Q:  What is the history of the company and the fund? A : I joined Ariel in April 2009 with a micro-cap portfolio I had been running since 2002 at a firm I founded. Ariel was one of the initial investors in that portfolio, had been a happy client for its first seven years, and continues to hold the account today. The strategy for Ariel Discovery Fund, which is now more than two years old, is the same one I have always used in micro-caps—just using a slightly higher market-cap range. Ariel assumed management of the Ariel Micro-Cap Value Portfolio in 2009 when I joined. In the micro-cap portfolio we focus on stocks under $500 million in market cap; it has an average market cap under $200 million. Ken Kuhrt works with me as a portfolio manager on both portfolios. He started working closely with me soon after I came to Ariel in 2009. I remain the lead portfolio manager and ultimately make all the final decisions. Ken works very closely and collaboratively with me on every aspect of running the portfolio. About 90% of the time we agree on new ideas or closing out positions. When Ken disagrees with my view he voices his take strongly—and so do the analysts, by the way—and then I carefully go back over the issue in question. As we were working on the micro-cap portfolio in 2010, Ken and I were finding a number of good ideas fitting the strategy well—except the companies were a bit too large for the micro-cap portfolio. We came up with the idea of a small-cap deep value fund using the same process and philosophy but with a market cap range of up to $2 billion at time of initial purchase—the realm of small-cap value funds. While the micro-cap portfolio is only offered as a separate account, we launched the new portfolio as a mutual fund, Ariel Discovery Fund, in February 2011 with $2 million in assets on day one. The new fund allowed us to leverage the work we were already doing and start building the small-cap track record. We are pleased to have attracted some positive attention in the fund’s first couple years. Q:  What is your investment philosophy? A : We are deep value investors who focus on a “margin of safety” in the Graham-and-Dodd tradition. As long-term investors, we are independent thinkers and willing to be contrarians. We can make decisions that feel hard at the time but firmly believe that is what you need to do to separate yourself from the pack. We are very focused investors who try to own the right number of stocks. That is, we want to own enough stocks to have diversification but few enough that we can really know the companies we own and why we own them. We think the very small end of the market is a great place to employ a deep value approach. Numerous academic studies have documented the small value effect, persistent inefficiency in the marketplace. In this niche, you can generate excess returns not only on an absolute basis, but also on a risk-adjusted basis. For us, one of the keys to reducing risk while maintaining strong returns is looking at asset values. When digging for small companies, you can still find stocks with a low price-to-book ratio. In fact, we rarely buy a stock that is priced above two times book value. We really get interested when stocks trade at or below their tangible book value. We spend a lot of time trying to determine the assets truly exist and have real value. We think, for instance, goodwill and intangibles rarely hold much value; they are not hard assets. We try to buy stocks whose prices are so low relative to the companies’ true value that, even if bad news comes, the stocks are a bargain. When we execute correctly, our downside is limited and the upside, if good news follows, is akin to a free call option on a company’s success. The next thing we look for are great balance sheets. Owning well-capitalized firms is wonderful. For instance, in 2008 I did not worry about any of my micro-cap stocks surviving the period. None of them needed to refinance, so I knew they could weather severe market declines. Now, I did not know when the bear market would end, nor did I know where the stocks might trade in the meantime. I did firmly believe that these companies could survive because I could see the cash on their balance sheets that would get them through a very tough, lengthy period. We spend an inordinate amount of time on management ownership and corporate governance. We want to know that we are investing with teams who have skin in the game, who are likely to get paid handsomely if they make their shareholders rich, but will not get rich simply by occupying an office year after year. We believe incentives drive behavior. If a management team and a board own a lot of company stock, they will be open to bids. If they are not properly incented, however, through direct ownership they might actually fight off a good offer to shareholders. In summary, we look for four things: a market cap under $2 billion, low price-to-asset value, balance sheet strength, as well as good corporate governance and inside ownership profile. Moreover, we think focusing on balance sheets and proper incentives help to avoid value traps, which are common among very cheap stocks. Q:  What is your investment strategy and process? A : Essentially, we are looking for hidden value. There are several ways we do so. First, we want to buy higher-quality companies that are considered, unjustly, low quality companies. That is, people think of very small companies as low quality, but we do not think they all are. Many have small, but very real, assets that are the bedrock of value. Second, we want to buy the best part of an already high-returning slice of the market. If you were to buy an index of micro-cap or small-cap stocks over time you would probably do well; it is a neglected area, after all. We think that by seeking out the ones where the risk is lowered