As a value investor, Charles Bobrinskoy often looks for attractively priced stocks that stand to benefit from an under-recognized risk. Right now, the 54-year-old manager of the Ariel Focus Fund views inflation as the unseen risk lurking in the shadows.
“The stock market pays attention to the short term, and inflation isn’t an immediate concern,” he says. “That’s the reason that stocks of energy companies and others that stand to benefit from inflation are still trading cheaply, and why we think they represent good values.”
After years of trailing the market, fund holdings such as Apache Corporation, National Oilwell Varco and Exxon Mobil saw gains in the 20% area in the first half of the year as energy prices began ticking up. Yet despite the recent run-up, they still have below-market multiples because they lagged for so long. The combination of attractive valuations and inflation orientation makes them a draw for the fund, which has an above-market weighting in the energy sector.
Although inflation will happen at some point, a weak economy has kept prices in check thus far, and there are plenty of signs indicating it won’t be much of a threat in the near future. Since the financial crisis, the Consumer Price Index has risen at only half of its long-term historic average. Gold prices are well below the $1,900 per ounce peak in 2011. Wages are stagnating, making it difficult for people to buy more goods and push up prices. And long-term Treasury yields, one of the first harbingers of rising inflation, are still near historic lows.
Nonetheless, Bobrinskoy thinks the key elements of an inflationary environment and rising interest rates are firmly in place. Thanks to a long stretch of quantitative easing by the Federal Reserve, the money supply has expanded rapidly, a condition that has historically led to inflation. Countries around the world are devaluing their currencies to make exports more competitive, another development that sows the seeds of rising prices.
A recovery in housing starts is also in the cards. “For most of the last 60 years, there have been an average of 1.5 million housing starts a year,” he says. “But for the last five years, that number has plunged to 1 million. There’s a huge pent-up demand here.” His anticipation of a housing recovery has led him to invest in a construction tool manufacturer, Stanley Black & Decker, the fund’s largest holding, as well as in home furnishing retailers Bed Bath & Beyond and Pier 1.
While he characterizes the stock market as “fairly valued to modestly expensive,” he doesn’t believe things are approaching bubble territory just yet. “One of the signs that a bubble is approaching is when investors pour money into equity funds, and that isn’t happening. Another good indicator is newsletter bullishness, and the fact that over half of newsletters are bullish concerns me a little. But I still don’t think that points to a bubble.”
Nonetheless, he still sees many yield-oriented investments as overpriced. That group includes so-called bond substitutes such as REITs and utilities, which investors have bid up to unreasonable levels. Certain corners of the bond market look particularly ripe for a downfall if interest rates rise. “The high-yield market is less attractive than it’s ever been,” he says. “With negative developments in Puerto Rico and state pension systems stretched, municipals are also very risky. And with a 2.5% yield, 10-year Treasury bonds are a return-free risk asset.”
Riding the Turtle
Even if it takes years for his expectations for inflation-driven stocks and others to pan out, Bobrinskoy has proved he’s a patient investor who is willing to wait for a stock’s price to catch up with his assessment of what it’s worth. To provide a margin of safety, he likes to buy a stock when it is selling at a 40% discount to his estimate of private or intrinsic value. Often, he’ll step in after it has taken a beating because of disappointing earnings that occurred for reasons he considers temporary. He typically hangs on for four to five years, although his turnover was higher than usual last year because many stocks in the portfolio shot up to their intrinsic value pricing targets in the bull market. He’ll also sell if an investment thesis proves wrong or if a better alternative comes along.
At the same time, he’ll hang on to a stock even after it sees a large drop if he believes the reason is temporary and the original investment thesis remains in place. Earlier this year one of his holdings, gaming manufacturer International Game Technology, fell 22% after a subpar earnings report. The stock rebounded sharply in July when an Italian gaming company entered into a merger agreement to buy the company for $4.7 billion in cash and stock.
Patient investing is the cornerstone of Ariel’s marketing theme, which features a turtle with the caption “slow and steady wins the race.” Known best for its founder John W. Rogers Jr., a former Princeton basketball star known to pepper shareholder reports with sports analogies, Ariel Capital Management has over $9 billion of assets under management. Since its founding in 1983, the firm has focused mainly on investing in small and mid-cap out-of-favor stocks whose virtues, such as a strong franchise or good cash flow, eventually come to the forefront. There’s also a hint of socially responsible investing here, since the managers won’t invest in companies involved in tobacco or the manufacture of handguns.
In 2005, the firm launched Ariel Focus to bring its value management style to the large-cap space. Bobrinskoy was no stranger to Ariel or its founder when he left a longtime career as an investment banker to manage the fund and become the firm’s director of research. He had known Rogers since high school, when the two of them sold hot dogs at Chicago’s White Sox Park. He had also served as an usher at Rogers’ wedding and was a founding investor in his firm.
His 20 years as an investment banker helped prepare Bobrinskoy for his new role by teaching him about the importance of strong balance sheets. “Many companies borrowed money which they could have repaid had the economy continued to be strong. But recessions come and debt becomes a heavy weight.”
Ariel Focus became an all-cap offering in 2013, allowing Bobrinskoy to invest in a broader universe and to share some of the ideas generated by its bigger and better-known sibling, the Ariel Fund. With a weighted average market capitalization of $36 billion, the concentrated portfolio of 25 to 30 stocks remains squarely in large-cap territory because Bobrinskoy believes large caps are generally cheaper than small caps right now.
Buying opportunities are popping up in stocks such as Bed Bath & Beyond. The stock was added to the portfolio in July of this year after it plunged 30% in the course of several months following two consecutive quarters of disappointing earnings. Bobrinskoy says the company’s earnings shortfall was due to temporary setbacks. Bed Bath & Beyond sales suffered because of bad weather and the company had to make an investment in its online platform. But he points out that the company has almost no debt and its balance sheet is strong. “This is a leader in the home furnishings business that will benefit from a pickup in the housing market. Investors don’t like negative price momentum. We see it as a buying opportunity.”
Another housing revival play in July was his purchase of Pier 1, following the stock’s drop of over 25% from its 2014 high. The home furnishings retailer had missed earnings estimates for the same reasons Bed Bath & Beyond had—bad weather and obligations to its online platform. “Sales were disappointing, but these were relatively minor misses,” Bobrinskoy observes.
He’s also been adding to the fund’s position in Stanley Black & Decker after investors, disappointed by earnings in the company’s European operation, sold off and caused the price to drop. Bobrinskoy believes this problem, like those of the other companies, is temporary and that Stanley Black & Decker will benefit from a housing recovery.
At 14% of assets, the health-care sector also represents a large chunk of the fund. Despite investor concerns about the Affordable Care Act (ACA), Bobrinskoy believes that aging populations and advancement in medical technology will lead to robust health-care spending for many years to come. Independent sources, as well as the firm’s own research, indicates that the health-care act has led to more, not less, spending on health care.
He believes one of the beneficiaries of that spending will be Laboratory Corporation of America, which he added to the portfolio in early 2014 after investors became concerned that Medicare reimbursement rates would harm the stock. An operator of independent clinical laboratories performing health-care testing, LabCorp should be able to weather the ACA storm because it maintains a lower cost structure than in-house hospital labs and has convenient locations near hospitals.
