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.
The stocks we lightened up on were differentiated businesses with clear advantages in the market place but often had lower growth expectations over the coming years. Yet these more predictable stocks were trading at forward earnings multiples in the high teens. At the same time, Royal Caribbean Cruises, Interpublic Group, and KKR were trading at nearly half the forward earnings multiples with significantly higher long-term growth prospects. Thus, our focus on owning securities for long periods of time led us to swap out the predictable slow-growing businesses trading at high earnings multiples for opportunities that offered better long-term growth opportunities trading at substantially lower multiples. The market is looking for near-term certainty, while we are patient and looking at the long-term potential of the businesses.
4. The fund's biggest holding is Gannett GCI. How do you think this firm will cope with the secular decline in newspaper readership?
We believe the secular deterioration in newspaper readership is understood by the market and is priced into the stock at current levels. At current levels, the market is discounting more draconian scenarios than a simple decline in readership. In our view, the stock is being priced as if the newspaper segment is of little to no value, even though the business still creates significant cash flows. The cash generation of the newspaper segment is even more impressive when you factor in the difficult economic conditions it has dealt with during the past few years. The market is also neglecting some of the other businesses at Gannett, including its television-broadcasting business and its digital business, which includes a majority ownership of CareerBuilder. Even factoring in a decline in newspaper readership, we believe investors will benefit from the near-term cash generation of that business combined with continued growth in Gannett's other business segments.
Using consensus estimates, Gannett stock currently trades at 8 times trailing earnings and 7 times forward earnings. The company has continued to generate healthy levels of cash flow and has focused on decreasing its debt levels and paying a dividend. Management has cut the total debt level to $1.9 billion, which is half its total debt level at the end of 2008. The debt-paydown level is impressive considering the recent period in which the company lacked significant growth. If management continues to effectively allocate capital, the stock should continue to strengthen.
5. A large chunk of the fund is invested in consumer-focused names. Why are you bullish on the U.S. consumer? What could derail the consumer?
Our heavier weighting toward consumer-focused names is more of a product of our investment philosophy than a near-term call on the consumer. Our process is focused on identifying differentiated companies with strong cash flows, low debt, high-quality products or services, significant barriers to entry, and low reinvestment requirements. Additionally, our patient investment strategy has us focus on industries where we can reasonably predict what the industry and competitive landscape will look like three to five years from now. This combination naturally fits the consumer-focused names and has been a power alley for the firm through the years.
Beyond our natural tendency to carry a heavier weight in consumer-focused names, we are more positive on the U.S. consumer than the market appears to be at this point in time. Even though U.S. consumers have battled through increasing unemployment, declining home values, and uncertainty in the global economy, they have still been able to increase their savings rates and decrease their personal debt levels. Once greater clarity in the economy and home values appears, the pent-up spending of the consumer should help drive the market upward. Note, we are not expecting the peak spending levels we saw during the mid-2000s, but the market is pricing in virtually no recovery in consumer spending. We believe it isn't a question of if consumer spending strengthens, but a question of when it strengthens.