Ariel Investments Global Q1 2024 Commentary

Developed markets continued their upward trajectory in the first quarter. Investor enthusiasm around artificial intelligence (AI), a recovery in bank lending growth, lower energy costs, a pick-up in global manufacturing activity, recent structural reforms in Japan and the near-term prospect of a rate-cutting cycle in both the U.S. and Europe drove a broad-based rally. While growth bested value and large cap issues outperformed their small cap brethren, all sectors in the MSCI ACWI Index, except real estate, logged gains. Fears of a recession have been replaced with optimism and bullish market sentiment. Such turns in market psychology and economic forecasts highlight the challenges of market timing and the importance of taking a long-term view. Although exuberance, particularly for AI-themed mega-cap stocks may eventually prove to be excessive, the patient investor knows stock prices trade on fundamentals. Meanwhile, we continue to improve our upside capture across our international and global portfolios while remaining laser focused on preserving downside protection.

Against this backdrop, the Ariel Global Composite increased +7.09% gross of fees (+6.88% net of fees) in the quarter, trailing the +8.20% gain posted by the MSCI ACWI Index but slightly ahead of the +6.85% return of the MSCI ACWI Value Index.

Ariel’s non-consensus approach seeks to identify undervalued, out-of-favor, franchises that are misunderstood and therefore mispriced. The Ariel Global bottom-up strategy is overweight Health Care, Consumer Discretionary, Information Technology, Communication Services, Utilities and Financials, significantly underweight Industrials and Consumer Staples, as well as lacks exposure to Energy and Materials. At the sector level, our low cash position and Consumer Discretionary holdings were the greatest contributors to returns, while our investment choices within Communication Services and Information Technology were the largest performance detractors.

Leading provider of dialysis services, DaVita, Inc. (DVA) outperformed during the period following a top- and bottom-line earnings beat. DaVita is benefitting from cost-saving initiatives, early signs of a normalization in patient growth trends on par with pre-pandemic levels, improved leverage and an aggressive share buyback program. The company also recently announced an expansion of its international operations in Latin America, presenting an attractive long-term growth opportunity. Furthermore, management provided a 2024 financial outlook which is well above consensus and anticipates favorable growth. In our view, we believe the market misunderstands the long-term clinical impact of glucagon-like-peptide-1 (GLP-1s) on dialysis and as such, DaVita currently trades at a significant discount relative to our estimate of its intrinsic value.

New position, German-based automotive manufacturing company, Daimler Truck Holding AG (DTG) (OTCPK:DTGHF), also advanced in the quarter. The market’s pessimism on the overall magnitude of the industry’s cyclical downturn provided us with an attractive entry point in the stock and then DTG delivered a significant earnings beat, highlighted by record margins at Mercedes-Benz, robust free cash flow generation as well as a favorable volume and margin outlook for 2024. In our view, Daimler is the highest quality truck original equipment manufacturer in the industry, and we expect it to narrow the multiple gap versus competitor PACCAR. We believe the company’s self-help efforts will result in higher margins throughout the cycle, improving Daimler’s profitability over the medium term.

Additionally, market leader for computer storage systems, NetApp Inc. (NTAP) increased in the quarter due to a top- and bottom-line earnings beat and subsequent raise in guidance. These strong results were supported by increased adoption of quad-level cell (QLC) NAND flash memory products, cost reduction initiatives and margin expansion. Longer term, we continue to believe NetApp is well-positioned to benefit from its cloud storage service, as it helps companies move data between public and private clouds seamlessly. Meanwhile, the company remains focused on digital transformation projects involving business analytics, AI and data security.

There were a few notable performance detractors in the quarter. China’s internet search and online community leader, Baidu, Inc. (BIDU) traded lower alongside Chinese equities as intensifying problems in China weighed on investor sentiment during the period. The company continues to invest heavily in Artificial Intelligence (AI) and recently launched its generative AI, Ernie Bot, aimed at rivaling Open AI’s ChatGPT. While monetization of the new technology is largely dependent on regulatory review, we think Baidu should continue to experience margin improvement with the ongoing implementation of efficiency and profitability initiatives. While some investors remain on the sidelines due to uncertainty surrounding China’s economic growth, government regulations, and the political rhetoric towards Taiwan, we remain enthusiastic about Baidu’s longer-term opportunity for revenue growth and margin expansion across internet search, cloud, autonomous driving, artificial intelligence and online video.

