Rupal Bhansali, manager of the Ariel International Fund, looks for things that can go wrong in a stock.

H/T Dataroma

Q3/Q4 2016 Hedge Fund Letters

When analysts at the Ariel International Fund get together to discuss which stocks to include or exclude from a portfolio, it can sound more like a face-off than a meeting. One analyst who champions an idea presents the case for buying. Then a devil’s advocate pokes holes in the story. A third, who has no skin in the game, opines as an unbiased and knowledgeable observer. It’s a stress test that gauges how a company will hold up under a variety of best- and worst-case scenarios.

Ariel International Fund

Ariel International Fund

This lively interchange, says 49-year-old fund manager Rupal Bhansali, is designed to avoid potentially long-lasting or even permanent capital losses that can decimate portfolios. “A lot of mutual fund managers like to think about what can go right with a stock,” she says. “We also like to think about what can go wrong.” That’s important because big losses in a sharply down market take a longer time to work off than more modest fluctuations.

Fortunately, the fund hasn’t had to endure a major downturn in its short history of just under five years. Still, it has managed to show its stripes by landing in the top 2% of its Morningstar foreign large-value category for performance over the three years ending September 30, and by gaining a five-star rating for the period. From its inception in December 2011 through the third quarter of 2016, the fund’s institutional class shares, which have a $1 million investment minimum and 1.01% expense ratio, had annualized total returns of 7.70%, while the MSCI EAFE Index returned 7.04%. Retail class shares, which have a 1.25% expense ratio and a $1,000 investment minimum, had annualized returns of 7.44% over the same period.

The fund’s volatility has also been below average.

Despite these attributes, Morningstar rates the fund as “neutral” because its expense ratio is above average for its category and it has not yet gone through a full market cycle that would test its true resilience. (Please note as of November 29, 2016, the Fund’s Board of Trustees approved a 12% decrease of the expense cap for the Institutional share class of Ariel International Fund, lowering it 0.88%.)

Bhansali, who was born and raised in India, has spent much of her career trying to sidestep the dangers of tanking markets and the stocks that are likely to bear the brunt of them. In 1991, she learned the meaning of volatility firsthand when she came to the U.S. to pursue her MBA at the University of Rochester. The Indian rupee had just been devalued by a massive 40%, and stock markets tumbled worldwide amid a global recession.

Ariel International Fund

Although it’s unusual for a long-only manager, her buy-side career began on the long-short side at Soros Fund Management, where she sharpened her focus on absolute returns and downside protection. Subsequent stints in investment management at Oppenheimer Capital and MacKay Shields in New York reinforced that mind set. At the latter firm, she served as lead manager at the Main-Stay International Equity Fund for 10 years. During that time, the fund was one of the best long-term performers in Morningstar’s foreign large blend category. Its performance was particularly impressive in down markets such as the one in 2008, when it lost only 26% and its peer group lost 47%.

Bhansali carried much of the MainStay strategy to Chicago-based Ariel in 2011, joining to launch her new firm’s first global and international offerings. Today, she heads Ariel’s first New York office, where she supervises 10 investment professionals and manages just under $4 billion in global and international strategies through mutual funds and separate accounts.

She considers herself neither a growth nor value manager, preferring instead to select stocks based on risk-reward criteria. First she screens out companies whose returns on invested capital fail to exceed the cost. She also shuns companies with high leverage, poor governance and unsustainable business models. Companies that make it through the screens must invest capital well, have sustainable competitive advantages and strong management teams. Often, the stocks she likes are going through corrections because the market has exaggerated short-term problems that are not likely to impair the companies’ longterm growth prospects.

Ariel International Fund

While the fund isn’t tied to the benchmark, there are some limits on how far it can stray. Its sector weightings are capped at the higher of 1.5 times the MSCI EAFE index benchmark or 25% of assets, and emerging markets must account for no more than 10% of assets. Each stock must account for no more than 5% of assets at the time of purchase. Bhansali also hedges developed market currencies to mitigate risk from currency fluctuation. The fund has a low portfolio turnover rate of 26%, reflecting Bhansali’s patience as a long-term investor.

Information technology is one of the sectors that’s heftier in the fund than it is in the benchmark; the Ariel fund’s weighting to the sector was at 22.52% of assets on September 30, while the MSCI EAFE Index’s was only 5.5%. Many companies in the sector have higher and longer- lasting cash-flow generation prospects that aren’t reflected in their stock prices. Also overweight are telecommunications services, which represent 15% of Bhansali’s portfolio, but only 5% of the index. She likes both the sector’s growth prospects and the industry’s consolidation trends in Europe.

Meanwhile, the fund is significantly underweight in materials and industrials, two highly cyclical sectors. Those companies face significant challenges to growth. Persistent deflation harms their products, while aging global populations in developed markets reduce the pool of future buyers. Also underrepresented in the Ariel fund are financials, which are 10% of the portfolio’s assets, while they contribute 19% to the index. Bhansali is cautious about the weak capital positions and low return profile of European banks, as well as the reinvestment risk in the bond portfolios of insurance companies in a low interest rate environment.

She isn’t afraid to go against the investment herd, and she often has. When it opened in 2012, the fund took a particularly bold stance by buying Japanese stocks, at a time when such stocks were at the bottom of most buy lists. Bhansali had thought she’d unearthed some particularly compelling buys, and the move paid off over the following two years (when the world began to agree with her insight). Also in 2012, she sidestepped then-hot emerging market stocks because she felt their substantial risks were not priced into the securities. Again, subsequent performance proved her correct.

Her picks also reflect a contrarian bent. For example, she began accumulating Michelin, a French tire company, about two years ago when the stock was faltering amid a decline in world auto sales. “The perception is that Michelin’s end market has peaked,” she says. “But tire sales are not shaped by the number of new cars sold, but also by how many miles are driven on existing cars. We felt this misperception presented a buying opportunity.” Also, the stock sells at a

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