Ariel Focus Fund: Q2 2014 CommentaryVW Staff
Ariel Focus Fund: Q2 2014 Commentary
Investing in equity stocks is risky and subject to the volatility of the markets. Investing in small and mid-size companies is riskier and more volatile than investing in large companies. The intrinsic value of the stocks in which the portfolio invests may never be recognized by the broader market. Ariel Focus Fund is a nondiversified fund and therefore may be subject to greater volatility than a more diversified investment.
Performance data quoted represents past performance. Past performance does not guarantee future results. All performance assumes the reinvestment of dividends and capital gains and represents returns of the Investor Class shares. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the period ended June 30, 2014, the average annual total returns of Ariel Focus Fund (Investor Class) for the 1-year, 5-year and since-inception periods were +24.67%, +17.58% and +6.38%, respectively. Ariel Focus Fund has an inception date of June 30, 2005, and does not yet have annual performance for the 10-year period. As of September 30, 2013, Ariel Focus Fund had an annual net expense ratio of 1.25% and a gross expense ratio of 1.54%. Effective February 1, 2014, Ariel Investments LLC, the Advisor, has contractually agreed to waive fees and reimburse expenses (the “Expense Cap”) in order to limit Ariel Focus Fund’s total annual operating expenses to 1.00% of net assets for the Investor Class through the end of the fiscal year ending September 30, 2016.
Through January 31, 2014, the Expense Cap will continue to be 1.25% for the Investor Class. Performance data current to the most recent month-end for Ariel Focus Fund may be obtained by visiting our website, arielinvestments.com.
Ariel Focus Fund: Quarter Ended June 30, 2014
After a slow start to the year, global equities accelerated in the second quarter of 2014. For the quarter, domestic large caps edged out mid caps and foreign equities—with small caps posting a solid but less dramatic quarterly gain.
The pattern from the first quarter continued: a preference for yield-bearing investments and equities with a reputation for steadiness and fundamental strength. For instance, across Russell’s main smaller-cap value indexes (2000, 2500 and Midcap), the two top-performing sectors were utilities and energy. Along the same lines, in smallercap stocks value topped core, while growth underperformed. The pattern was not as pronounced abroad, where emerging markets stocks outpaced developed markets—with sagging China being a key exception. This quarter Ariel Focus Fund gained +4.95%, lagging the Russell 1000 Value Index’s +5.10% return, as well as the +5.23% rise of the S&P 500 Index.
Ariel Focus Fund: Strong returns
Several of our holdings posted strong returns this quarter. Natural gas and oil company Chesapeake Energy Corporation (NYSE:CHK) soared +21.71% based on first-quarter reports that had revenue and production up +47%. The market cheered the unexpectedly large jump in output. While we by no means were predicting such a sharp, quick jump, we did believe results would improve faster than naysayers believed.
Similarly, oil and gas equipment company National-Oilwell Varco, Inc. (NYSE:NOV) surged +17.99% following reports of a +9% increase in revenue year to date on April 29th. About a month later, the company raised dividends for shareholders by +77%. Investors clearly appreciated the combination of good results and returning proceeds to shareowners—and we count ourselves among that group.
A few of our holdings struggled throughout the quarter. Education company Apollo Education Group Inc (NASDAQ:APOL)) slid?8.73% because new starts were slow. Management said there will be future improvements this year, but the Street did not buy the story. As patient investors, we are comfortable waiting for the new start trend to turn. Also, information technology company International Business Machines Corp. (NYSE:IBM) fell –5.28% due to poor quarterly results. Specifically, first-quarter revenue fell short of consensus by $500 million. The market continues to question whether the IBM machine has broken. As long-term investors, we believe IBM will recover from recent short-term setbacks.
Ariel Focus Fund: Added positions
In the second quarter of 2014, we initiated five new positions and exited four in Ariel Focus Fund. We added Kennametal Inc. (NYSE:KMT), a new firm-wide holding, which manufactures cutting tools and tooling systems as well as specialized tools for oil and gas, mining and road construction industries. These products are precisely engineered to withstand extreme conditions. The company is a number-one or -two player in its geographies and end markets, which include aerospace, defense, transportation, general engineering, energy, and mining. Another new firm-wide holding is Barrick Gold Corporation (NYSE:ABX), the world’s largest gold mining company. We also initiated two firmwide holdings in the retail space, Pier 1 Imports Inc (NYSE:PIR) and Bed Bath & Beyond Inc. (NASDAQ:BBBY). Pier 1 Imports is North America’s largest specialty retailer of imported home furnishings and décor, while Bed Bath & Beyond operates a chain of retail stores under such names as Bed Bath & Beyond, World Market and Buy Buy Baby. Lastly, we purchased consumer products giant Newell Rubbermaid Inc. (NYSE:NWL), which has been a long-term holding in our smaller-cap portfolios. Most of Newell’s brands, such as Rubbermaid, Graco, Calphalon, and Sharpie, are number one or two in their respective categories, but the stock price showed weakness early in the quarter—we used that as an opportunity to add the stock to this portfolio. We sold our positions in Illinois Tool Works Inc. (NYSE:ITW) (as it reached our estimate of its private market value) and Omnicom Group Inc. (NYSE:OMC) in order to pursue more compelling opportunities. We also eliminated DIRECTV (NASDAQ:DTV) on the news of AT&T Inc. (NYSE:T) proposed $48 billion acquisition of the company. Lastly, our exit of Telephone & Data Systems, Inc. (NYSE:TDS), which we owned for only three months, was a special situation. We purchased the stock in March of this year when it appeared possible to us that changes to the company’s historically poor corporate governance were in the making. Unfortunately, the company’s annual meeting produced none of these changes, so we sold the stock.
Ariel Focus Fund: Market pullback
At the end of the first quarter we publicly surmised that we had just seen a slight pullback in the market. This quarter the market got back on course, and we think the rest of the year may well be more of the same, for several reasons. First and foremost, the long-awaited—and in our mind overdue—wave of mergers and acquisitions is clearly in place. According to Goldman Sachs Group Inc (NYSE:GS)NYSE:GS, 2014 is on pace to be the second-biggest year ever for M&A. Housing news has been positive: as noted in the Wall Street Journal, in May sales of new homes rose to their highest level in six years, and sales of existing homes jumped a seasonally adjusted +4.9%. Finally, the Wall Street Journal notes, “U.S. payrolls in May hit an all-time high after the first four-month stretch of job creation above 200,000 since the boom days of the late 1990s.”1 We think corporate transactions, housing and employment are huge forces in the economy that should serve to accelerate the ongoing recovery.
This commentary candidly discusses a number of individual companies. These opinions are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.