Q:  Would you give us a brief history of your fund?

Ariel Investments is a firm that has been dedicated to value investing for 26 years. Our logo depicts the tortoise from Aesop’s classic fable and our motto is "Slow and Steady Wins the Race". We are inspired by Warren Buffett’s patient investment time horizon and desire for high quality businesses. We don’t believe in so-called ‘cigar-butt investing’ but rather when a high quality company goes on sale, we want to move in with conviction and own it for a relatively long time.
There are about 70 employees at Ariel Investments and we oversee around $5 billion in assets under management with our offerings ranging from micro-, small-, mid- to large-cap investment products. I co-manage Ariel Focus Fund, which is a mid/large fund launched in 2005, and am a portfolio manager for Ariel Appreciation Fund as well, which is our mid-cap fund. We are long-term investors and we believe deeply in thinking independently and avoiding the crowd. Being contrarian, we often view things very differently from the market and we will invest accordingly. Our funds represent a concentrated portfolio organized around these principles.
Q:  What are the core philosophies that guide your investment process?
We have a number of basic ideas that define our process and philosophy. The first one is to be contrarian: to see what others aren’t seeing and be different from the crowd. We tend to have an inherent distrust of the consensus where ‘group-think’ can take over and drive stock prices away from fundamental long-term value. Second, instead of being singularly focused on stocks as pieces of paper to be traded, we try to analyze the business as a private owner would, overlooking the short term focus of Wall Street. Our turnover is low and our average holding period is from three to five years. The third would be to have a concentrated portfolio focus, not to own a little piece of everything but invest with conviction in only our best ideas. This is reflected by our low number of stocks which ranges from 20 to 40 depending on the market cap range. Finally, classic value investing is at the core of everything we do.
Q:  Would you elaborate on those guidelines?
Our process is built around what what we call QEV: quality, expertise and value. Above all, we want to own quality businesses. These are not businesses that we think are distressed or troubled in any way, but rather they have an ability to grow at least at a double digit rate over the next few years.
We favor businesses with high returns on invested capital, strong balance sheets and high free cash flow generation. Since we are long-term investors, we also look at the quality of management because this can have a significant impact on the results. We look at the their experience, how they are paid, what motivates them, and most importantly, their track records - especially with respect to capital allocation in the large cap range, where organic growth can be slower to come by than with smaller companies and the pressure to grow through acquisition is huge. While we don’t favor companies that have acquisition strategies, we do consider those companies that have a proven track record of making acquisitions work without impairing shareholder capital.
Given our concentrated approach and long time horizon, it is critical for us to try and understand our companies as best as we can. These are businesses that we can analyze and have some ability to predict what they are going to look like 5 to 10 years out. Equally important is where we source our information from. To see what other don’t see you often have to look where others aren’t looking. The majority of our analyses are informed from basic primary sources such as trade press, customers, competitors, suppliers, and industry experts versus the more conventional approach of going straight to Wall Street analysts and company management.
With respect to valuation, we do use some of the same traditional metrics as others and look at price to earnings, book value, cash flow, etc., but the process revolves around our estimate of a company’s private market value. In addition to performing discounted cash flow analyses, the values we arrive at are supported by reviewing strategic multiples of what similar businesses have sold for in the past in the M&A markets as well a comprehensive examination of what the public market has been willing to pay for these assets on a ‘full and fair’ basis. At the end of the day, our goal is to buy these companies at a 40% discount to our estimated private market values.
Q:  Why is it important to focus on the free cash flow rather than just look at the book value?
Each specific industry has its own specific valuation metrics that are important. With financial services firms like insurance companies or banks, book value is the critical metric as it best approximates the amount of capital employed in what are highly capital intensive business models. 
For most businesses, determining the value of the business is an exercise in estimating the amount of cash that you can pull out of it over time net of the cash you have to invest to maintain the company. This free cash flow is the ultimate metric of value that we look at and the same one that matters to a private owner who owns the entire business.
