Rupal Bhansali manages the Ariel International (AINTX) and the Ariel Global (AGLOX) funds. She spoke with me about taking a contrarian, value-oriented approach to investing.
—Charles Rotblut, CFA

Charles Rotblut (CR): Since you’re a contrarian investor with a different focus on risk, let’s talk about it. You are more concerned with the permanent loss of money than with price volatility, correct?

Rupal Bhansali (RB): Yes. I think investors confuse risk and volatility, which are very distinct and different. Risk is something that can take advantage of you. Volatility is something you can take advantage of. Volatility is a short-term price fluctuation that proves to be short-lived, whereas risk is a long-term phenomenon that results in a permanent loss of either capital or opportunity. As long-term investors, we are more concerned about permanent losses. So we view volatility as an opportunity, not a threat. Risk is the real threat. You want to make sure you are very risk aware to ensure you are paid for the risks you are exposed to.

CR: How do you handle a situation where you view a stock as attractive when you purchase it, but the price drops after purchase? At what point does someone make the distinction between short-term movement and the possibility of being wrong about the stock?

RB: Whether a stock price move is a short-term price fluctuation or a long-term impairment can only be answered with reference to the investment thesis and intrinsic value of the business, which we estimate via rigorous fundamental research. That’s what we do day in and day out. This estimate of intrinsic value gives you something to anchor around.

If a fundamental development occurs in the business that undermines or invalidates your thesis, or impairs your original estimate of intrinsic value, that should be viewed as a risk. You must reassess whether the price decline puts the stock at a discount or premium to your revised thesis and newly estimated intrinsic worth. But if neither the thesis nor the intrinsic worth is impaired, then a correction in the share price represents a short-term price fluctuation—aka volatility, which should be viewed as an opportunity, not a mistake.

CR: Would it be fair to say that as long as the fundamentals remain attractive, any additional downward price moves should be viewed as being short term in nature? As a contrarian, you need the psychological background to stick with a stock over the short term.

RB: It’s not just about sticking with the stock; it’s actually viewing downward price move as an opportunity. Let’s say the intrinsic worth of a company is $100 and the stock is trading at $80—it’s at a $20 discount to its intrinsic worth. Let’s say that $80 stock now goes to $50. As long as your assessment of the business having an intrinsic worth of $100 does not change, the fluctuation in the share price is giving you an amazing opportunity to own it at a more attractive upside/downside ratio.

It’s important to recognize what has happened to both the upside potential and downside risk of the investment. The risk has been reduced, because the share price has gone well below the intrinsic value. And the greater the discount to intrinsic value, the larger the margin of safety. Simultaneously, the further the stock falls below its intrinsic value, the greater the reward. At $80 converging to $100, you will generate a 25% profit on the investment. At $50, you will make 100% on the investment. Notice what has happened—there is a bigger reward and lower risk as the price falls. So volatility is not just something to psychologically withstand; it’s actually something to psychologically take advantage of.

CR: If somebody’s following a contrarian strategy and they have a scenario where, say, they put $1,000 into a stock and the price drops, should they consider allocating more to the stock to take advantage of the lower price?

RB: I think you make a very important point here about portfolio construction—how one should think about accumulating and paring back a position. When we conduct our intrinsic worth assessment, we do scenario analysis and generate multiple price targets to facilitate our decision-making framework on position sizing. This is what differentiates us from many other investment managers. A lot of managers have just two price targets: one that they’re going to buy at and one that they’re going to sell at. We have four price targets. One of the targets takes into consideration the worst-case scenario; that is, if everything that can go wrong in the business does go wrong, what is our intrinsic value estimate? The best-case scenario is if everything that can go right goes right. We have two additional scenarios and price targets that fall between these two extremes of best case to worst case. Stocks tend to trade somewhere in between, and our job is to know what scenario the stock is pricing in.

As a portfolio manager, I am going to try to take advantage of the opportunity presented me and accumulate a position as a stock falls, because I can constantly compare the stock price with the intrinsic worth based on different scenarios that have already been debated, vetted and developed. So if the stock is at $80, knowing that the worst-case scenario might be $50, I keep powder dry to accumulate the position. I don’t expend all of it in buying my full position size when the stock is at $80, even though there is upside to $100.

