Markets worldwide continued their upward trajectory in the second quarter–defying expectations. The dominating performance of the “magnificent seven1” and excitement for artificial intelligence technologies, overshadowed a potential debt ceiling breach, a brief banking crisis, ongoing inflationary pressures and the prospect of even higher interest rates. Meanwhile, the U.S. economy continues to show signs of cooling, as tightening credit conditions weigh on consumer and business confidence. While some investors remain cautiously optimistic policymakers will engineer a gentle slowdown, others fear a Fed-induced hard landing. Although uncertainty is high and volatility will likely remain elevated, we view these near-term risks as noise within the context of our long-term investment horizon. Against this backdrop, Ariel Fund advanced +3.11% in the quarter, lagging both the Russell 2500 Value Index and the Russell 2500 Index, which returned +4.37% and +5.22%, respectively.
Several stocks in the portfolio had strong returns over the period. Global cruise vacation company, Royal Caribbean Group (RCL, Financial) , was one of the top 3 performers in the S&P500 during the quarter. Shares surged following a significant top- and bottom-line earnings beat, as stronger than anticipated consumer demand is driving a record WAVE season. Forward booking trends are also ahead of historical ranges at record pricing. These factors combined with further improvement in onboard spend and solid cost containment led management to increase RCL’s full-year 2023 guidance. We believe the revised revenue and earnings outlook lays the foundation for RCL to exceed its’ three-year strategic imperative, the Trifecta Program.
Leading global manufacturer of power generation equipment, Generac Holdings, Inc. (GNRC, Financial) , also advanced and was among the top 5 performers in the S&P 500 this quarter. Shares traded higher amid reports of widespread power outages and oppressive heat across the southern U.S. Moreover, demand trends for home standby generators have begun to pick up, while pandemic related headwinds from high inventory levels began to subside. In our view, GNRC’s unmatched distribution network and product portfolio enjoys strong brand advantages, creating a wide moat for this niche business which commands a 75% market share in the North American residential market. Historically, growth has been limited due to a lack of awareness around the benefits of having a home standby generator, as well as its high price point. However, elevated power outage events, both weather-related and due to aging infrastructure, have tipped the scales in both the residential and commercial markets. We expect these heightened consumer sensitivities to result in a long runway of penetration across an expanding addressable market, margin expansion and free cash flow generation.
Branded home improvement and building products manufacturer Masco Corporation (MAS, Financial), was another top contributor to relative results this quarter. The company continues to successfully raise prices to offset cost input inflation and is capturing operational improvements to neutralize lower sales volume. Additionally, management continues to demonstrate financial stability by utilizing its strong cash position to return capital to shareholders through the use of dividends and aggressive share repurchases. Going forward, we expect the company to enhance its operating profitability, as it continues to benefit from scale, technological know-how and the positioning of its supply chain.
Alternatively, several positions weighed on performance. Shares of leading entertainment company, Paramount Global (PARA, Financial) traded sharply lower following a lackluster earnings report and subsequent cut to its dividend. Linear Pay TV pressures including shifts in viewership, subscriber erosion and softer ad revenues presented headwinds. In response, PARA began a restructuring of the TV Media business, reducing domestic staff by 25%. Filmed Entertainment revenue and operating income also declined in the period due to timing and mix of theatrical releases, however the 2023 and 2024 movie slate include many high-profile franchises returning to theatres. Meanwhile, Paramount+ continues to add subscribers, with global direct-to-consumer (DTC) subscriptions reaching 60 million. Although DTC revenues continue to grow, DTC operating losses expanded versus a year ago due to increased investment in content and marketing of the service. To cut down on spending and strengthen the value proposition of its streaming services, Paramount integrated Showtime with Paramount+ in June. We expect 2023 to be the peak year for streaming losses as management magnifies its focus on profitability for its DTC segment, which should drive positive free cash flow in 2024 and beyond. In our view, the company’s long-term opportunity in streaming and the value of its proprietary content remain meaningfully underappreciated at current trading levels.
Leading global financial franchise Northern Trust Corp (NTRS, Financial), also declined in the quarter. Consistent with broadertrends in the banking sector, NTRS clients exhibited meaningful cash sorting behavior as they withdrew funds in search of higher deposit yields. This resulted in lower than anticipated wealth management fees, partially offset by increased costs for short-term funding as well as deposits. While net interest margin and net interest income will likely remain under pressure near-term, we believe NTRS remains well positioned. The company is a trusted name in a favorable industry with a diversified product offering and high barriers to entry. We believe Northern’s 130-year track record highlights its strength and stability of navigating macroeconomic volatility with a conservative, operating approach.
Finally, global leader in for- profit education, Adtalem Global Education (ATGE, Financial), traded lower alongside the release of theBiden Administration’s proposal for Gainful-Employment regulations, however management does not expect the new rules to be problematic. Shares came under further pressure following an investor day where ATGE lowered its financial outlook for 2024 on plans to increase its marketing spend to improve brand awareness and invest in the student experience to enhance growth and retention. Although investors remain skeptical of the near-term backdrop, we believe ATGE is on the path to be number one in undergrad and graduate nursing enrollment in the U.S. and the largest producer of African-American MDs, PhDs and nurses in the country.
Also in the quarter, live entertainment business, Madison Square Garden Entertainment Corp. (MSGE, Financial) completedits spin- off from Sphere Entertainment Co. (SPHR) in the quarter. The company’s portfolio includes a collection of venues, such as New York’s Madison Square Garden, Radio City Music Hall, Beacon Theatre and The Chicago Theater. MSGE also features the original production of the Christmas Spectacular starring the Radio City Rockettes. In our view, MSGE’s assets are stable cash flow generators and should enable deleveraging. At current valuation levels, the company is trading at an attractive 40% discount to our estimate of private market value2.
By comparison, we sold real estate services company CBRE Group Inc. (CBRE, Financial) to redeploy capital into higher convictionopportunities from a risk/reward standpoint.
As the market swings from one scenario to another, our sole consideration of recent events and macroeconomic developments is to consider their effect on the long-term intrinsic worth of our names over the next five-to-ten years. As we look to the future, we are adjusting our portfolios to the new rate environment. The ‘higher for longer’ rate regime will likely present headwinds to corporate earnings growth and change the capital return on investments businesses make. Accordingly, we believe owning high-quality companies with sustainable business models, low leverage and robust balance sheets will deliver stronger returns over the long run. Given our “slow and steady” approach, we remain confident in our portfolio positioning, especially with our domestic strategies trading at a discount relative to their indices.
1 The “Magnificent Seven” are the largest stocks in the S&P 500 Index driving market performance: Apple Inc. (AAPL), Amazon.com, Inc. (AMZN), Alphabet Inc. (GOOGL), Meta Platforms Inc. (META), Microsoft Corp. (MSFT), NVIDIA Corp. (NVDA) and Tesla, Inc. (TSLA).
2Private Market Value is the percentage discount the portfolio holding trades at relative to Ariel Investments’ internal estimate of the portfolio holdings’ private market value (PMV). There is no guarantee that companies we invest in will achieve our PMV or projected future earnings.
