Value Investing

John Rogers: Investing With A Patient, Long-Term View

There are only a handful of managers that are still at the helm of the funds they founded 30 years ago, and John W. Rogers, Jr. is one of them. The Ariel Fund seeks companies that have the capacity to overcome temporary setbacks while avoiding businesses that are more likely to struggle or face decline.

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John Rogers
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What is the history of the fund?

Launched on November 6, 1986, Ariel Fund seeks to invest in small- to mid-cap companies with the potential to consistently outpace the market. We invest when these companies are selling at bargain prices and hold them for the long term. In a nutshell, we are buyers of good businesses but only when they are temporarily out of favor.

We’ve held true to these principles even during major market crises when stocks have unraveled and bubbles have burst. At times, the fund underperformed and some clients began to lose confidence. What appeared to be setbacks, though, were actually periods where we found favorable circumstances and created great opportunities for the fund. By adhering to our core mission and buying targeted stocks while markets and prices were collapsing, the fund recovered each time, delivering above market performance and distinguishing itself from its peers.

For example, when the stock market crashed in 1987, we bought more of our favorite bargains while other investors stayed on the sidelines. This set the fund up for truly great performance in 1988, and I was gratified to be named “Co-Mutual Fund Manager of the Year” by Sylvia Porter’s Personal Finance Magazine.

Another major milestone occurred when the internet bubble was booming. Because we stayed true to our principles and didn’t chase dot-com or technology stocks, we fell behind the market. When that bubble finally burst, though, the fund emerged with stellar performance as we moved into the new century.

Finally, the financial crisis of 2008 was a very trying time in the firm’s history. It was one of the few times we underperformed significantly in a down market, and we lost clients. But, just as we had in 1987, we continued to buy our favorite stocks even as the market collapsed. Though the portfolio didn’t perform well in 2008, we laid the groundwork for a tremendous recovery in 2009. This contributed to the fund’s strong 10-year and 30-year track records.

How do you define your investment philosophy?

Our focus is on small and midsize companies which we believe can grow fast and are inefficiently priced, and we invest in them when they are cheap. Valuation is a principal part of our strategy; typically, we buy relatively low price-to-earnings companies trading at a 40% discount to their private market value (PMV).

Finally, we are long-term investors. The fund’s turnover is usually 20%, which implies the average stock is held for five years, but we’ve owned many stocks for 15 to 25 years.

We invest in companies with a large moat and the ability to maintain that moat over time. Typically, businesses like this generate a lot of cash, have high return on invested capital, and relatively strong balance sheets.

Though catalysts are good to have, they aren’t necessary for us to buy a stock. We remain patient and are willing to wait for the markets to understand the quality of the businesses, management teams, and balance sheets we have invested in.

What is your investment process?

We look for differentiated companies with strong brands/franchises, strong cash flows, low debt, high quality products or services, significant barriers to entry (moats) and low reinvestment requirements. We don’t feel a need to be invested in every industry. Typically, we avoid industries/sectors that are heavily cyclical, commodity-oriented, or lacking a moat. With 40 stocks or fewer, our portfolios are quite concentrated, which substantially narrows the universe of 3,000. We invest in companies we understand extremely well and which we enjoy reading about and studying.

In-depth sector and industry expertise informs each investment decision. Our portfolio managers and research analysts evaluate companies within a wellestablished “circle of competence”—industries where we are truly experts. Our in-depth industry knowledge, in turn, helps uncover investment ideas others may have overlooked.

A senior analyst covers a sector and tracks all the companies within it, ranking companies from top to bottom, using a valuation-based ranking system that’s an important part of our discipline and process. Each ranking, in turn, is based upon a company’s discount to its PMV.

Each analyst knows their sector extremely well: they know which companies are the highest-quality and which ones are the weakest; the lowest-priced and most expensive. We wait for the “perfect pitch,” meaning we want to invest in high quality businesses selling at bargain prices. This can happen over time or suddenly—with one bad announcement, a stock we’ve always wanted to own can become substantially cheaper.

We read extensively, monitor computer-generated screens and meet with industry experts while also staying abreast of former holdings that can become candidates for repurchase. A large part of my job as lead portfolio manager is to constantly search for fresh names and new ideas and learn about their businesses and sectors.

Studying our peers and competitors is also important, as we find creative ideas that are out of favor with other managers. We analyze what they own and why, looking not only at their winners, but also at those which have underperformed over the last six, 12, or 18 months.

Finally, we’ve established a strong network of people who understand the types of companies we are searching for, and the sectors in which we invest. We also often talk and meet with CEOs and industry leaders.

Does your process involve talking to management?

We look for management teams that are direct and honest about their company’s strengths and weaknesses, and don’t have an interest in those that are misleading or make excuses for underperformance.

Beyond that, it’s critical that management understands capital allocation decisions – stock buyback versus dividend versus acquisitions, the use of the balance sheet, and their capital markets. Our goal is to understand the thought process behind the decisions management makes. Our strategic questioning of company management teams enables us to determine critical issues affecting companies. So yes, we’re regularly on the phone with management teams.

Every quarter, we talk to management about their strategic plan and the progress they are making toward it. We track if they’ve fallen off plan, and if so, discuss whether this is because they don’t believe in it any longer.

Can you describe your investment process with an example?

A great example is Nielsen Holdings plc (NLSN), the global provider of critical data and analytics about what consumers watch and buy. Nielsen is well known for its technology and services. The company’s television ratings are the de facto currency for media and advertising decisions totaling hundreds of billions of dollars globally. Its consumer purchase data is unmatched in scope and scale, and therefore mission-critical information for the world’s leading consumer packaged goods players. Tracking the viewing habits of television audiences is the heart of what the company does, and Nielsen has dominated this sector for many years.