CR: Taking the reverse of that: If you want to allocate X%, but you only invest, say, half of your target amount and the stock rises, what do you do? Do you keep the position the way it is and simply wait for the time to sell versus trying to get to your targeted allocation?

RB: There are elements of a science and an art to accumulating and paring back. The science part of it is what I was mostly describing earlier. The art part of it is to be aware of the rest of the market’s views around that company. For example, how misunderstood is the company? How correct are we in our thesis?

When a stock is pricing in all the good news that could possibly happen for it, that’s the time to exit the position entirely. If a stock is only pricing in some of the good news and you know there is more positive news still to come, then you have to decide how much money to take off the table. At that time, you also have to look at what the rest of the opportunity set is looking like. Your money has to flow to the highest level of return per unit of risk.

Let’s say there was a broad correction in the market and—hypothetically speaking—shares of Disney (DIS) went up. At that time, the risk/reward on many other stocks may look more attractive than Disney. Then it makes sense to take more money out of Disney and put it into something else, because ideas compete for shelf space in the portfolio.

However, if the markets have done nothing but risen to new highs and many stocks have become overvalued and overbought, then it may not make sense to take all the money off the table even on stocks such as Disney that have performed well. This is because the alternative to be deployed into something better might be limited (as most of our clients require us to be fully invested at all times). So it’s a continuum of judgment calls one has to make.

This is a dynamic exercise of not just the individual risk/reward of one stock, but also that of the competing opportunity set, because managing a portfolio is always about making trade-offs on those two fronts. You also have to think about diversification and not just individual position sizing. Many, many considerations go into constructing a resilient portfolio.

CR: At the CFA Institute’s annual conference, you said that you screen for stocks in a different manner than most people. Instead of looking for characteristics that make a stock look attractive, you try to screen out everything you don’t want.

RB: Unlike our peers, we do negative screening—i.e., we are looking to eliminate bad investments from the get-go. We want to reject instead of select. This is why our initial focus is to look for things we dislike, while most of our peers do the opposite—they look for things to like and things that screen well because they are looking to shortlist names to potentially own. Our first priority is to avoid what I call “the big losers,” because they are what end up costing you a lot in portfolio performance.

Too many people think investing is about picking the big winners. Actually that’s only part of the battle. The war is won by avoiding the big losers, because you always lose money from a larger amount and you always make money on a smaller amount. So if you lose a lot, you have to gain even more to just break even from the losses you just made. A case in point is a stock declining from $100 to $50; if that same stock then gains 50% from $50, the stock is only at $75. In order to break even, that stock will need to increase 100% because you have lost so much money. This is why our first step, namely screening, is designed to eliminate risk (which we define as losing money) as much as possible.

CR: Is there any trait you could share that you find very useful to try to avoid in a company?

RB: Absolutely. I think some of the traits that we are very concerned about involve the propensity of a business to fail or its competitive advantage to become irrelevant. Research In Motion comes to mind. You may recall that BlackBerry was a very addictive smartphone that many of us depended on; today, it’s practically nonexistent. So, there are strong businesses that become marginalized over time. You want to be very mindful that you don’t own those blue chips of yesterday as opposed to the blue chips of tomorrow.

Investors should also avoid companies whose returns on invested capital do not exceed their cost of capital. Because we are global investors, we need to level the playing field of a company that is generating a lot of its cash flows in a high-cost-of-capital country like, say, Brazil, with another company generating a lot of its cash flows from a low-cost-of-capital country, such as America or Germany.

The risk profile of those cash flows is different because they are generated in different currencies with very different devaluation risk profiles. We develop a weighted average cost of capital and compare it to the returns of invested capital of the business to ensure returns are commensurate with risk. If they are not, we walk away.

The other kinds of companies we eliminate are those that are highly leveraged, especially those that have both operating leverage and financial leverage; which we believe tends to be a pretty deadly cocktail. We also look for contingent liabilities like an under-funded pension plan, because these are important liabilities that reduce the intrinsic value of the business.