One of the world’s largest semiconductor chip manufacturers by revenue, Intel Corporation (INTC), also underperformed in the period as management provided a disappointing near-term outlook due to ongoing weakness and inventory right-sizing in non-core products. Nonetheless, Intel delivered solid quarterly earnings results, highlighted by a top-line beat driven by upside from the cyclical recovery of personal computers (PCs) and central processing units (CPUs). In our view, the market is overlooking the progress Intel is making to advance its manufacturing process and regain its technology advantage to compete as a top industry supplier. We believe the separation of the design and manufacturing businesses will be a key catalyst in unlocking improved financial performance while also enhancing the competitiveness of the foundry business.

Finally, leading electric utility in Spain, Endesa S.A. (OTCPK:ELEZY, OTCPK:ELEZF) fell in the period. Earnings came in below expectations mainly due to the negative impact of a provision related to a gas contract arbitration. Broad weakness across the gas sector, driven by lower-than-expected consumption and a decline in prices further weighed down shares. Nonetheless, Endesa reiterated its strategic plan through 2026, which includes expectations for higher gas margins, a 70% dividend payout and an optimistic regulatory environment. In our view, Endesa presents a compelling long-term ESG opportunity, as it works toward shuttering coal capacity and moves forward with a multi-billion-euro investment in renewables to reduce greenhouse gas emissions and lower the cost of power generation.

We initiated nine new positions in the quarter.

We added Aptiv PLC (APTV) which designs and manufactures vehicle components and provides electrical/electronic and active safety technology solutions to the global automotive and commercial vehicle markets. We believe the secular trend of electrification and digitization within the automobile industry, coupled with the expansion of Chinese original equipment manufacturers (OEMs), will accelerate demand and drive long-term growth. Additionally, we anticipate APTV will grow earnings per share over the near-term through its divesture of the autonomous driving joint venture, Motional. In our view, the name is currently trading at a significant discount relative to our estimate of intrinsic value.

We purchased Japanese video game publisher, Bandai Namco Holdings, Inc. (OTCPK:NCBDF, OTCPK:NCBDY). While anime has been highly popular in Japan, Netflix’s recent streaming of anime content has expanded its popularity to markets overseas. Bandai is capitalizing on the strong growing demand for the genre through toy and video game sales, a global movie deal as well as the expansion of licensing its intellectual property across merchandise, trading cards and amusement arcades. In our view, the market is currently underappreciating Bandai’s diversified growth potential. We see upside in the company’s toys and hobby unit and forecast solid free cash flow generation in the years ahead.

We bought American healthcare company, CVS Health Corporation (CVS), following recent concerns related to potential new laws affecting Pharmacy Benefit Managers (PBMs)-intermediaries that negotiate drug prices between insurers and pharmacies-and issues with pricing in its Medicare Advantage plans, a type of health insurance for senior citizens. Shares presented an attractive entry point after the company lowered its 2024 outlook. While investor apprehension regarding the new laws appears to have eased, utilization of Medicare Advantage plans is also stabilizing. Our purchase of CVS reflects our efforts to capitalize on temporary setbacks and secure positions in companies poised for a rebound.

We established a position in global financial services company, Capital One Financial Corporation (COF). The company is the largest online consumer and commercial bank with a leading position in general purpose and small business credit cards. We view the company as competitively advantaged particularly due to their investment in technology. According to recent reports, COF is also rated as one of the leading banks within Artificial Intelligence (AI). Notably, the company recently announced an acquisition of Discover Financial Services (DFS) which we believe would produce significant long-term earnings accretion. COF will be able to leverage DFS’ proprietary payments network, enabling direct interaction with merchants and consumers. This closed loop dynamic should lead to higher volumes of credit card conversions presenting further upside for its shares. At current levels, we view the long-term outlook to be attractive, given favorable business trends, stabilizing delinquency rates within the credit card industry, synergies from the DFS acquisition and COF’s enhanced focus on technology.