Q:  What is the fund’s investment process?
The actual individual stock analysis is a fairly lengthy process which takes about two weeks from start to finish. Our investment committee is organized by industry and so all of us have responsibilities for individual sectors. Each analyst is responsible for maintaining a watch list of companies that we look for, mostly industry leaders that have some sort of competitive advantage or point of differentiation, and these are attributes that do not change quickly over time. While the company attributes are fairly static, the prices can swing wildly which is what we monitor for our opportunities.
We have a list of companies in each type of industry we would want to own and we wait for the opportunity to buy them when they go on sale. We have a universe of about 400 such companies and this universe is monitored regularly for price. When such a company does get attractive, whether through neglect or sharp price movement, we start the full research process on an individual company in earnest. 
We talk to management and look to our proprietary independent network of contacts that we have developed over the years, similar to what Philip Fisher called “The Scuttlebutt Network”, to get a good view of what the franchise is worth. Being contrarian, as noted earlier, we want to look where others are not looking, and thus conduct our research without relying on Wall Street research that everyone else is focused on but rather on the inputs from customers, suppliers, competitors, former employees, board members – anyone we think who has an important view or insight on the company that others may be overlooking.
So, when we move into an investment that we think is cheap and unwanted, we have a very good idea of what we are seeing differently, and that shows up in the form of investment thesis for us. A full research report is compiled by our industry expert on the investment committee which includes our estimate of intrinsic value and our own set of financial projections and forecasts. This report is then put before the entire investment team where we debate the conclusions and give further direction on how to pursue the idea and tighten up some of the arguments. The analyst is then responsible for the follow-up to answer these new questions and present the findings to the team again.
At this point the portfolio managers of the fund will have the final say on what goes into the portfolio. Once a company is in our portfolio, every analyst is responsible to review their work at least twice a year and present to the investment committee. Through this basic maintenance research we ensure that the stock is under constant review. This is our buy discipline.
The sell discipline is fairly straightforward and is the mirror image of the buy discipline. We will hold a company in the portfolio until it reaches our estimate of intrinsic value or when our reasons for purchase no longer apply. We will sell it before this point if we see better opportunities with other stocks where we can buy at a 40% to 50% discount to what we think it is worth versus say a stock trading at a 15% discount. Of course there are cases where our investment thesis is impaired or rendered invalid such as major acquisitions, changes in the company’s competitive landscape, or a loss in confidence with management in which case we will sell out and move on to better investment opportunities.
Q:  Could you give us a few examples that highlight that process?
A recent purchase we have made in this portfolio is the pharmaceutical giant Merck. I have been watching this space since the early 90’s, but as a value investor one doesn’t get many opportunities to buy healthcare. There have been only two times when value investors could invest with a healthy margin of safety: 1994 and now. With the recent discussions concerning healthcare reform, there has been a severe market reaction and we are seeing some good opportunities as valuations have collapsed in the sector. Since we started Ariel Focus Fund, Merck has been on our watch list of companies we would like to own if we were able to get it at our price. Now with all the bad news swirling around this company, FDA pressures, and the threat of healthcare reform, we saw a terrific company at a very attractive price and so we moved in. 
When we value their pipeline of currently marketed products, we get to a value of $32 which is around the current stock price, meaning we get any future drug development from this company for free. We are also constructive on the recent merger with Schering-Plough which makes Merck a much stronger company from an R&D and pipeline perspective. This is before even considering the massive amounts of cost-cutting that the combined enterprise can achieve.
Another example would be Morgan Stanley which exhibits very strong competitive advantages and differentiation in the financial space. The global investment banking area has suffered greatly over the last two years and we feel that the survivors are going to gain global market share and find themselves in even stronger competitive positions than they were before the turmoil. Yet even though Morgan Stanley is a clear survivor and has a terrific franchise, the stock price did not enjoy the strong recovery as others such as Goldman Sachs and we think this is unwarranted. We did a great deal of stress testing with respect to what potential regulatory changes could do to the operating model and are encouraged by the eventual normalized earnings power when we get through this period of tough earnings. We found that if you look beyond a one to two year timeframe, it is not a stretch to see $5 to $6 in earning power for this world-class franchise, yet the stock wallows in the low $30s. It fit our philosophy well as this is a high quality company that is suffering from weak macroeconomic conditions and we have the advantage of patience on our side.