Table 1. Performance of Ariel Funds Managed by Bhansali

	YTD Return (%)	2015 Return (%)	Avg Ann’l Return (%)		Exp Ratio (%)
			Last 3 Yrs	Last 5 Yrs
Ariel International Investor (AINTX)	-0.2	4.2	5.8	na	1.3
Foreign Stock Category Average	-2.7	-0.8	5.7	5.8	1.1
Ariel Global Investor (AGLOX)	2.1	0.4	6.9	na	1.3
Global Stock Category Average	-0.3	0.3	2.9	2.4	1.2
Both funds have inception dates of 12/30/2011. na = data not available for period. Source: Morningstar/Steele Mutual Fund Expert and AAII’s Quarterly Mutual Fund Update. Data as of June 30, 2016.

Equity shareholders are residual claimants of cash flows, so we are always trying to understand what that residual amount is that is left over after all other stakeholders get paid. If we find that there is nothing left over, then that’s the kind of business you want to avoid, because it will compound your problems instead of your returns.

Keep in mind, I have said nothing about seeking or avoiding companies based on valuations. There is a big distinction that investors must make between the valuation of a stock and the value of a business. Value is the fundamental intrinsic worth of the business. Valuations only represent what the market wants you to pay for something. I like to think of the market as a magician. It’s always trying to redirect your attention to the price action of the stock or the price multiple in the stock. As a fundamental investor, you must first know what you are getting, and only then think about what price or valuation multiple you are being asked to pay for it by the market, as opposed to the other way around.

CR: I was actually just about to bring that up, because you said at the CFA conference that you view valuation ratios as being more of a distraction than a help to investors. You think investors should first look to see if it’s a good business and then see if it’s reasonably priced, versus just looking at what’s reasonably priced?

RB: Yes, because it’s impossible to make a determination of what’s reasonable until you know what you’re getting. Here is an analogy for you to consider. Imagine going into a department store and having a salesperson walk up to you and say, “Give me $100, I’m going to sell you something.” You’re going to say, “Well tell me what I’m going to get for that $100,” right? You don’t care that she’s asking for $100, you want to know what are you going to receive for your money. Then imagine if that salesperson told you, “Well, you know, last week this merchandise was marked at $200; I’m giving it to you for $100.” You’re still going to say, “But what am I getting?”

Imagine if that same salesperson said you were going to get a bag of apples for $80. You would consider it an insane proposition. Until you know what merchandise you’re receiving, you have no idea whether the price quoted represents value or not. On the other hand, if the salesperson told you you’re going to get a pair of designer shoes for $80, you’re probably going to seize the opportunity to buy a pair of high-quality shoes at a big discount. So until you know what you’re getting, what you are paying tells you nothing about whether you are being offered a great bargain or being duped.

CR: If you see a company that looks really attractive but the price just isn’t right, do you wait for it to come down?

RB: Yes. All of our time is spent on researching businesses and trying to understand what we like about the business, what we don’t like, what can go right in the business and what can go wrong in the business. We view ourselves very much as business analysts first and foremost, and then try to figure out what we are willing to value those cash flows at. This is my point about the intrinsic value, and the worst-case to best-case scenario analysis. After we do our analysis, we then compare it to what the market is telling us to pay to own it. Some days the market is telling us to pay way more for the business than we think it’s worth and some days way less. Obviously we will then go and buy what costs way less and avoid what costs way more. Patience is key—you should wait for the opportunity to come to you instead of chasing it.

CR: On the other hand, what makes for a good stock? Are there any specific traits you seek? What do you look for to say: This is an attractive stock that I want to look at closer?

RB: We look for business model misunderstandings, where the business is of higher or improving quality than the prevailing wisdom. Another aspect is to look for inflection points where others have not figured out the implications. Usually that which is misunderstood is often mispriced—this is what makes for a great stock with an attractive risk/reward ratio. But in order to identify such misunderstandings and mispricings, you have to do differentiated fundamental research. If all of your deep research resulted in you forming the same conclusions everyone else already has—i.e., your views are consensus—then it is already priced into the stock and there is no money to be made. So we come full circle to being a contrarian and being correct as the prerequisites to finding great stocks.

