Ariel Appreciation Fund commentary for the third quarter ended September 30, 2016.
Equity markets shook off the malaise that took hold at the end of the second quarter—remember Brexit?—to post a strong quarter all around. Returns were especially good in domestic small caps and international stocks. While the S&P 500 Index advanced +3.85%; the Russell 2000 Index jumped +9.05%; and the MSCI EAFE Index rose +6.43%. The third quarter was the best period for the MSCI EAFE Index in nearly three years, and the best for the Russell 2000 Index in almost two years. We do not believe much changed to drive this result: we simply think people recognized the economy is sound and interest rates remain low—a good environment for equities. This quarter, Ariel Appreciation Fund rose +7.00%, outperforming the Russell Midcap Value Index’s +4.45% rise, as well as the +4.52% return of the Russell Midcap Index.
Ariel Appreciation Fund
Some of our holdings rose nicely during the quarter. Cutting tools maker Kennametal Inc. (KMT) jumped +32.19% as its modernization efforts started to gain traction. To a large extent this means more automation, which increases efficiency and slashes costs. The company is also focusing on its more profitable, large customers and shedding smaller ones. We see these moves as an essential part of making its moat wider and better; we think the financial benefits will be significant and long lasting. Also, asset manager and financial advisory firm Lazard Ltd. (LAZ) surged +23.46% after beating earnings expectations. Asset management revenues were above consensus numbers, largely the result of $453 million in net inflows. Lazard also had strong restructuring revenues, which offset weaker advisory revenue. The market, which often extrapolates short-term problems, projected summer outflows would continue.
Other holdings fell back a bit. Jam, peanut butter and coffee company J.M. Smucker Co. (SJM) retreated -10.64% due to a recent acquisition that has not met expectations. In 2015, the company moved into pet food as a part of its “center of the store” strategy with the purchase of Big Heart Pet Brands. That unit did not deliver the revenues or profits analysts expected. We believe the shortfall is mainly due to pet food cost deflation and a price war from its chief competitors. We think the management team will get things moving in the right direction and are content to own the stock at a cheaper multiple in the meantime. In addition, media firm Viacom, Inc. (VIAB) declined -7.61% amidst its management shuffle. As you may know, the company ousted CEO Philippe Dauman in August and temporarily replaced him with Chief Operations Officer Tom Dooley. In late September, Dooley announced he was resigning, effective mid-November. Amidst the turbulence, the company declared a 50% cut in its quarterly dividend—a move we felt was prudent. Clearly in the short term the news from Viacom is unsettling, but we continue to believe in the company’s assets and competitive positioning long term.
In the third quarter, we added new firm-wide holding BOK Financial Corp. (BOKF) to Ariel Appreciation Fund. BOK Financial is a leading bank holding company that provides services to businesses and individuals located in the middle-south. Skilled underwriting capabilities and an experienced management differentiate BOK Financial from its competitors. Recent macroeconomic headwinds in the energy industry caused by depressed oil and natural gas prices have created significant pressure on the stock price. As a result, we see this as an opportunity to own a conservatively managed bank with a geographic niche. We sold all of our shares of St. Jude Medical, Inc. (STJ) on the news of it being acquired by Abbott Laboratories (ABT), as well as PrivateBancorp, Inc. (PVTB) on the news of its acquisition by Canadian Imperial Bank of Commerce or CIBC (CM).
Looking ahead, we are optimistic. That is, most of our companies have been doing well. Management teams are making rational decisions, revenues and profits look good, and the holdings in need of changes are making them. Plus we think fundamentals, broadly, are sound. True, concerns about valuation are growing, and we agree some areas of the market have questionable valuations. So we have steered clear of those areas as well as specific stocks priced for perfection. In short, we believe our own portfolios are in good shape.
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