Q:  Companies such as Morgan Stanley, Merrill Lynch and Bear Stearns got into trouble because they had high leverage which, combined with their lack of risk controls, made their balance sheets untenable. How has the situation changed now, in your opinion?
The world has changed for them, that’s for sure. For starters, these are now bank holding companies with a great deal of regulation already in place. The fixed income capital markets which led them down this path has changed dramatically. It is not going to be the same for the next ten years or so at least and the likelihood of witnessing a liquidity-driven market bubble in the near term seems very low to us. We are not going to see things like the failed originate-to-securitize approach to managing credit risk getting them into trouble anytime soon. With respect to Morgan Stanley, we looked at how their business model was changing and we could see lot of changes for the good. The balance sheet is in order and we see them moving away from high risk, high capital intensity businesses. They are now JV partners with Smith Barney which is a high return, low capital intensive business. Furthermore, the M&A advisory market which was completely bombed out is starting to revive which is not a risk trading based model either. 
The number of players who can service this space is very few and that really is the key. Morgan Stanley is trading at book value right now and we believe this company can easily earn 15% to 20% returns on shareholder equity capital - if not higher - in a much less riskier fashion. Companies are always going to need capital and related advice and services worldwide and more so in the faster growing emerging markets around the world. To service this need, we feel there are only a few firms around with such economies of scale and Morgan Stanley is one of them. 
Q:  If the M&A market returns, will the government allow these firms to charge hefty fees?
The government’s involvement is most acutely focused on the capital infusions to stabilize the system and related issues surrounding companies that are still leaning on the taxpayer’s capital. Many of these firms like Goldman Sachs, JP Morgan, and Morgan Stanley have paid back that capital or are in the process of unwinding the government’s direct involvement. Looking ahead, the government may increasingly regulate and raise the amount of capital these bank holding companies will need for their risk based operations, which will certainly lower returns, but direct price controls would be an escalation and dramatic step that we don’t feel is either warranted or probable. Fees that the banks charge will remain determined by market forces and we don’t have any reason to believe that customers are going to pay less for those types of services going forward.
Q:  What are your primary considerations while building the portfolio?
Right now we have 23 stocks, but on an average we will have around 20 stocks in the portfolio. The weights in the portfolio typically vary anywhere from 2% to 7% and will not go over 10% at any point. We do not manage to a benchmark so you will see the traditional Ariel bias in terms of what industries we tend to invest in. In portfolio construction we look for companies with higher sustainable returns and higher barriers of entry which prevents us from investing an any meaningful way in true commodity sectors and deep cyclical companies. Our positions in technology and healthcare vary over time as valuations are more subject to a boom/bust dynamic in these areas, but right now we feel that you have a once-in-a-generation opportunity of owning world leading companies at very low prices in both industries and our portfolio weights reflect that.
Q:  What benchmark should people look at when comparing your returns?
The S&P 500 as a reflection of the broad market and the Russell 1000 Large Cap Value Index for the value specific market index.
Q:  How do you control risk in your portfolio?
At the portfolio level we control the size of a stock by limiting it to 10%, although the highest weighting we have ever held was approximately 8%. Cash would be the other factor which we control by keeping it under 5% at all times. In terms of other risks, we follow the Buffett concept of putting all your eggs in one basket and watching it very closely. Most of our other risk controls are at the company level and those include things as varied as interest rate coverage, debt to EBITDA, etc. By picking companies with the potential for double digit growth over the next three to five years also serves as a safeguard against the risk of owning value traps, or stocks that are cheap for a reason, where it’s easy to get caught up in a seemingly low, yet justified reason.