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Linsanity a Slam Dunk for This Fund

Russel Kinnel

Russ Kinnel: Hi. I'm Russ Kinnel, director of mutual fund research. I'm joined today by David Maley, fund manager of Ariel Discovery, a small-value fund that was launched in early 2011. Its trailing one-year and year-to-date performance is outstanding, not that that alone is a reason to buy, but it beats having bad performance.

So, David, thanks for joining us.

David Maley: Thanks for having me, Russ.

Kinnel: Maybe you could tell us a little about your deep-value strategy. I think of kind of the two things that are scary about deep value are: one, you can be vulnerable through an economic recession like we had in 2008; two, you can be vulnerable to bad management because obviously there's a reason the stock is cheap and sometimes bad management can kill an otherwise good company. How do you combat those two things?

Maley: Sure thanks, it's great to be here, Russ. By deep value what we try to do is we try to invest with such a margin of safety that even if things go wrong, we can still be OK as investors. So a lot of times the stocks we’ll invest in have actually had these difficulties happen, and in fact worries about the economy can be what creates the opportunity to buy the stock at a very deep discount. What we look for are stocks that trade at a low price to book value first of all. We recognize it as you get small it gets very hard to predict earnings and particularly earnings growth. So when the market focuses too much on those, we feel like we get opportunities as we focus on asset values first. Those are a lot more stable, so you don't have the same problems there.

Second, we always look for stocks with great balance sheets. That allows our companies to ride out tough times, and in fact, a lot of our stocks have significant excess cash. Sometimes we'll even buy stocks trading below their cash, or very close to their actual cash values.

Then third, the other thing we look for, once we find something that kind of screens those parameters, is good corporate governance. We want management teams that own stock. We like to see boards of directors that own stock. We don't like to see excessive perks, excessive pay packages. So we want to feel like managements are incentivized to think and act like us the shareholders, and we think those things help us avoid the value traps that are so common in deep-value investing.

Kinnel: This year what's driving performance at the fund?

Maley: I think a couple things. One is that we have managed to avoid for the large part disasters. So in this world of investing, if you can avoid having a lot of big disasters, you're ahead of the game usually to start with. Then we've just had a handful of stocks that have done particularly well for us. One stock that I guess we bought right when we started the fund last February, Market Leader, a software company that serves the real estate market, has had some great news. We originally bought it for barely more than its cash near its book value, and it's actually signed some very good contracts with big real estate companies, Keller Williams and Century 21, that have basically let the business start to grow. So that's done particularly well for us.

It's kind of a combination of a few stocks that have done well, not in any kind of thematic way, just kind of stock-by-stock, which is how we invest. [Our approach is] very much bottom-up, stock-by-stock, [and we] look for very cheap stocks with a margin of safety.

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Kinnel: I know in your last portfolio, Pervasive Software was another big holding. So what are these software names doing in a deep-value fund?

Maley: Well, it's interesting because we do tend to find some stocks in the technology area, but we tend to find them when they're so washed out that we're not betting on anything great happening. Again Market Leader was bought near its cash originally. We thought it had a good plan. We sort of viewed that as a free option.

Pervasive was very much the same way: a stock that trades for a little more than twice its cash on hand, has a legacy database business that generates significant cash and has led the firm to 44 straight quarters of profitability. It has a management team that owns a lot of stock. The CEO and CTO combined own about 16% of the company. They buy back shares smartly. And then the firm has a big data business, which is the part of the market that gets big multiples. Right now it isn't getting that multiple, so if that business catches on, we see very significant upside. On the other hand, the legacy business plus the cash on hand we think gets you pretty much where the stock's trading now. So you're kind of getting that free option again. We're not betting on that happening. If it works, we could have a huge home run. If not, we think we’ll be OK.

Kinnel: I know about a year ago you told me that you're finding a lot of values, particularly in the smaller market-cap end, and I know the fund’s got a fair number of micro-caps. I'm curious, does investing in micro-caps require any different approach? Do you have to adapt the sometimes lower levels of liquidity.

Maley: Yes. I think it does require a different approach, but it creates a lot of opportunity. Again it's sort of that idea, as you get smaller and lower price/book value ratios, if you go back to the Fama-French studies and other academic studies, they show that that's a part of the market that does provide outperformance. And again I think it goes back to that idea that the investing world pays so much attention to earnings, and when these stocks get neglected and they don't see visible earnings, they kind of throw them away. In general, the smaller you get, the more opportunity there is. So, when we can take our small-cap fund down into the micro-cap world but yet still go up to kind of that $2 billion range for opportunities, we get a nice range of opportunities that tend to be neglected, tend to have huge dislocations from price versus value, and give us some real opportunity.

Kinnel: I know one of your previous top holdings was Force Protection which got bought out. Is that kind of a big piece of the strategy finding names that happen to get bought out?

Maley: Sure. We've been surprised at the slow pace this year of mergers and acquisitions as a lot of people have, but we have a number of the candidates. The portfolio has somewhere little over 35 names. I would say half or two thirds of them could be taken out at any point in time, wouldn't surprise us at all. I mean again a lot of them have significant excess cash, so the enterprise value is quite low. A lot of them have a great niche products that could fit very well with a bigger company, and again we like to have management teams that are incentivized for shareholder value. So, we think most of our management teams would be open to that when and if a larger suitor comes along. Again it's something we expect to happen, and at times this helps us quite a bit.

Kinnel: I can't resist asking about Madison Square Garden which owns the New York Knicks because when we heard about Jeremy Lin and his free agency, there was a debate about, well, if you look at how much Madison Square Garden stock has gone up since he started playing for the Knicks, he has added $600 million in market-cap value. Of course, that's not a cause; it's correlation. Do you think that actually was a cause or what actually was driving it?

Maley: Well, it's interesting when we first bought the stock--and I think it was exactly the first stock we bought the day that we just started the fund--it is one that we had researched and didn't really have a place to put at the time because our micro-cap strategy didn't allow us to buy stocks that big. It was kind of in that $1.5 billion to $2 billion range.

We looked at the cash flows that the firm had from its regional sports networks and said the cash flows there pretty much give you the value of the stock, which then was in kind of the mid- to high $20s. Now I think it's $35 or so and it got close to $40 earlier this year. And then you have all these assets. You have the Knicks, you have the New York Rangers, you have the Garden itself, other sports properties, and while those are hard to value, we knew there was a lot of value there.

Well, then we got a real benefit from the Jeremy Lin excitement, and the great thing about that was there was a conflict going on with the Time Warner Cable deal. And actually the excitement around him and the desire, particularly in New York City, to have him available on TV actually helped get a deal done. Now that's a long-term deal. So, we're still going to benefit from that over time. As shareholders in the company, we obviously become fans, and Lin is exciting to watch, but the big thing is to see the firm take advantage of the opportunities it has and then put a competitive team on the floor, which I think it will continue to do. The Rangers are now very competitive. Every game that you have in the playoffs adds to the cash flows and builds the excitement. So, we think there is still a very good story there and potentially a lot of value still.

Kinnel: So, it sounds like you're saying Lin did add value, but his absence* probably isn't subtracting $600 million?

Maley: Right, exactly. I think that's a good way to think of it, yes.

Kinnel: David Maley, thanks a lot for joining us.

Maley: Russ, thanks very much. It was a pleasure.

* Jeremy Lin signed a contract with the Houston Rockets in July.