Ariel Focus Fund: Top contributors Lockheed Martin and Microsoft

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The third quarter of 2014 experienced a sharp divergence between the major stock market indexes. While domestic large caps inched ahead, foreign stocks fell, and U.S. small caps dropped rather sharply. Specifically, the S&P 500 Index gained +1.13%, the MSCI EAFE Index returned -5.83% and the Russell 2000 Index slid -7.63%. Spreads this wide between large-cap and small-cap returns in just one quarter are rare. The last time the Russell 1000 and Russell 2000 indexes differed by more than this quarter’s 801 basis points was in the 2008 crash, and the last time Russell’s large-cap bogy outperformed the small-cap one by this much was in 1999. Whether this quarter will be a bump in the road or the beginning of some form of broad dislocation is unclear; we are being opportunistic in the search for any and all values that may arise. This quarter Ariel Focus Fund retreated -0.98%, just behind the Russell 1000 Value Index’s -0.19% return and the +1.13% rise of the S&P 500 Index.

Ariel Focus Fund: Top contributors Lockheed Martin and Microsoft

Several of our holdings posted strong returns this quarter. Defense firm Lockheed Martin Corporation (NYSE:LMT) rose +14.59% on strong earnings. In July, the company reported second quarter earnings of $2.76 per share, topping consensus of $2.66. Moreover, management maintained revenue guidance while raising margin and earnings guidance. We see the company as boasting a broad and gradually expanding moat1. Similarly, technology giant Microsoft Corporation (NASDAQ:MSFT) returned +11.86% after announcing a restructuring plan. When the company acquired Nokia’s main business, it was clear it would eventually gain from synergies; the company announced significant workforce rationalization over the summer. We continue to see Microsoft as having a very wide moat and a high-quality set of businesses.

Ariel Focus Fund: Top detractors Pier 1 Imports and Chesapeake Energy

A few of our holdings struggled throughout the quarter. Home furnishings retailer Pier 1 Imports Inc (NYSE:PIR) fell -22.54% after a quarter that disappointed Wall Street. Pier 1 had weaker-than-expected store traffic and resorted to more markdowns and coupons than analysts anticipated. We think a continued housing recovery is likely to boost Pier 1’s business more than the crowd expects. Also, natural resources firm Chesapeake Energy Corporation (NYSE:CHK) returned -21.53% due to declining commodity prices. Chesapeake’s business is most closely tied to natural gas, which fell from nearly $4.50 per Mcf to roughly $4.00 during the third quarter. Our focus is not on short-term commodity prices but on the long-term fundamentals of the business, including the company’s highly valuable assets.

Ariel Focus Fund: Added Hanger; eliminated Hospira

During the third quarter, we purchased premier provider of orthotic and prosthetic services and products Hanger Inc (NYSE:HGR) in Ariel Focus Fund. We also eliminated our position in Hospira, Inc. (NYSE:HSP) in order to pursue more compelling opportunities.

At Ariel, we do not let Mr. Market’s mercurial nature and occasional gloom whipsaw our own perspective. The market has hummed along for the past few years with relatively little pain, which can lull the crowd into complacency. As independent thinkers, however, we stay focused on valuation levels and become pessimistic when bullishness is widespread rather than when others are nervous. We have been cautiously optimistic for some time. We would not go so far as to welcome negative returns, but we think a slowdown or slight pullback is healthy at this point.

The Russell 1000® Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price/book ratios and lower expected growth values. The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index, representing approximately 92% of the total market capitalization of that index. It includes approximately 1000 of the largest securities on the basis of a combination of their market cap and current index membership. Russell® is a trademark of Russell Investment Group, which is the source and owner of the Russell Indexes’ trademarks, service marks and copyrights. The S&P 500® Index is the most widely accepted barometer of the market. It includes 500 blue chip, large-cap stocks, which together represent about 75% of the total U.S. equities market.

H/T dataroma

See full Ariel Focus Fund 3Q14 in PDF format here.

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