Ariel Fund Q3

third quarter of 2014 experienced a sharp divergence between the major stock market indexes. While domestic large caps inched ahead, foreign stocks fell, and U.S. small caps dropped rather sharply. Specifically, the S&P 500 Index gained +1.13%, the MSCI EAFE Index returned -5.83% and the Russell 2000 Index slid -7.63%. Spreads this wide between large-cap and small-cap returns in just one quarter are rare. The last time the Russell 1000 and Russell 2000 indexes differed by more than this quarter’s 801 basis points was in the 2008 crash, and the last time Russell’s large-cap bogy outperformed the small-cap one by this much was in 1999. Whether this quarter will be a bump in the road or the beginning of some form of broad dislocation is unclear; we are being opportunistic in the search for any and all values that may arise. Ariel Fund held up well in the quarter’s slide, fading -2.96%, finishing ahead of the Russell 2500 Value Index’s -6.40% loss and the -8.58% drop of the Russell 2000 Value Index.

Ariel Fund gains with Royal Caribbean Cruises, Janus Capital Group

Several of our holdings posted strong returns this quarter. Cruise line Royal Caribbean Cruises Ltd (NYSE:RCL) sailed to a +21.56% gain, powered by strong earnings. Its $0.66 earnings per share beat consensus of $0.53, as well as the $0.15 mark from the prior year. In addition, management announced a “Double-Double Program” designed to increase return on invested capital (ROIC) to double digits and double the company’s earnings per share by 2017.

We think these are ambitious yet sensible goals. In addition, asset manager Janus Capital Group Inc (NYSE:JNS) leapt +17.30% in the wake of “Bond King” Bill Gross’s arrival. Gross, who founded and was lead investor for PIMCO, unexpectedly joined Janus to manage its unconstrained bond strategy. Neither we nor anyone could have anticipated this development, but we see it as a side benefit of Janus CEO Dick Weil’s long tenure at PIMCO.

Ariel Fund loses with Contango Oil & Gas and Brady

A few of our holdings struggled throughout the quarter. Oil and gas producer Contango Oil & Gas Company (NYSEMKT:MCF) fell -21.44% despite strong earnings. Although Contango has its own results and cash flows, the stock tends to trade with oil prices, which slid from $102 per barrel to $91 in the third quarter of 2014. On a fundamental basis, we are pleased that earnings beat expectations, onshore production is up and Contango continues to move toward an even lower-risk production strategy. Also, identification specialist Brady Corp (NYSE:BRC) slipped -24.38% as it continues to turn its business around under a new CEO. J. Michael Nauman, who took the reins this summer, says even though recent sales and earnings were better than expected, profitability fell short. The company has certainly had a rough stretch, but we think the situation was temporary and believe improvement has already begun.

Ariel Fund adds KMT, exits IGT, BYI and SMA

During the third quarter, we added Kennametal Inc. (NYSE:KMT) to Ariel Fund. A current holding in Ariel Appreciation Fund and Ariel Focus Fund, Kennametal manufactures cutting tools and tooling systems, as well as specialized tools for the oil and gas, mining and road construction industries. These products are precisely engineered to withstand extreme conditions. The company is a number-one or -two player in its geographies and end markets, such as aerospace, defense, transportation, general engineering, energy, and mining. We exited three holdings during the quarter: International Game Technology (NYSE:IGT), Bally Technologies Inc. (NYSE:BYI) and Symmetry Medical Inc. (NYSE:SMA). We sold the shares of two of our gaming companies on the good news of acquisitions. International Game Technology announced that it was being acquired by GTECH for $6.4 billion, and Bally Technologies announced that it will be acquired by Scientific Games Corp (NASDAQ:SGMS) in a $5.1 billion transaction. Lastly, we eliminated Symmetry Medical in order to pursue more compelling opportunities.

At Ariel, we do not let Mr. Market’s mercurial nature and occasional gloom whipsaw our own perspective. The market has hummed along for the past few years with relatively little pain, which can lull the crowd into complacency. As independent thinkers, however, we stay focused on valuation levels and become pessimistic when bullishness is widespread rather than when others are nervous. We have been cautiously optimistic for some time. We would not go so far as to welcome negative returns, but we think a slowdown or slight pullback is healthy at this point.

H/T Dataroma

See full Ariel Fund 3Q14 Letter here.

Ariel Fund Profits In Q3 From Bill Gross' Pimco Departure