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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?

A: We have seen lots of bargains ? the screens we use to identify candidates are showing more names than at any time since mid-2009. We have added to a few of our favorite holdings, initiated a position in one new name last week, and are working on several others. The new name is typical of what we look for in that it trades just below book value and barely above its cash on hand, yet the company is highly profitable with growth potential. With the market continuing to be volatile, we are seeing plenty of cheap stocks and the bargain prices are staying around long enough for us to act.

Q: Now that the dust has settled somewhat are there names or sectors that appear particularly attractive?

A: While virtually every sector has become more attractive on a valuation basis, the one generalization I would make is that smaller has gotten cheaper. It seems that in investors' rush to de-risk their portfolios, the assumption has been that smaller means riskier. Yet when we find small-cap stocks trading at deep discounts to asset value as described earlier, we believe that these are actually very low-risk, long-term investments. So while Ariel Discovery Fund generally invests in stocks with market capitalizations below $2 billion, most of our recent buys have been in the under $1 billion category.

Q: Some of your holdings are pretty far off the beaten path. How do you find them?

A: We find most of our ideas through a series of screens. I rely most heavily on those that search for stocks based on low price-to-book ratios with strong balance sheets, as I mentioned earlier. Another favorite screen looks for those characteristics combined with profitability and/or positive cash flow. A small company trading at or below asset value which is also profitable during a challenging economic period is a great candidate for further research.

It is true that many of our holdings are off the beaten path. That is one of the things that make this job so interesting. Since we will seek out value wherever it can be found, I never know where the next new idea will lead. Our top holdings include Force Protection FRPT, which makes vehicles to protect U.S. and allied troops from IEDs and other explosives, along with Madison Square Garden MSG, which owns the Garden, New York Knicks, New York Rangers, and the MSG regional sports networks--among other sports and entertainment properties. We also own Ballantyne Strong BTN which distributes digital theater projectors, produces silver screens for IMAX IMAX and other 3-D exhibitors, and installs and services not only its products but also those of its competitors. Another interesting name is Contango Oil & Gas MCF, a Houston-based exploration and production company with only eight employees that has an outstanding record of successful capital deployment and allocation led by CEO Ken Peak, who is also the company's largest shareholder. This diverse group of companies has in common outstanding financial strength, significant asset value, and, we believe, underappreciated long-term earnings potential.

Q: At First American Financial FAF (a 3.7% holding in the last portfolio), is it a matter of simply waiting for a real estate rebound to boost results in title insurance or is there more to it than that?

A: The company has made significant improvements to its cost structure that we believe the market is not giving it credit for. With these improvements First American can now achieve 8% to 10% operating margins on half the mortgage-origination volume that was required in the past. So even in a depressed real estate market, we believe we can make a good return simply by waiting for the market to recognize this improved profitability. In the meantime, we own an industry-leading company that is earning profits during a time of historical lows in mortgage-origination volume, and which is also trading below book value and only modestly above tangible book value. We do not know when housing will recover, but when it eventually does, we feel comfortable that First American will be well-positioned to benefit.

Q. In light of the huge redemptions in the fund industry following the downgrade, what would you counsel investors to do?

A: While Ariel Discovery Fund has fortunately not had any significant redemptions during this period, and in fact has had net inflows, uncertainty and fear have clearly led to huge redemptions for many funds. As long-term, contrarian investors, we tend to view lower stock prices as an opportunity to buy businesses when they are on sale. Sir John Templeton famously advised buying stocks "at the point of maximum pessimism," and it appears that in the wake of the U.S. debt downgrade we are rapidly approaching that point. On top of that, despite concerns about an economic slowdown and a potential double-dip recession, corporate America is in much better shape than three years ago. Bank capital structures are much improved and there is more than $1 trillion of cash on corporate balance sheets.

So while I would never encourage an individual to put cash needed for the short-term into stocks, I believe that the long-term values being created in this fearful environment are extraordinary. I would strongly advise against panic selling, and would expect that, in years to come, this will be seen as a great time to have invested in U.S. equities. 

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