It is difficult to determine when investors will shed fears and the recovery will be full, according to Ariel's Ken Kuhrt, but consumer-focused names are finding the power alley right now.
1. There was a lot of market and economic volatility last year. Given this, what would you point out as the most remarkable event in 2011? Why?
We wouldn't point to a specific event as most remarkable during 2011 but would note the divergence between the positive trends of businesses versus the negative performance of stocks. We are bottom-up investors so we look at market movements from the perspective of our ownership in individual businesses. Market volatility and performance in 2011 would make you think there was significant uncertainty and poor performance at the individual businesses. This was simply not the case, whether you look at the financial results of the companies in our portfolio or the tone of discussions with their management teams.
In Ariel Fund's holdings, we saw 2011 earnings-per-share growth average approximately 13% over the 2010 results. This kind of earnings growth normally fuels excitement about businesses and drives strong stock performance. Unfortunately, investors have been more focused on global economic issues rather than the fundamentals of the underlying businesses. This has resulted in investors fleeing to perceived safe stocks rather than looking for the best risk/reward the market is offering. Thus, during a period of solid performance at the company level, we have seen earnings-multiple compression in our portfolio of more than 20% versus numbers the end of 2010. This multiple compression has occurred off of what were already very low multiple levels.
The strong performance of our companies at the individual business level, combined with the multiple compression we experienced in 2011, have us feeling very positive about our portfolio for 2012. We are believers in Ben Graham's famous quip that, "in the short run, the market is a voting machine, but in the long run it is a weighing machine." When investors stop focusing on macroeconomic issues and start weighing the actual cash our businesses generate, we expect to see stock appreciation from current levels.
2. Your recent market commentary indicated that "we are in the recovery's third inning." When do you anticipate the economy to be out of this cycle?
The length of an inning in a baseball game can vary depending on what happens on the field, and we believe the same holds in an economic recovery. It is extremely difficult to predict when the market will fully recover, but the key is to position your portfolio to benefit from the eventual recovery. Our companies tell us business is improving, but most remain hesitant to make a call on the exact timing of a full recovery.
This hesitation is primarily because of the long list of events during the past few years ranging from European economic issues to natural disasters that have weakened confidence and slowed the economic recovery. The market seems to still be on edge after the difficult market conditions of 2008-09 and is constantly shifting from one worry to the next. The market has been focused on the troubles of Greece. Once it appears that austerity measures in Greece will get the country back on track, the media points to Spain, Italy, or Ireland as the next problem, and so on.
One big key to the economic recovery is rebuilding consumer confidence. Consumer spending drives a significant portion of the economy, so attempts to increase government spending can only do so much to improve economic growth. Strengthening of the housing industry is critical to the recovery because it affects the problem in many ways. First off, improving conditions in the housing industry will help get more Americans back to work, which will help power consumer spending. Additionally, stabilization and growth in the value of homes will also calm worried homeowners who have been reluctant to spend as they have dealt with underwater mortgages and declining home prices for the past few years. Stabilization and growth in the housing sector should get the U.S. economy back on track to solid growth.
3. Where across the market-capitalization spectrum are you finding the best values today?
Ariel has been finding our best opportunities in some of the smaller-capitalization names. Investors have looked for safety rather than opportunity in this volatile period. This nervousness has resulted in flows to areas that are perceived as safe, such as fixed income and large companies with more stable economics especially those that pay large dividends. A clear sign of investors' flight to larger, more stable companies during the year was the Dow Jones Industrial Average beating the Russell 2000 Index by its largest margin in the past 13 years.
This shift in risk tolerance has occurred across all market capitalizations in our portfolios and allowed us to find high-quality, differentiated businesses at bargain prices. Great businesses such as Royal Caribbean Cruises RCL, Interpublic Group IPG, and KKR KKR were trading at significant discounts to our calculation of their intrinsic values. We ended up selling down our positions in some more predictable stocks which have been longtime holdings, such as Tiffany TIF, McCormick MKC, and Clorox CLX.