Fund Times

A Buffett Approach That's Not For the Faint of Heart

Christopher Franz, CFA

The following is our latest Fund Analyst Report for Ariel Fund (ARGFX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Ariel Fund features a long-tenured mid-cap manager and a Warren Buffett-inspired value approach, but high volatility limits its Morningstar Analyst Rating to Bronze.

John Rogers founded equity boutique Ariel Investments in 1983 and has led this fund since its 1986 inception. Over the years, he's assembled an experienced team, including two comanagers here, while fostering a culture focused on long-term results. The team seeks strong cash generators trading at steep discounts to their estimate of intrinsic value. Crafting a focused portfolio, the team follows Buffett's advice of investing within one's circle of competence and buys companies with strong franchises and competitive moats.

The fund has eclipsed the Russell 2500 Value Index since inception but hasn't done as well on a risk-adjusted basis. As a high-beta offering, the fund's concentration and high average price multiples contribute to high volatility versus its benchmark and peer group. Over the trailing 10 and 15 years ended March 2018, it was the mid-value Morningstar Category's most volatile offering, as measured by standard deviation. After plummeting over 70% during the financial crisis, Rogers and team have kept a closer eye on company debt levels, resulting in the fund's average debt/capital level dropping from 50% to 35%.

Since the March 2009 market bottom, the fund has come roaring back, landing atop the mid-value category. It gained 23.6% annualized versus 19.0% for the Russell 2500 Value Index and boasted the category's highest upside capture ratio over the 10-year period ended March 2018. However, such high-flying results cut both ways, and despite steps to cut risk, the fund fell more than its bogy and peer group in both the 2011 and 2015-16 market pullbacks.

Still, Rogers and team remain focused on the long term, despite the fund's feast-or-famine results. The fund's five-year average turnover is 24% (versus 65% for mid-cap peers), and its weighted average holdings duration is nearly seven years. The fund is still quality-oriented with above-benchmark profitability metrics. Investors who can stomach the ride should succeed here.

Process Pillar: Positive | Christopher Franz, CFA 04/09/2018
Managers John Rogers, John Miller, and Ken Kuhrt take a few pages from the Warren Buffett playbook. They look for strong cash generators trading at a 40% discount to their estimate of intrinsic value. Steep discounts like those usually don't come without controversy, explaining the managers' willingness to invest in beaten-down stocks. Rogers has employed this approach since founding the fund in 1986, though in the wake of the 2008 financial crisis, he and his team have paid closer attention to balance-sheet health. The team's robust and sensible approach leads to the fund's Positive Process rating.

Over the years, the fund has transformed from a pure small-cap offering into one that leans increasingly mid-cap. In 2011, management started targeting stocks with market caps between $1.0 billion and $7.5 billion. The managers will let their picks appreciate deep into mid-cap territory, and the portfolio sprawls across the bottom two thirds of the Morningstar Style Box. (In the aggregate, it has landed in mid-value.)

Drawing upon the Buffett advice to invest within one's circle of competence, they employ a relatively focused approach, holding about 40 stocks. They stick to companies with strong franchises and competitive moats, while undifferentiated utilities, telecom, and materials holdings are rare. The managers parted company with Buffett in 2005, however, when they started maintaining a fully invested portfolio versus holding cash.

John Rogers and his team look for companies with competitive advantages, and it shows. Of the companies in the latest portfolio covered by Morningstar equity analysts, nearly all of them have a competitive moat. Additionally, the fund's average returns on assets and returns on equity tend to beat its benchmark and peers.

Strong returns on capital stem in part from avoiding sectors where differentiation is hard to come by. As of December 2017, the fund didn't own any utilities, telecom, or materials stocks. Meanwhile, more than half of the portfolio was in industrials, consumer discretionary, and financials companies. The managers held on to longtime financial holdings  Lazard (LAZ) and KKR & Co. (KKR) following challenging performance in 2015 and were rewarded as they were two of the fund's top 2017 performers. However, this willingness to remain patient and add to falling names presents risk.

Helicopter service provider Bristow Group (BRS) was first bought in late 2012 above $50. Its price has since dropped to around $13, in part owing to a lack of offshore drilling demand and the collapse of a close competitor. The fund has maintained a roughly 2% position over that time as the team aggressively added to the stock as it fell; in aggregate, the firm owns nearly 30% of its stock. While Rogers and team don't usually own companies to this level, investors should be prepared for concentrated, contrarian positioning.