through a depressed multiple, even if fundamental performance is poor we can come out even. And if they do well, we think the stock should outperform. Third, we think we can take advantage of other investors’ arbitrary guidelines. Some investors will only buy a stock of a certain market cap size—nothing below $250 million for instance. Hypothetically, say we find a stock with a $200 million market cap but we think it is worth $500 million. It might take a while to climb to $250 million, but when it gets there somebody is now allowed to buy it but could not before. Then it can really spike, but not based on much besides some other investor’s line in the sand. Q:  What is your research process and how do you look for opportunities? A : Our universe is anywhere from 5,000 to 8,000 companies. I have a series of screens that narrow down the opportunity set in different ways; typically we quickly get to about 800 to 1,200 potential candidates across both micro-cap and small-cap. Initially there are the four things we screen on; size, price-to-book, strong balance sheet, and great corporate governance. We want to buy stocks for significantly less than their intrinsic value, however we believe that value can be determined in a lot of different ways. Sometimes the stock might be cheap purely on its assets. Sometimes we can buy stocks for less than their cash or their liquid assets. Sometimes our analysis revolves around liquidation value and we see a discount there. Other times the value can be in the cash flows. It is taking a step back, looking at the stock differently than the rest of the world does, and finding the opportunities. For instance, one common situation is when we find something trading extremely cheap on an asset basis but with low cash flows. We will start picking through the balance sheet and looking for what parts of the balance sheet we know what the underlying value is and which ones get softer in terms of the clarity of that value. When we see things like cash and marketable securities, we get a lot of comfort out of that. But when you get into things like intangibles, we do not handicap the market in valuing those softer assets. We simply give full value for the clear assets owned today and use them to craft a “floor” for its valuation. With this type of stock, after establishing an asset-based valuation, we typically examine the business to see if we can exclude really bad scenarios and identify reasonable, positive scenarios—to see if the odds are in our favor. A lot of people try to guess what will move the stock. We do not. We try to make sure harsh downside scenarios (like bankruptcy) are not there so we know the company will be around with a solid capital base Another fairly common situation is a business with solid cash flows and a decent asset base—but not enough assets to drive a purchase. In that case, we create projections of the cash flow generation of the business. Ariel has done this work for years in our core strategy. When following this process, we ask: What is the competitive advantage of a business? What is the competitive environment over time? To explore these issues, we might create a full Discounted Cash Flow analysis. We might look at things like change of control, maybe an Leveraged Buyout Option (LBO) analysis or historical acquisitions within a space, and then we will look at trading multiples. The analyst has flexibility in the toolkit to portray what the cash generating power of a business is and the proper way to value this particular business at this point in time. For instance, when we launched the Discovery Fund, Madison Square Garden (MSG) was our biggest position. It was a very recognizable name trading at higher P/E multiple than most value buyers would pay. We studied it and said that we had historical ownership of similar companies, and from them we knew MSG had a true asset in the regional sports networks, named MSG and MSG Plus. When we valued just that piece of the business, it accounted for basically the entire market cap. So we felt we were getting the rest of the company and its assets for free. The remaining pieces were the Madison Square Garden arena itself and the Knicks, the Rangers, and the Liberty franchises as well! Meanwhile, the pure price-to-book buyers looked at it and they thought it was not trading below book value; so they did not want to touch it. Our flexibility allowed us to value the hard assets represented by real estate, separately determine the value of the company’s sports teams, and then capture the cash-generating power of the regional sports network with DCF analysis. Right now, one of our largest positions is Mitcham Industries, Inc., based in Huntsville, Texas. They primarily lease seismic equipment to large companies that help with oil and gas exploration and production. Mitcham has an exclusive agreement with a company called Sercel to buy their equipment, and then lease it out to large exploration companies such as Exxon Mobil or Shell. Mitcham can flex their capital budgets to take on new equipment for another month, or two, three, or six months. This stock trades around its book value, but given this business model, we think that understates the true value in at least one major way They lease out equipment, depreciate the property down to zero, and yet it still has value not reflected on the books. At that point, Mitcham will either continue to lease it out or sell it off for a profit. All of this is clear enough to us but not well understood—because, given the $200 million market cap, analysts do not follow it or have little incentive to dig in if they do. In the meantime, seismic exploration is becoming more and more important in the oil and gas space due to directional drilling. Using the current equipment available you can actually bend the drill bit as you are