We purchased China-based technology-driven E-commerce company, JD.com, Inc. (JD) The brand has long been known across the region as a superior online shopping channel due to its unique first-party model and unparalleled fulfillment service underpinned by JD Logistics. Yet, a challenging macro environment drove shares lower as shoppers began seeking bargains. In response, the company made significant investments in elevating its third-party merchant platform to enhance its variety of product offerings and price competitiveness for consumers. We believe these actions will yield an improved product mix, stronger top-line growth and margin expansion on a go-forward basis.

We added leading German multinational technology conglomerate, Siemens AG (OTCPK:SIEGY). The company’s operations encompass automation for manufacturing and processing, smart infrastructure, energy systems, rail technology, and digital healthcare solutions. Although shares have historically been undervalued due to concerns over the complexity of its disparate portfolio of businesses across sectors, we have identified several factors conducive to a potential re-rating. Over the last five years, Siemens has simplified its portfolio into high-quality businesses benefitting from secular growth themes such as energy transition, digitalization and industrial automation. Additionally, the new, shareholder-friendly management team is focused on enhancing free cash flow generation and improving capital allocation, which we view as a key catalyst benefitting the stock longer term.

We initiated a position in multinational automotive manufacturing company, Stellantis N.V. (STLA), which was formed from the merger of Fiat Chrysler Automobiles and the French PSA Group in the period. With deal synergies lowering overall operating expenses and contributing to healthy free cash flow generation, management has begun increasing shareholder returns through dividends and share buybacks. Although some investors remain on the sidelines over concerns auto sales and margins have peaked, STLA’s average transaction price is growing year-over-year. We think this momentum will continue and expect STLA to deliver double-digit operating profit margin as it further expands its leading position in the Middle East and South America.

Furthermore, the company’s Leapmotor joint venture presents a unique way to benefit from the strengths of Chinese original equipment manufacturers. Meanwhile, in the current electric vehicle slowdown environment, we believe STLA is best positioned to weather the storm. Management believes it can maintain profitability and is open to rationalizing its 14 brands. STLA seeks to be number one in the commercial vehicle segment by 2027, which comes with high customer stickiness, solid profitability and recurring revenue streams.

We also added American software company, Teradata Corporation (TDC), which is a provider of business analytic solutions, hybrid cloud products and consulting services. Teradata stands out for its ability to manage and analyze large, complex datasets, with the largest number of concurrent users and lowest cost per query while offering deep analytical insights across various operational data sets. Although the market is focused on near-term setbacks in the company’s transformation to a cloud-based computing model, we believe the Teradata’s technology advantages, updated cloud offerings, and install base provide for a solid long-term trajectory in an important growth area.

And as mentioned previously, we initiated a position in German-based automotive manufacturing company, Daimler Truck Holding AG.

By comparison, we exited ten positions in the quarter.

We exited the following positions on solid performance across our holding period to pursue more compelling opportunities: British property and casualty (P&C) insurer, Admiral Group PLC; provider of product-driven information system solutions to major telecommunication companies, Amdocs Limited; processor, producer, and seller of cigarettes and other tobacco products, KT&G Corporation; tobacco maker, Philip Morris International Inc. (PM); German reinsurer, Munich Re; Swiss multinational food and drink processing conglomerate Nestle S.A.; and Italian midstream energy company, Snam SpA.

To pursue higher conviction opportunities and pair back holdings representing less than 1% of the portfolio so each of our resulting holdings may have more impact, we sold our stakes in the following names: maker of health, hygiene, post-natal and home products, Reckitt Benckiser Group PLC; real estate investment trust, Equity Commonwealth (EQC); and China based air travel ticketing company, TravelSky Technology Ltd.

As broad optimism continues to prevail, there are cautious undertones. Although market concentrations have their own peaks and troughs, volatility is near historical lows. The mega-cap technology names-whose elevated valuations continue to highly influence overall market performance-appear vulnerable to a correction. Escalating geopolitical tensions, unpredictable monetary policy, as well as the outcome of the upcoming U.S. Presidential election also pose risks. As the bull market climbs the proverbial “wall of worry,” we expect these uncertainties will likely result in a period of heightened volatility and widening dispersion of returns, creating opportunities for active managers with focused expertise to shine. In our view, higher quality companies with robust balance sheets will be the drivers of future outperformance. Accordingly, we are finding many mispriced stocks where valuation is attractive, profitability less vulnerable and balance sheets remain strong.

Click to enlarge

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.