John Rogers Comments on August
In his first six NBA seasons, Larry Bird won two NBA championships (in 1981 and 1984) as well as two MVP trophies (in 1984 and 1985). In his sixth season, he scored 28.7 points per game and hit 52% of his shots. He was on top of the basketball world. But in the first 25 games of his seventh season, he became mired in a bad shooting slump; his scoring fell five points per game and his shooting percentage dropped to 45%. Opinions on how to fix the problem ranged from the superficial and obvious, such as getting closer to the basket, to the extreme, such as hiring a shooting coach. In an interview during the slump, Bird had another take: The only thing I can do is work harder, try to give that extra effort and get over the hump . . . I have to go out and shoot that extra hour. I got to go out and run the extra hour. I have to go out and work on my foot movement.
Bird's answer was to do what he had always done, but more so, and to focus intently on fundamentals—notice the attention to footwork. He did, and the results were clear: his Boston Celtics won the NBA title that year, and Bird won the season MVP as well as the Finals MVP awards. Not only did his shooting percentage recover to 52% in the last 57 games of the season, but his scoring shot back up to 26.9 points per game. Plus, there was an added bonus. In his first six seasons, Bird's free-throw percentage was always very strong at 80% or above per season, but it never topped 90%. After the thousands of free throws he shot to get out of his slump, his average rose to more than 90% in the 1985-1986 season and stayed there for the next three seasons. During a temporary performance shortfall, his hard work on fundamentals helped end the slump and went on to make him a persistently better player.
Throughout Ariel's history, our flagship strategy has targeted growing small- and mid-cap companies selling at a discount to their intrinsic worth. The focus, of course, is on bottom-up stock-picking rather than the derivatives of stock picking, metrics such as alpha, beta, standard deviation, tracking error, and so forth. Still, our diligent, disciplined process has led to consistently stable returns. In our first 25 years, for instance, we tended to outperform the broad market with market-like volatility that was lower than the relevant benchmarks. For instance, the Ariel Small Cap Value Tax-Exempt Composite's one year standard deviation from its 1983 inception through late 2008 was 14%, matching the S&P 500 Index's 14% standard deviation and below the Russell 2000 Index's 18% standard deviation.
Then, despite the fact that we did not change anything in our process, the volatility of our portfolios spiked as the worst of the financial crisis hit in October 2008. The volatility remained elevated for years. From October 2008 through September 2012, our small-cap portfolio's standard deviation was twice its long-term average at 31%, much higher than the S&P 500 Index's inflated 19% level and even the Russell 2000 Index's 26% mark. The datapoints that flow down from absolute volatility—beta, upside and downside capture, and so forth—also changed radically. Changes to our other portfolios' behavior were similar. And just as Larry Bird had to handle a torrent of questions about his shooting slump, we received innumerable inquiries about our portfolios' heightened volatility. On the one hand, we knew we had not changed and that the bad period was likely to end so long as we did not alter our philosophy and our process remained stable. On the other hand, we consistently refuse to simply admire a problem.
Like Larry Legend, we knew that working harder than ever on fundamentals—regarding very specific issues—was the right thing to do. To our minds, fundamental business stability ultimately drives higher performance stability. So we looked to bulwark what we were already doing to ensure we were buying and owning high-quality franchises. We formalized three improved practices. First and foremost, we launched proprietary debt ratings. We have always focused on financially healthy companies with low levels of debt. So we created our own metrics to track the numbers, which led to even greater focus on the details—debt loads, interest coverage levels, changes in rates, and so forth. These debt ratings challenge us to "look under the hood" and examine the nuances of each company's financial quality. Second, we began paying even greater attention to "moats," the durable competitive advantages that help companies fend off the competition. We instituted internal moat ratings: wide, narrow, and none, along with trend ratings, stable, increasing, and declining, to help put rigor around our descriptions of our companies. Finally, we had always charged our research analysts with tenaciously but productively challenging each other's stock ideas, but we decided to refine the process. Each stock now receives a Devil's Advocate who is explicitly responsible for presenting the bear case on the security. We believe that assigning the role as a specific duty decreases any emotion involved and greatly heightens the intellectual level of our conversations. Mind you, there is literally no way of knowing just how much each new step in our process contributed—but as with basketball, you know when you are working even harder than before.
Eventually our portfolios returned to their more typical behavior. For example, the Ariel Small Cap Value Tax-Exempt Composite has averaged a 13% standard deviation since October 2012—a level even lower than those from the product's first 25 years. Although that remains a bit above the broad market's 10% standard deviation (which is abnormally low) and even a bit above the Russell 2000's 12% level, it is in the same range as before. That is, the volatility has returned to normal. Along the same lines, the secondary measures of volatility such as beta and upside/downside capture are starting to improve. We think this change would have been inevitable, but are thrilled we took advantage of the opportunity to implement new measures that would persistently drive better analysis.
The opinions expressed are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
Past performance does not guarantee future results. Investing in small and mid-sized companies is more risky and more volatile than investing in large companies.