drilling to hit a reserve in the exact spot to get a maximum yield from it; that did not used to be the case. So people are using more and more equipment to get a better picture of resources in the ground. Mitcham has a global footprint so if you are, say, ExxonMobil and you are working on several projects around the world and one starts looking very interesting, moving your own equipment can be a costly and lengthy process. Instead, you can contact Mitcham and within 48 hours they will supply that additional equipment on-site for seismic analysis. Also, because the easy oil has been found, the environment is getting more complex and harsh. So you have more wear and tear on equipment, meaning you can price it higher. And it gets even better. Mitcham’s global scale creates asset management possibilities others lack. A regional firm will buy new cutting-edge equipment if it is needed and sell off old equipment at a loss to fund it. But Mitcham operates on a global scale. It can buy new, cutting-edge equipment to use in certain geographies and move the more basic, older equipment to different regions. So, overall you have predictable demand, the cash-generating power of the business, as well as underlying asset values. So this stock happens to hit everything we want. Due to its size it is underfollowed and misunderstood. It trades right around its stated book value, but we think its asset value is much higher. It has great growth prospects, which are misunderstood, and it has a great balance sheet. You also have a great governance profile. Billy F. Mitcham Jr, CEO, controls a little over 5% of the company. Moreover, the company has an outside chairman who also owns over 5%. This is very rare for a company this size where you see the owner’s name on the door. Billy Mitcham has actually put in place the kind of corporate governance profile that you like to see but you really do not expect when someone has built a company and is the entrepreneur who created it. Q:  What is your portfolio construction process? A : We usually own about 35 to 40 stocks. This is enough to have reasonable diversification, to not ever have any one or two stocks capable of essentially destroying returns, but yet few enough that we can really understand what we own and why we own it. We are completely benchmark and sector agnostic—we look for value wherever we can find it. We tend to invest between 1% and 6% of assets in any given stock. We do not want to own less than 1% unless we are on our way in or on our way out. Typically, when we buy a stock for the first time it will be in that 1% to 1.5% range while we get to know management and understand the business. That is an incremental process. It is very rare that one meeting or one set of work is going to give you the confidence to have a 5% position. We divide our stocks into four categories, which we refer to as “buckets”. Our largest positions, in the top bucket, are in the 4% to 6% range because they have two characteristics: first, there needs to be a very large discount to fair value. Typically we would think of that as 40% or more below their current fair value. Second, we have very high conviction. That would mean confidence in the CEO and CFO, understanding how they do business, and recognizing that the business has staying power. The smaller positions of 1% to 2%, the bottom bucket, are moderate in both the valuation opportunity and conviction level. The stocks are somewhat cheap and we have some conviction. Those can change over time obviously, and if they rise we will increase the position sizes. Then there are the two buckets in the middle, between the very cheap, high conviction stocks and the less cheap, lower conviction stocks. These stocks are in the 2% to 4% weighting range. In one group are those we think are extraordinarily cheap but in which we do not have great conviction—sometimes the corporate governance profile is acceptable but not great or maybe the business is somewhat binary. Alongside those are stocks where our conviction level is very high but the discount to fair value is not as big. We are continually dynamically adjusting the portfolio weights to reflect this mix of valuation and conviction. On a day-to-day basis we think about it, and periodically Ken and I will each take a blank sheet of paper with those four empty buckets and fill them. We put every stock that we own, as well as new ideas where we have done a lot of work, into its proper bucket. Then we will compare notes and discuss what we see. Are we too optimistic about this one? Has this one become cheap enough to merit a larger position? The conversation often leads to some change in position weights. Q:  How do you define and manage risk? A : We want to find about 40 different, idiosyncratic, asymmetric risk reward tradeoffs in our favor. We believe the biggest thing we do to manage risk is to buy stocks at such a low price that they should not trade lower on a fundamental basis over any significant period. Bankruptcy risk is very low in our strategy due to the fundamentals of the portfolio. First, the vast majority of the stocks have excess cash. Additionally, the vast majority of the companies have no debt or very nominal debt. And, almost always, those that do have debt have more cash than debt. For example, the Discovery Fund has a weighted average debt to capital across the portfolio of about 7% or 8%. It has cash as a percentage of market cap that is between the 20% to 30% range. That means, in aggregate, the portfolio has a very significant net excess cash position. We believe that Ariel Discovery Fund presents a unique way of approaching the often volatile small-cap world. By always thinking first of downside protection and a Graham- and-Dodd “margin of safety,” we hope to produce outsized returns for our investors while limiting their risk.