Q:  What is your investment philosophy? A : We focus on the underlying business of the stock and thus view ourselves as business analysts, not stock analysts. As a result, we seek to buy a small number of high quality companies that we would want to own as private owners. This involves evaluating them in the same way that a private owner would look at a business, with a strong emphasis on underlying cash flow dynamics and competitive advantages. Sustainable competitive advantages play a major role as we believe that a company may only earn an excess return on capital when there are material barriers to entry. Thus, even if a business exhibits outsized current profitability, unless there are those barriers to entry, new capital will flow into the industry and compete away the excess return. That is a core concept in all of our holdings. Under this model, there will be no commodity stocks – every business we own must have some kind of a sustainable competitive advantage or point of differentiation. Our logo is the tortoise, as in The Tortoise and the Hare, and “Slow and steady wins the race” is our firm’s motto. We try to find businesses that are growing over time and where we can take part in the underlying growth of the intrinsic value of the business because, in the end, stock prices have to follow the underlying fundamentals of the business. Our holding period tends to be between three and five years on average. There are always two things that we primarily consider when we look at a particular stock. First, whether the stock is available at a discount to what the intrinsic value of the business is, or what we think it is ultimately worth, and how fast that intrinsic value is growing. In short, our philosophy can be described in three words: quality, expertise and value, which we refer to as QEV. However, even if you have a company with a sustainable competitive advantage, if it is not trading at a good value, then the stock may not emerge as a suitable holding. Therefore, we require value as well as high quality. The stock has to be trading at a 40% discount to our calculation of its intrinsic value before we will buy it. Q:  Why will commodity stocks not fall into your model? A : The rationale is that most commodities-driven businesses, by their nature, have no competitive advantage and thus cannot generate excess returns for shareholders over time. One example we would like to give is the ethanol business, which has enjoyed wonderful tailwinds. These companies have received government subsidies owing to politicians who have become increasingly interested in ethanol, and all through the political benefits of the people of Iowa and Kansas who want to see the price of corn go up. For a while, ethanol companies were doing very well. Yet, as the price of ethanol went up and people started earning increases returns, new plants were being built. We are in a position now where the returns on those ethanol plants have turned, in some cases, negative. There were no barriers to entry and the ethanol business has eventually become a bad business. We see that happen in many different industries. We are witnessing the same scenario with oil, steel, coal and other commodities. Without a material barrier to entry or point of differentiation, there is nothing to help you maintain an excess return on capital. Q:  How do you leverage the QEV into the investment strategy? A : First, our analysis starts with an assessment of quality and this covers a broad range of company attributes which includes a thorough examination of profitability, returns on capital, growth prospects, free cash flow generation, balance sheet strength, and management to name a few. Ideally, we target companies with consistent and predictable earnings and fundamental strength to allow for doubledigit earnings growth. Furthermore, healthy balance sheets enable companies to weather difficult market environments are often decent proxies for underlying returns on capital as management teams do not need to lever up the balance sheets to earn acceptable returns on equity capital. The next tenant is expertise, which, for us, is the understanding and assessment of companies and the industries they are in. One cannot expect to be knowledgeable about everything, or to be able to evaluate every industry, and so, it is only prudent to invest in industries that you understand well. Over the last twenty-five years, we at Ariel have been focusing on certain industries where we have expertise allowing us to do value added research. Q:  What are those industries? A : Our focus is unquestionably on understandable, predictable businesses within our circle of competence. Beyond that we seek out industries and sectors where companies can carve out profitable niches or where industry conditions allow for companies to earn attractive returns on a sustainable basis through differentiation or low cost positions. These are industries where companies can build and exploit brands and proprietary products such as the broad consumer space, business services, areas of industrial services, and retail. When valuations are cooperative, we also find our kinds of companies in some pockets of healthcare and many times in technology. Another area we have done well with over the years is financial where relationships, reputations, and systems that are hard to replicate can give business a real competitive edge. What we will stay away from is investments or industries that are commodity price driven like basic materials, subject to obsolescence risk like much of the technology space, or what we would put in the ‘too hard’ pile like biotechnology where the fundamental visibility is just too obscured at the individual company level. Q:  You mentioned that financials have a relationship that cannot be replicated, but finance comes hand-in-hand with leverage and leverage brings a huge risk along with it. How do you protect yourself from that? A : If you look at the underlying stocks that we hold in the financial services industry, you will find them in areas that are away from simple interest spread businesses like a regional bank or a small cap bank. For example, we have long held positions in asset managers, which typically have the strongest and simplest balance sheets in the entire industry, generally holding a great deal of cash, enjoy very high margins, and are subject to almost no capital requirements. Obviously, their fundamentals are a function of a capital market return, so they also tend to grow faster than the average financial company. An additional consideration is that you have a branded product as well. For example, we own Franklin Resources in the Focus Fund, which, whether it is the Templeton or the Mutual Series group of funds, has tremendous brand awareness and a powerful distribution system. We have owned Northern Trust in this fund and we continue to own it in our mid-cap portfolios. Northern Trust has been providing services to wealthy families and institutions for the last hundred years without taking the same kind of credit risk as a traditional bank. That is a brand position that is not likely to go away. Others that we currently own include AFLAC Insurance, which is a financial stock with very little leverage. It is a highly predictable business that retains 90% of their clients