Ariel Appreciation Fund commentary for the first quarter ended March 31, 2015.
Capital markets were rather erratic in the first quarter of 2015, showing little discernable pattern to translate into a simple characterization of investor sentiment. In January, U.S. bonds were up more than +2%, U.S. large and small caps were both down at least -3%, and foreign stocks were up less than +1%. That looks a lot like risk aversion. February, however, saw a huge reversal: U.S. large caps and small caps, as well as international stocks were all up nearly +6%, while U.S. bonds fell nearly -1%. It was clearly a bullish month, or as some would have it, a riskembracing environment. March was a lot less clear: U.S. bonds and small caps rose less than +1%, international equities lost a bit but were essentially flat, and U.S. large caps fell nearly -2%. To our minds, such an environment translates as a stock-picker’s market, where the individual securities owned can make a big difference. A majority of our portfolios outperformed with some doing so quite strongly.
This quarter, Ariel Appreciation Fund jumped +4.34%, ahead of the Russell Midcap Value Index’s +2.42% rise, as well as the +3.95% return of the Russell Midcap Index.
Ariel Appreciation Fund: Performance contributors
Some of our holdings posted solid gains for the quarter. Diversified health-care company Hospira jumped +43.09 on the good news of its acquisition. In early February, Hospira entered into a definitive merger agreement with Pfizer for $90 per share in cash—a total enterprise value of roughly $17 billion. Shares rose about 35% the day of the announcement. We had long seen Hospira as a good stand-alone company and a very attractive acquisition target. We exited the position on the news. In addition, global leader in money transfer Western Union advanced +17.12% after a solid quarter. The company’s earnings per share (EPS) of $0.42 was well ahead of Wall Street’s $0.34 prognostication. It also delivered full-year guidance above expectations and returned $753 million to shareowners through buybacks in 2014. We continue to think the pessimism overhanging the company is exaggerated because we believe the company’s position is stronger than conventional wisdom says it is.
Ariel Appreciation Fund: Performance detractors
Other holdings fell in the turbulent three-month period. Oil and gas services company National Oilwell Varco (NOV) retreated -23.01% as oil prices fell sharply. Indeed, the company’s EPS of $1.69 topped the $1.60 Wall Street estimate. The market is afraid of falling oil prices and tightly connects National Oilwell Varco’s long- and short-term prospects to these ever-changing figures. We, on the other hand, think the company is by far the leading expert in the mission-critical offshore rig field and therefore continues to have the potential for a very bright future. Also, helicopter services company Bristow Group Inc. (BRS) dropped -16.81% in sympathy with oil prices. Global oil prices have plummeted roughly -50% in the past six months, driving investors to sell companies connected to oil and gas exploration. Bristow’s contracts are long term and more tied to ongoing production than Wall Street seems to realize. As such, we think the sell-off was an overreaction.
Ariel Appreciation Fund: Portfolio changes
During the quarter, we initiated one new position and eliminated two holdings in Ariel Appreciation Fund. We purchased shares in Anixter, a current holding in some of our other portfolios. Anixter is a leading global supplier of communications and security products, electrical and electronic wire and cable, fasteners and other small components. Its innovative supply chain management services reduces the total cost of production and implementation for its customers. We sold our shares of City National on the good news that it was being acquired by the Royal Bank of Canada (RY) for $5.4 billion, roughly half in cash and half in stock. We also sold our shares of Hospira, Inc. when it entered a definitive merger agreement with Pfizer Inc., an all-cash deal totaling about $17 billion.
We are becoming more cautious than optimistic toward equities. We think investors should be prepared for a correction, although we do not endorse market timing and do not think it is time for a major portfolio shift. The current bull market, which mostly dates back to March 9, 2009, has persisted far longer than most. Over that period, annualized returns have been tremendous, nearly double the long-term yearly average; some reversion to the mean seems nearly inevitable. Finally, in the United States, the current price/earnings (P/E) ratio for both large and small caps hovers around 18x. That is pricier than long-term averages of between 15x and 16x. We are concerned largely with valuation, and we do expect the U.S. economy to continue to grow. We also think evidence shows that the worst bear markets tend to occur when economic cycles peak alongside high equity valuations. We do not see that scenario occurring. In the meantime, we continue to strive to identify and purchase mispriced stocks of businesses that are better than the market price suggests.