Although we’d had our eyes on the stock for a long time and have a thorough understanding of its story and sector, it’s always been quite expensive. However, as technological changes occurred, people became skeptical of it. As television viewership and purchasing behavior became more fragmented across online and mobile devices, investors became concerned that Nielsen’s dominance was at risk. Nielsen experienced a loss of customers and earnings disappointments, and suddenly the stock began moving into our buy range.

Nielsen’s pricing power hadn’t disappeared, despite what skeptics thought. In our view, the fragmentation only makes Nielsen’s data more valuable. Because it is not in a terribly competitive environment, advertisers and broadcasters don’t have many choices when it comes to getting the information they need. We saw the current fears as an opportunity to own a market share leading information services brand with highly recurring and growing free cash flow.

When we are interested in a company like Nielsen, our analysts put together a full-blown research report to evaluate its pros and cons. It focuses on metrics regarding a company’s valuation, balance sheet strength, and whether it has a moat. With Nielsen, we also assessed whether the changes to television viewing brought on by the internet would fundamentally destroy Nielsen’s business model over the long run.

As part of our process, a devil’s advocate—in this case portfolio manager John Miller—was charged with challenging the assumptions and conclusions of the research report. In addition, the head of our investment group, Charles Bobrinskoy, conducted a thorough analysis of its balance sheet.

After the initial report is finished, our research and portfolio management teams meet twice a week, poring over every detail, asking questions, and basically surrounding the story with as many perspectives as possible. We also try to meet with company management, as well as its customers, competitors, sell-side analysts, and friends on the buy side.

These meetings always shed more light on a company – one of us will think of an argument that’s been overlooked, or remember someone else in our network who might share valuable information. In Nielsen’s case, we were trying to determine how broadcasters like CBS, NBC, ABC, and the cable networks viewed the company.

Inevitably, the analyst will rework the research report, and then we go through the process again – it can take several months to thoroughly vet a new idea. After this has played through to the end, we gather the investment team and ask for their honest opinions. Although as lead portfolio manager I make the final investment decision, I do so only with the entire team’s input.

Do you evaluate whether an opportunity is temporary or transitory?

This is at the heart of what we do because the business we’re in is all about vision. The most successful money managers are the ones who can see more clearly into whether an industry is permanently impaired or if it will be able to get back on track and become a great business again.

It’s hard to do that all the time, and no one gets it right all the time. Vision, tenacity, focus and discipline pay off  when there is an enormous amount of turmoil and short-term noise. However, in market environments like the global financial crisis of 2008 and early 2009, we were able to create a lot of value for shareholders.

What is your portfolio construction process?

The portfolio has approximately 40 names, with full positions being between 4% and 6%, medium positions between 2.5% and 4%, and smaller ones less than that. We will not allow a position to exceed 6% in the portfolio. The Russell 2500 Value Index is the fund’s primary benchmark, and we see ourselves as more in the small-mid cap space.

To keep diversification appropriate, no more than 10% of the fund can be in exactly the same industry. For example, in real estate services, we own CBRE Group Inc. and Jones Lang LaSalle Inc. Together, they make up roughly 7.5% of the portfolio, and we will not allow them to become more than 10% of our portfolio.

Although we don’t use short-term targets, we do have what we call our private market value (PMV). Our PMV analysis is critical to our work because it gives us a sense of what a business is worth and what someone would pay for it in the current environment.

Conducting a discounted cash-flow analysis each quarter keeps our PMV on stocks fresh. When stocks reach a premium to our PMV or are selling at more than 20 times next year’s earnings, we start to scale back or out of those positions.

What drives your sell discipline?

In addition to valuation, sell decisions are triggered when we have lost faith in management and their strategic direction for the company, or when they are not effectively executing their plan. We become extremely concerned when management teams aren’t thoughtful about asset allocation, particularly if they lever up to do things we don’t think are healthy for shareholders – like overpaying for a strategic acquisition or buying a business outside their circle of competence.

Our companies know beforehand what kind of balance sheets and industry diversification we can live with, so if they ignore our core beliefs and point of view that gives us reason to sell.

Of course, because our focus is on small and midsize companies, we have a disciplined process to make sure we don’t own stocks that have become large caps.

How do you define and manage risk?

We define risk as a permanent loss of capital, controlled at the portfolio and stock level via allocation limits; our focus is on PMV and our in-depth understanding of the companies we choose. We also mitigate risk by investing with a margin of safety (40% discount to PMV), employing proprietary debt and moat ratings and using a devil’s advocate to challenge our own views. Because we think it is risky when companies get expensive, we carefully monitor the valuations of our holdings and scale back positions in any which become overpriced relative to our PMV analysis.

Although we do not define risk as volatility, we must be certain our companies have the balance-sheet strength to weather inevitable storms.

Before the economic downturn, we thought we had an appropriate margin of safety and that our approach to the balance sheet was sufficiently conservative.

However, we learned we needed to be even more conservative, and as a result, developed proprietary debt ratings. These debt ratings are a major improvement to our process and help us to avoid investments that could lead to a permanent loss of capital.

Learning to work through problems and bounce back from ugly times was particularly reinforced during the financial crisis. We don’t allow ourselves to be swept into the emotions of the moment, but instead take a long-term perspective – our experienced team has been through the worst together, and we’re always finding
ways to improve.

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