Ariel Investments commentary for the month ended March 31, 2016.

H/T Dataroma

As we examined the results of our three traditional value mutual funds this quarter, there was one common detrimental thread– the lack of utilities stocks. The sector has been on a tear, meaning that our avoidance of the area hurt short-term returns broadly. This commentary will address the performance issue, explain why people seem to gravitate toward this sector, and why we generally avoid utilities companies.

Ariel Investments – Pros & Cons of Utilities

First, the math. Utilities have been hot for a full year: it was the top-performing sector in the broad large-and small-cap universes the past twelve months. For instance, over the trailing twelve months the small-cap Russell 2000 Index fell -9.76% as all nine sectors lost ground—except utilities, which gained +6.46%. This disjuncture was key in the first quarter of 2016. Utilities stocks made up between 9.5% and 14.5% of the benchmark indexes for our traditional value funds; meanwhile, we had a zero weighting. So when the utilities sector gained double-digits in these benchmarks this quarter, we obviously did not share in those returns. Taken altogether, relative to the primary indexes, the utilities sector cost Ariel Fund -1.05%, Ariel Appreciation Fund -1.60% and Ariel Focus Fund -1.22% of outperformance, respectively, in the first three months of 2016.

So, why have investors found utilities so attractive lately? We think nervous investors flock to utilities shares for performance reasons. Most utilities stocks have two soothing qualities: relatively high dividends and comparatively low volatility. Over the last year the typical small-cap utilities stock had 20% lower standard deviation than the rest of the small-cap market. In the large-cap universe, they were 24% less volatile. Meanwhile, the average small-cap stock has just a +1.44% dividend yield, while the average small utilities stock yields 2.51%. Among large caps, the market yield is 2.05%, but 3.60% for the average utilities stock. As legendary value investor Ben Graham notes, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” That is, as investors lately were voting: they have become edgy over the last year and have strongly desired the stability and yield of utilities, sending the stocks higher even in the flat to down market.

On the other hand, we avoid utilities for investment reasons—they simply do not meet our standards for investment. That is, we strive to own high-quality businesses boasting durable competitive advantages that can drive significant growth. We think many investors forget what utilities companies actually do. As you know, utilities companies maintain the infrastructure as a public service. Generally speaking, they provide electricity, natural gas and water. These products are pure commodities—nobody believes one company’s electricity or water is superior enough to justify a higher price. Indeed, many utilities companies generally receive exclusive rights to sell these commodities in a given territory, in exchange for tight regulation. Public commissions set prices, regulate capital expenditures, and determine the profit margins for these companies. In other words, utilities companies lack the ability to create an edge and profit from that advantage—so clearly growth is limited as a result. Over the long run, we believe the market will properly asses utilities’ intrinsic value—and judge them to be worth less than the types of companies we strive to own.

Taken altogether, what does this mean? When pessimism drives the market in the short term, we accept that our avoidance of utilities may hurt relative returns. It similarly means, however, that over the long term we believe our view will help relative returns. So, simply put, when our lack of utilities holding causes soft returns, we accept that result. Indeed, we think our current stance on his sector is an excellent example of our company motto: slow and steady wins the race.

Ariel Investments