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A Deep-Value Investor's Hunt for Bargains

Ariel's David Maley surveys the wreckage for keepers.

Russel Kinnel, 08/30/2011

Deep-value investors buy the companies that everyone else hates. In downturns like the one we just witnessed, the market is lending them a hand in finding oversold names. Of course, it's a tricky strategy to execute well.

I checked in with David Maley to see what he was doing. Maley is an experienced deep-value investor who came to Ariel from Maple Hill Capital but with a very new fund. Ariel Discovery ARDFX was launched at the end of January.

Q: Deep value seems like an easy strategy until you actually try to do it and learn that many stocks are beaten down for good reasons. How do you figure out which ones are really in a position to recover?

A: Ariel Discovery Fund's deep-value strategy relies heavily on the search for a margin of safety. We recognize the fact that earnings and growth are difficult to predict in small companies, but that asset values are inherently much more stable. When the market overemphasizes short-term earnings trends, it often leads to significant disconnects between price and value. We frequently make purchases of stocks trading below tangible asset value--sometimes even below liquidation value--which we therefore expect to provide good returns even in the absence of fundamental business improvement. When we also get growth that the market has not anticipated, the returns can be extremely attractive.

One thing that we believe sets us apart from many deep-value investors is our extreme distaste for debt. The vast majority of our holdings have little or no debt and in fact hold significant excess cash positions. This increases our margin of safety, as we feel that our companies can ride out difficult periods. Another factor that is very important to us is corporate governance. We look for managers and directors who have significant stock ownership, and we avoid situations where excess pay and perks create a divergence between our interests as shareholders and those of management. We believe that this focus on balance-sheet strength, along with a search for properly incentivized leadership, helps us avoid value traps.

Q: On the flip side, what leads you to sell?

A: We sell when a successful investment reaches our estimate of fair value, or when it approaches fair value and more attractive opportunities become available. As long-term value investors with an asset focus, we very rarely sell because of a disappointing earnings report or outlook. If we lose faith in management we would sell; seeing a previously debt-free company take on significant leverage to make a transformative acquisition would be the most obvious sell signal.

Q: This would seem an ideal strategy for little meltdowns like the one we saw after the downgrade. Did you see many bargains pop up and did they last long enough for you to act on them?

Russel Kinnel is Morningstar's director of mutual fund research. He can be reached at russel_kinnel@morningstar.com.
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