CR: What about valuation ratios such as the price-earnings ratio and price-to-book ratio?

RB: We don’t screen on them because they are not representative of the underlying economic reality of income, cash flows or balance sheet quality. In the U.S., earnings per share (EPS) numbers are reported on a non-GAAP basis. That artificially lowers the headline multiple because non-GAAP EPS is typically higher than GAAP EPS. A price-earnings multiple is very sensitive to the accounting method used to report earnings. Management teams typically tend to have an incentive to flatter reported earnings, which tends to make the price-earnings ratio look better than what it actually might be. [Editor’s note: GAAP is an acronym for generally accepted accounting principles.]

Second, price-earnings ratios don’t capture the capital structure of a company. If a company is highly leveraged or has high operating leverage because it’s a very cyclical business, chances are that the price-earnings ratio will look low, but the low multiple could be a red herring if it’s on peak earnings. You could end up owning a value trap where the earnings keep falling and the price-earnings multiple keeps going up. Headline multiples don’t tell you if you are getting a value or falling into a value trap. This is why they can be a distraction rather than a driver of good investment performance.

Indebted companies also come to mind, especially if they borrow money to do acquisitions. A company can pay a price-earnings multiple of 50 times if they’re borrowing at 2% aftertax and still make the transaction look accretive to earnings. But paying 50 times earnings for most businesses is pretty egregious, so acquisitions haven’t created a lot of value. A price-earnings ratio will not capture that.

On the other hand, although discounted cash flow (DCF) analyses have their challenges, DCFs are far superior because they will take into account all the leakage of free cash flow, whether it’s for acquisitions or whether it’s for investments that need to be made in the business, or peaks and troughs over a cycle, etc. Even if you know there are some accounting gimmicks that companies have used to flatter earnings, it’s very hard to flatter free cash flows.

If you don’t know the limitations of priced-based ratios, you can actually fall into a sinkhole, which is why we don’t rely on priced-based multiples to determine value. We do a lot of fundamental research and, again, figure out intrinsic worth before we look at what the valuation metrics look like—not as a screen, but as a sanity check afterward.

Bonus Questions

CR: For an individual investor who wants to follow a contrarian strategy, do you have any guidance or any thoughts you can share?

RB: Well, I would caution investors, and especially your readers, that I have never said that being contrarian is the sole secret to my success. It is a necessary, but not sufficient, condition; I cannot stress this enough. You cannot go around just buying things that are out of favor and hoping that all will end well. You have to be both contrarian and correct.

What I mean by correct is correct in your investment thesis, correct in your estimation of the intrinsic value of the business under different scenarios. Believe me, if you’re contrarian and incorrect, you could lose your shirt. I want to make sure that I am not being misunderstood: It is important to be both contrarian and correct.

CR: Finally, could you comment on how investors should utilize the information they find about a company?

RB: Information is available so widely and readily that it is not a source of alpha anymore. It’s how you connect the information that enables it to become a source of alpha. Connecting information means you need to understand what questions to ask about that business, know what your blind spots are, what the unknowns are, what the distinguishing characteristics are, what the risks are, what the prospects are, etc. None of that is readily available, but that’s exactly why the markets reward that kind of deep, fundamental research (provided it is proven correct).

In today’s complex business environment, I think being a generalist has become a handicap in equity research. Analysts on my team specialize in certain sectors, because the domain expertise you need for understanding a technology company is fundamentally different from what you need to understand a retailing company, and the questions you ask need to be customized. When it comes to numerical information such as financial results and metrics, the value is not in the information itself but in how you analyze and interpret the information. Once again, it’s how you connect the dots that others have not that makes the difference.

Bottom line: Domain expertise, figuring out the right questions and knowing how to analyze and interpret available data are all critical to convert information into differentiated and actionable insights. Simply gathering a lot of information is of no use. If it were, then Google or the NSA would be the world’s best money managers because nobody has access to more data than they do!

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