dates through March 31, 2000, the DJ Global Health Care Index’s +220.07% total gain topped the DJ Global Index’s +198.47% return.
When a complex narrative based on reality becomes overly simplistic, groupthink replaces actual analysis. As such, the market created very rosy forecasts for health care companies that were inevitably too good to be true. But as optimism peaked, key health care companies encountered short-term issues. A wave of key drugs faced patent expirations, but with relatively few new approved drugs to replace them. Thus, pharmaceutical giants were unable to meet revenue and earnings targets. So the market created a new gloomy heuristic to explain disappointing numbers in the beginning of the new century. Health care companies, the argument went, had gotten fat and happy (and therefore lazy) in the heyday of the 1990s and were now doomed to slow growth because their scientific creativity had waned. Thus, in the two multi-year global rallies of this century, health care stocks have lagged. From January 2004 to October 2007, the DJ Global Index gained a total +85.04%, but the health care sector index gained just +40.85%. Similarly, from March 2009 to April 2011, the DJ Global Health Care Index returned +65.48%, well below the +103.98% leap of the broad global index.
The experience of specific companies, of course, differed from firm to firm but followed the general pattern. Below we will explain the current opportunities we see in the stocks of Johnson & Johnson and Roche, but first we will describe how they got there.
Johnson & Johnson (JNJ) was a true favorite in the 1990s mega-cap bull market, with its glory days persisting until the end of 2002. From that point through 2010, it hit a relative rough patch. During the 1991 to 2002 period, Johnson & Johnson’s revenues gained a remarkable +10.2% annually; in the subsequent period they slipped to a still-solid +6.8%. Its earnings decline was not as steep. The company compounded earnings per share (EPS) at a remarkable +13.6% in the 1990s and early 2000s period before slipping to +10.4% annually in the second era. Its price/earnings (P/E) ratios showcased its increasing popularity in the first period, as well as its fall from grace. Johnson & Johnson’s earnings multiple soared from 26.1x in 1991 to a lofty 37.6x in 1998 before drifting down in the bear market to 24.9x at the end of 2002. From there it plummeted, however, to a low of just 12.9x at the end of 2010. Note that while investors chopped its P/E multiple in half from 2002 to 2010, its earnings per share more than doubled.
Roche (XSWX:RO)’s story is different, and even more provocative. Its revenue growth has been quite steady, shifting only slightly from 9% in the 1991 to 2005 period down to 8% in the 2005 to 2012 period. Its earnings and P/E multiple, however, have been more jumpy throughout the multi-decade period, largely because Roche has had negative earnings years such as 1997 and 2002. Still, there is a very clear drop in sentiment in the recent period not reflected in fundamental results. That is, in 2005 Roche earned $1.37 per share, rising to $3.02 per share last year—a growth rate of +11.9% annually— without any negative earnings years. The recent steady growth is far better, we think, than the volatile rise of 3 +9.8% per year from 1991 to 2005. And yet the market chopped Roche’s P/E ratio in half, from 27.3x in 2005 to 13.6x in 2011 (before it recovered a bit recently).
What we see, then, is two companies with very long, strong track records before one even considers any details about the businesses—and both stocks are much cheaper than they have been historically. That prompted us to investigate, and when we dove deeply we got even more interested.
After its slide in the current century, Johnson & Johnson took the opportunity to reinvigorate itself. Alex Gorsky, who became CEO in 2012, led a major transformation; he charged his new operations head, Sandra Peterson, with structural improvements across the company. On the pharmaceutical