Ariel Investments Portfolio Commentary for the month ended May 31, 2015.
With the year nearly half over, we think it is a good time to look at market leadership in the United States. Last year at this point, the story was all about large versus small, with large caps turning in much better performance. This year, the big disparity is between growth and value, with the tilt strongly toward growth stocks.
Here are the 12 Russell indexes we use as signposts:
All 12 indexes have gains for the year, with the top four being growth benchmarks. The four lowest returns come from value indexes, with the core benchmarks falling in between. This clear preference for growth fare suggests investors are optimistic and risk-embracing, as opposed to risk-averse. Less obvious in the above chart is something we find intriguing. That is, the return gap between growth returns and value gets larger as one goes down the ladder from large caps to small caps (with mid-caps being an exception, as tends to happen). That is, in large caps, the disparity between value and growth returns was nearly 450 basis points; in small/mid-caps, it was more than 550 basis points; and in small caps, it was more than 650 basis points. Market commentators often tend to suggest there are preferences for large over small or vice versa, glossing over the reality that preferences within market cap ranges can be bigger than those between them. To suggest that investors really love small caps this year would be misleading; they seem quite fond of small growth but not small value.
Ariel Investments: American investor’s shifting mindset
An interesting takeaway from this performance data is how the American investor’s mindset has shifted in a year. Last year we noted the generally positive returns, highlighted by the biggest gains in mid- and large value and losses in small growth, suggested cautious optimism. The current picture more strongly suggests significant optimism, with gains across the board and especially in the more economically sensitive growth and small-cap areas. We are skeptical about that stance for two reasons. First, as you have no doubt seen, economic growth in the first few months of the year was softer than expected. While that is certainly not cause for alarm, a rising taste for growth when it appears to be slowing can be a recipe for losses. Second, and more importantly, as we have said before, the stock market is not especially cheap. Paying up for growth fare in a relatively pricey market is a dangerous game plan in our view.
The data also provide a helpful way to put our own portfolios’ returns in perspective. In our traditional value strategy, we seek companies that trade at a significant discount to intrinsic value and also have good earnings growth prospects. That tends to put our portfolios on the line between value and core, so it is unsurprising that Ariel Fund and Ariel Appreciation Fund have outperformed their value benchmarks this year. Ariel Focus Fund employs a similar strategy, although portfolio manager Charlie Bobrinskoy often has a greater taste for very cheap stocks—now and often putting it more in the center of the value box. So it is also not surprising that it has underperformed this year to date. Finally, Ariel Discovery Fund, a niche product investing in deep value stocks toward the bottom of the small-cap universe, has underperformed, which is not surprising, given it operates in the most unloved of the unloved areas.