Value Investing

Ariel Focus Fund 4Q15 Commentary

Ariel Focus Fund commentary for the fourth quarter ended December 31, 2015.

H/T Dataroma

The fourth quarter of 2015 was a positive end to a mixed year for equities. The three flagship indexes tracking our asset classes all rose nicely. Specifically, the large-cap S&P 500 Index rose +7.04%, the small-cap Russell 2000 Index gained +3.59%, and the large-cap, developed-market MSCI EAFE Index advanced +4.71%. These quarterly results continued an intriguing pattern for the year: domestic small caps and international large caps tracked each other more closely than either one of them paralleled domestic large caps. A large/small split or a domestic/foreign divide would make sense, but the pattern from 2015 is a bit confusing from an economic, fundamental basis. That said, in equities returns can stem from sentiment or understandings of risk and growth rather than fundamentals: the theme of “risk on” versus “risk off” sometimes tells the story. From that angle, the performance pattern does follow. It seems investors were moderately optimistic in the first half of the year, fairly fearful in the third quarter, but hopeful in the final three months.

Ariel Focus Fund

Ariel Focus Fund Performance

This quarter, Ariel Focus Fund rose +1.90%, behind the Russell 1000 Value Index’s +5.64% return, as well as the +7.04% rise of the S&P 500 Index.

Ariel Focus Fund – Portfolio Holdings

Some of our holdings posted solid gains for the quarter. Computing giant Microsoft Corp. (MSFT) ascended +26.20% as it posted better-than-expected quarterly results. Driving the result were strong adoption of Windows 10 and solid growth in its cloud-computing segment. Many seem to see the company as too old to be relevant, but its remarkable cash-generating power suggests otherwise to us. Toolmaker Stanley Black & Decker, Inc. (SWK) gained +10.61% based on good quarterly results. Although currency was a headwind, the company’s organic growth was 6% and its operating margin expanded nicely. Moreover, management raised its full-year earnings-per-share guidance range, previously $5.70 to $5.90, to between $5.80 and $5.95.

Other holdings fell amidst the volatility the past three months. Cutting tool and tooling systems maker Kennametal Inc. (KMT) returned -22.33% as end demand has been weaker than previously expected. That cyclical issue has crimped cash flows, making it rather challenging for new CEO Don Nolan to fully execute his plan to improve efficiency via modernization. Long term we think the future is fairly clear; it simply will take longer than we (and the company) previously expected. Housewares retailer Bed Bath & Beyond Inc. (BBBY) returned -15.38% after reporting slow sales. Specifically, the company pre-released comparisons in late December in advance of its January quarterly report; it said third quarter sales would dip from low single-digit growth to slightly negative growth. These short-term issues compounded the longer-term challenges the company is addressing: there is huge overlap between its wares and those from, Inc. (AMZN)—so shoppers tend to go to its stores when coupons create a good deal. We think the company has a solid chance to rebuild its brand and find its niche.

In the last quarter of the year, we acquired one new security in Ariel Focus Fund. We purchased global private equity firm KKR & Co. (KKR), a prior holding in Ariel Focus Fund and a current holding in Ariel Appreciation Fund. KKR is one of only a handful of firms that possess the size and organizational structure to benefit not only from the continued high level of institutional interest in alternative assets, but also from still attractive corporate valuations and near all-time low interest rates. KKR retains an extensive track record of strong performance across all types of economic and financial conditions.

Although it may not bring immediate emotional (or financial) rewards, a flat or softly down year in a long, rising market can be a good thing. So long as there is economic growth, as there was in 2015—such a pause means stocks are cheaper at year-end than they were at the beginning. So, we enter 2016 with the same basic view we held entering 2015 as well as 2014. That is, we are confident and optimistic about U.S. fundamental growth and slightly cautious about the valuation of domestic stocks. Overseas, we think there is a more fundamental risk—especially in China—but we see international stocks broadly as less expensive. Taken altogether, that means we see a “stock-picker’s market” where choosing individual securities within a set of stocks has greater potential to contribute more strongly to returns than the choice of one set of stocks over another. Of course we always embrace the philosophy of long-term investing and strongly prefer it to any attempt to time the market or seek out turning points, bottoms, tops, and so forth.