every year. Q:  Would you describe your research process? A : Our research team of 13 people is organized along industry lines. Each industry has a senior member of the team responsible for the research effort including report writing, financial modeling, management contacts, etc. Each industry vertical in our research department maintains a watch list which ranks all the stocks in terms of quality and valuation among other parameters. While many value managers follow cheap stocks and hope that the company is good enough for their process, we have inverted that. Rather, we look for the industry leaders first and patiently wait for an opportunity where we can get these long-term winners at our valuation requirements. Our focus is set on the highest quality companies and the businesses we would want to own at the right price if we were able to get it. Obviously, that requires a great deal of patience. The positive aspect, though, is that industry leaders do not change very often. Yesterday’s great companies are often today’s leaders although the stock market can frequently overreact to the daily news flow and price them differently in the short-run which is what creates our opportunities. We recently bought retailer Tiffany & Co. which is a name that we have followed closely for almost 10 years. We have owned it once in the past and we sold it when it reached our valuation targets but multiples have deteriorated with the poor retail environment such that it is cheap again yet still remains one of the best run retailers in the world. You will see this dynamic time and time again in our portfolios as the market alters their assessment of company quality and industry position more often than these changes actually occur. In addition, we lean heavily on our network of independent contacts including other analysts, management teams, or industry sources that we have built over the years to inform our decisions. Ultimately, when a stock gets to the point where we think it is attractive enough, or getting closer to that point, we will write research reports with full models, forecasts, as well as valuation analysis. These reports and recommendations are presented and evaluated at two separate research meetings every week. One is a meeting of the entire research team and the other involves the smaller investment committee, which is the ultimate decisionmaking body for the firm. Q:  How many holdings do you have and, generally, how do you achieve diversification in the portfolio? A : The Focus Fund is a concentrated portfolio and holds a small number of about 20 companies. It is a focused product as the name implies. The industry and stock selection is bottom-up so we are going to be buying stocks because we think that they are able to overcome our quality and valuation hurdles rather than making top-down sector allocation decisions. We do find over time that value tends to cluster. Therefore, there will be times in which we will find two or three names in similar industries that meet our criteria. For example, we currently own a few of healthcare names that have drifted out of favor – well regarded companies like Johnson & Johnson, IMS Health, and Covidien, which was formerly known as Tyco Healthcare. One of the things that we watch in order to manage risk is that, at any given time, the largest position will typically be around 7%. Portfolio turnover tends to be lower than the average fund as we seek to hold our investments for three to five years which translates to a turnover rate of approximately 30%. Q:  You recently added American Express. What is it that you admire about the company and its investment potential? The current economic climate is not conducive for the company’s business. A : American Express is a classic example of a very good company getting thrown out with rest of the industry under times of severe duress. Our analysis shows that even under default scenarios that are going to be worst than anything we have seen historically, the company is still going to make money, which is very different from other financials in question. We are in a very difficult time where investors are reassessing entire business models and even the potential survival of firms. In times like this investors sell first and ask questions later and we think that characterizes the situation with American Express. Although it will certainly be a difficult credit environment in the near term, as contrarian investors with long time horizons, this is when we get a chance to buy a terrific long-term franchise on sale. Q:  What kinds of risks do you measure? A : We are traditional investors and to us, risk is the permanent impairment or loss of capital. Most people define risk in this environment as being different from the benchmark, which, to us, is an odd concept. We do not manage to a benchmark. With a concentrated portfolio of, in our case, 23 stocks, most of the risk management is done at the individual company-by-company level. The majority of our thinking around risk is monitoring the underlying businesses that make up our portfolio of stocks. We spend a great deal of time trying to avoid the two classic mistakes value investors tend to make. One is the value trap, and the second would be chasing low multiple stocks and mistakenly underestimating the level of risk in these seemingly ‘cheap’ stocks. We attempt to get around these common errors by demanding minimum long-term growth rates and having a strong focus on margin of safety in all our investments. In terms of market risk or stock specific risk, we think it is well established that once a portfolio gets up to 20 stocks, the vast majority of the advantage of diversification is achieved and adding more stocks for the pure sake of further diversification doesn’t make much sense to us. Q:  Could you dwell on some other unique features of your fund? A : In addition to exploiting the market’s short term orientation through a patient long-term investment horizon, we believe another part of our competitive advantage to be thinking independently and employing a disciplined contrarian strategy. In looking for stocks trading 40% below what it is ultimately worth, you have to spend a great deal of time articulating and defining what it is that you are seeing differently than the market. To think independently from the rest of the market and to stay away from the crowd is not only psychologically demanding, but also requires you to look in places where others may not be looking. Being part of the crowd certainly provides comfort while the notion of independent thinking and a willingness to be different requires the support of a whole firm of determined and dedicated members. One thing that our founder and CEO John Rogers has done extraordinarily well over the last twenty-five years is to develop a unique firm built in a very different mold than the average asset manager. That serves as a wonderful foundation for a firm charged with thinking differently and independently and taking contrarian bets when they make sense. This emphasis on quality and value has produced a portfolio that tends to do well in troubled times. When people get scared, they can only flee towards quality. What you have seen in the history of this product is that, during turbulent times like 2008, we have provided adequate shelter.