Earnings- and asset-based miscalculations often cause investors to overlook market efficiencies, says Ariel's Timothy Fidler.
Timothy Fidler is co-portfolio manager of Ariel Focus
Additionally, he homed in on some of the key distinctions between Ariel Focus and Ariel Appreciation
1. ExxonMobil was the fund's biggest contributor to performance during the first quarter of 2011, in large part because of rising oil prices. Are you bullish about future oil-price increases and if so, how do you arrive at your forecasts? What's your information edge in a widely owned, widely analyzed company like ExxonMobil?
If you look back over the nearly 30-year history, Ariel has avoided commodity and deeply cyclical businesses that require precise short-run forecasts on macroeconomic variables such as interest rates, gross domestic product, unemployment, and oil prices. It's an extraordinarily difficult game to play for those who attempt to do it and one that we would not consider within our circle of competence. So our position in ExxonMobil is not actually an attempt to change our game, but instead it reflects a number of different Ariel philosophical elements coming together.
The first opportunity we saw played to our willingness to take a contrarian view toward energy prices when we first bought the position. Although trying to guess where commodity prices will go during the next month or quarter does not interest us, there are times when the markets can swing to irrational extremes. The price of oil went from around $145 a barrel in July 2008 to almost $30 in December of the same year. Our thinking at the time was that as crazy as energy prices had gotten on the upside in the summer, it looked like they had overshot on the downside in the winter, well below what most experts felt was the marginal cost of production.
Second, though we didn't know where energy prices would bottom, we were convinced that over a reasonable investment time horizon that the equilibrium price of oil was much higher than the spot price and would increase over time for a host of reasons. Although we do not explicitly forecast macroeconomic or market variables, we do have biases and leanings as to how valuation, economic growth, commodity prices, inflation, and the dollar look at any point in the cycle. Our view was that as the market and economy were collapsing in January 2009, when we first bought ExxonMobil, time would be our friend on all of the above.
Third, the ability to buy large-cap stocks in Ariel Focus allowed us to find a business that met the desired characteristics that we look for in a company. Because ExxonMobil's product is a pure commodity, it is very difficult to find an energy company that earns consistent, attractive returns on invested capital over time because of the inherent capital intensity and unpredictability of the sector. Upstream operations require excellent capital discipline and exploration skill. On the downstream side of the business, the only hope of earning a decent returns on invested capital comes from scale. Not only did ExxonMobil check both boxes in a unique way, but we also took comfort in the margin of safety present at the time of our initial investment. The net asset value of the company's oil and gas reserves covered the stock price, and the AAA balance sheet removed any concern over financial distress at a time where there was a lot of it going around.
Lastly, we would share your skepticism toward informational advantages in such a widely owned and analyzed company like ExxonMobil. However, though potential information asymmetries and analytical benefits collapse toward zero in the mega-cap range, these stocks are not exempt from short-sightedness and emotions that cause the vast majority of dislocations between price and value. Our perspective on large-cap value investing leans heavily on the behavioral-finance school of thinking, where a willingness to be contrarian and think long term matter, while informational advantages do not.
2. Johnson & Johnson also holds a dominant position in this very concentrated portfolio. Given recent manufacturing problems, a slew of product recalls, and patent losses, what merits your continued conviction in this firm?
Large-cap, high-quality companies are currently the cheapest area of the U.S. equity markets in our opinion. Johnson & Johnson is representative of a class of stocks that have been inexpensive for a while now and just keep getting cheaper. Many of the former large-growth darlings from the tech-bubble era have suffered massive multiple compression during the last decade. Although a key reason was that they were quite overvalued at the turn of the century, in most cases these businesses have grown nicely since then.