It Pays to be Contrarian

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Many fund managers claim to follow the footprints of respected value investor Warren Buffett, but few actually have the guts to stick with stocks through the tough times.

Aiming to outperform their benchmarks and attract institutional investors, they simply can't afford to ride out down markets. But the managers at Ariel Investments are agnostic to the indexes, making them able to stick with contrarian value plays regardless of short-term market fluctuations.

We recently spoke with Charlie Bobrinskoy and Tim Fidler, co-managers of Ariel Focus (ARFFX), about their Buffett-esque strategy and how that's contributed to their fund's success as it approaches its five-year anniversary. --Benjamin Shepherd

It Pays to be Contrarian

You're both very critical of the fact that so many analysts are obsessed with quarter-to-quarter estimates. Why don't you pay much attention to those numbers?

Charlie: The sell-side analysts and the buy-side community are very motivated by short-term considerations and often misprice securities which should ultimately be valued by their long-term cash flows. We don't see any point in trying to time the market since it's extraordinarily hard to do. Others trying to do it create market inefficiencies that we take advantage of.

Tim: This is rooted in the Warren Buffet idea of trying to be business analysts rather than stock analysts. The vast majority of the effort of the sell-side complex is spent trying to guess next quarter's earnings and playing an information game.

The way we look at it is that, in the Buffet spirit, we're not trying to trade paper but buy pieces of real businesses. When you want to buy a real business, you have to evaluate what the business can do over the next 5, 10, or 15 years and figure out what those cash flows are worth today.

That approach flows through not only in our time horizon but also in the way we do our company-specific analysis since we spend a great deal of time trying to understand managements' resumes and capabilities, what makes them unique and gives them a competitive advantage. We want to look at what kind of growth rate companies can achieve over the long run because the return of the underlying business is going to determine the stock return.

But the fact that the investment community will take things that are temporary in nature and capitalize them into the prices of businesses as if they're permanent, delivers shocks to the stocks and creates an opportunity for us as value investors.

You say that you buy value companies without a clear catalyst in sight. Isn't that a risky proposition?

Charlie: We don't pretend to know when a stock is going to make a big move, but what has been absolutely proven over time is if you buy stocks at a discount to their intrinsic value you will outperform over time because in the end, a stock's return is based on the cash flows from the underlying business over the long run.

Tim: IBM ( IBM ) would be a specific example of that. When we meet with analysts they usually say that they really like the company but they can't get excited about it because there's nothing they can see in the next three to six months to drive the stock price higher.

But if you get back to the idea of buying the right business at the right price, IBM was a company that we bought at the inception of the fund that was a very cheap and one that we thought was going to grow nicely over the next few years. There wasn't any specific event that people were waiting for with the company and yet the earnings power has doubled in the past five years and it's still a cheap stock. The underlying operating performance has been so good that it has been one of our better performers.

What's your outlook for the next year?

Charlie: We think that people are underestimating the strength of the recovery. They're excessively angered over the bad economy we had last year but we're seeing very consistently that the companies in our portfolio are recording results that are better than the estimates. There's been a noticeable change in the confidence of the managers that are running our portfolio companies.

Before they were talking about how things had stopped getting worse and now they're saying things are getting better and we don't think that's fully reflected in analyst expectations for earnings or the overall market valuation. Again, we aren't good at figuring out when exactly that's going to change, but it's good to be in situations in which the market is underestimating the earnings power of your companies.

Is that what's driving your interest in advertising, a sector that there doesn't seem to be much confidence in?

Charlie: These names would go into the category where the market is underestimating earnings power. The work we're doing indicates that the media and advertising spend is going to be up in 2010, yet most of the analysts are estimating flat spend rates this year, which we think is too conservative.

Tim: The best way to characterize our thesis on advertising companies is that while we've seen a lot of disruption in how media is delivered and how advertisers are going to market, the advertising firms themselves are fairly agnostic to that trend and actually benefit from shifts to digital media.

That's because in a number of ways digital is more profitable and it also has become more important to advertisers to help navigate through what is an increasingly fragmented and difficult environment. That's the longer term case for advertisers.

In addition, we've also gone through a period in which companies had to cut costs very rapidly and a lot of those cuts were in media and advertising spend. Right now we're in a period where as the economy and corporate balance sheets strengthen, advertisers are going to come back to the market.

Omnicon Group ( OMC ) is trading at its lowest valuations in 15 years and it is by far the world class advertising company. Interpublic Group of Companies ( IPG ) is a slightly different situation as a company with very powerful brands in the marketplace with their agency networks but is still coming out of a period where they've had to turn around operations that were below peak profitability. So we see a slightly different stock specific case there but we're pretty optimistic about how it's going to shake out over the next few years.

What sectors are most attractive to you right now?

Tim: Healthcare is one that we have an outsized weighting in right now. If you go back through the 27 year history of our firm, we've only owned healthcare in any meaningful way twice: once was in 1994 and then again over the last year and a half. I think you'll immediately see the reason why.

There's been a lot of fear and uncertainty in how healthcare reform was going to shake out and now that it has passed there's still some confusion over what the ultimate impact will be on fundamentals. The market hates any wide scale uncertainty and that has taken the valuations on some world class leading companies down to levels that are building in the worst case scenario without really looking at what should be a positive for them a few years out in terms of increased volume.

What's interesting is a company like Merck ( MRK ) is trading effectively for the value of the drugs they have for sale, giving them virtually no credit for future productivity in their pipeline and which to us is an incredibly bearish view on a company that has a very long history of highly productive R&D.

They're a tremendous franchise that's trading at 8 times next year's earnings which just seems overly bearish. Baxter International ( BAX ) is another company that's trading at a single digit price-to-earnings if you look out a year. It's had a few specific issues in their plasma business but by and large, is a very high-quality and growing healthcare company.

Covidien (COV) is another one that we own which doesn't have that much exposure to healthcare reform since they sell a lot of healthcare and surgical consumables, low-ticket items that aren't going to see a lot of pressure from healthcare reform.

Generally what we're seeing is the baby being thrown out with the bathwater and the whole sector is being hit by investors who are out of the sector, waiting to see what happens. We're contrarian value investors so we have to be willing to get in there and make these investments before the uncertainty is resolved, because at that point, the market has already moved.

Charlie: There's obviously a lot of concern about financials and the big money center New York-based firms are facing concerns about new financial regulation. We don't discount that because we think there are new rules coming. But the banks have been pretty good about dealing with consumer-based regulation in the past and we think they will be going forward.

There was fear about an end to proprietary trading but that isn't going to happen. It would be a big deal if all of a sudden J.P. Morgan Chase (JPM) couldn't own positions for its own account. The definition of proprietary trading is going to work itself out and be very manageable. Right now we think J.P Morgan and Bank of New York Mellon (BK) of particularly high quality.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Article Republished with permission from <a href="http://www.KCIinvesting.com" rel="nofollow">www.KCIinvesting.com</a> and <a href="http://www.rukeyser.com" rel="nofollow">www.rukeyser.com</a>


This article appears in: Investing , Stocks

Referenced Stocks: BAX , IBM , IPG , MRK , OMC

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