Performance Pillar: Neutral | Christopher Franz, CFA 04/09/2018 
The fund has delivered mixed risk-adjusted returns since its 1986 inception, leading to its Neutral Performance rating. On a very long-term basis, returns remain solid. Since inception--all on lead manager John Rogers' watch--the fund has edged its benchmark, returning 11.5% annualized versus 11.2% for the Russell 2500 Value Index through March 2018.

But these returns have been accompanied by above-average volatility. The last three bear markets are reminders of the fund's potent risk profile. It fell 70.1% peak to trough during the credit crisis versus a decline of 61.1% for its benchmark, and 34.4% in mid-2011 versus its bogy's 27.5% drop. Despite taking steps to cut risk, the fund fell 24.9% peak to trough versus a negative 20.6% return for the index during the 2015-16 bear market.

Those subpar results owed in part to the fact that since 2005 the fund has usually been fully invested. This contrasts with prior years when Rogers would allow cash to build to 20% or so of assets when he couldn't find buying opportunities. Those occasionally hefty cash balances dulled some of the edges that accompany a concentrated portfolio and a willingness to sometimes buy distressed companies.

Conversely, the fund has excelled during rallies. Since the market bottomed in March 2009, the fund gained 23.6% annualized through March 2018 versus the index's 19.0% return.

People Pillar:  Positive | 01/25/2018 
John Rogers, who founded Ariel Investments in 1983 and this fund in 1986, leads the charge. From the beginning, he has implemented a Warren Buffett-inspired value philosophy. His extensive experience makes him the longest-tenured manager in the mid-value category, underpinning the Positive People rating.

While Rogers is the lead manager and Ariel's public face, key-man risk isn't as great as it may appear. He's built a capable team around him, beginning with John Miller, who has been with Ariel since 1989 and a comanager since November 2006. Miller leads the firm's research on asset managers and media, both prominent parts of the fund. Miller worked in Cantor Fitzgerald's institutional-equity group prior to Ariel.

In December 2011, Ariel named Ken Kuhrt as an additional comanager. Kuhrt joined Ariel as an analyst in 2004 and specializes in consumer services and industrials companies. He also is comanager of micro-cap-focused Ariel Discovery (ARDFX). Prior to joining Ariel, Kuhrt was an investment banking analyst at William Blair and a senior auditor at KPMG.

The fund draws on experienced managers at other funds, including vice chairman Charles Bobrinskoy and director of research Tim Fidler. The team will often research and visit companies together. At Ariel, U.S. stock managers also act as analysts and have sector responsibilities.

Parent Pillar: Positive | 04/18/2017 
Ariel Investments has the hallmarks of a strong steward, earning it a Positive Parent rating. The value-oriented boutique has carried its "slow and steady" mantra from its patient investment process to its business plan, having launched just six funds in its 35-year history--all of which stem from its signature approach. The staff of investment professionals is fairly small, but the firm has been adding to both its domestic and global research teams during the past five years. Its portfolio managers are experienced, and the firm has lost just one in the past five years.

Ariel is employee-owned, but founder John Rogers owns the largest portion of the firm. Rogers is a key person at the company but is a named manager on just two of the firm's offerings and has at least one comanager on both. The concentrated funds are not currently closed, but they don't seem to be particularly bloated. Overall, the firm has $11.7 billion in assets under management.

One of Ariel's more endearing attributes is its concerted effort to educate investors. The firm does a great job of explaining its reasons for owning stocks in its informative shareholder letters and timely portfolio updates. This is also a learning organization. As CEO, Rogers takes the lead in bringing in experts to teach the investment team. In recent years, behavioral finance has been an area of focus.

Price Pillar: Positive | Christopher Franz, CFA 04/09/2018 
The fund's assets are split between two share classes, investor and institutional. As of the fund's February 2018 prospectus, the investor share class' 1.01% expense ratio fell just below the 1.02% median of no-load mid-cap funds, but its institutional share class was priced more competitively, clocking in at 0.71% versus 0.89% for peers. The fund's below-average turnover helps keep trading costs in check, and with total strategy assets near $2.5 billion, capacity doesn't present an issue. Overall, this adds up to a Positive Price rating.

Christopher Franz, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.