Ariel Investments 1Q17 Letter – KKR & Morgan Stanley

Smart Money

Ariel Investments – Focused Value Composite 1Q17 Letter, April 25, 2017

  • Ariel Focused Value Composite posted a return of 7.07% compared to 6.07% for S&P 500 and 3.27% for Russell 1000 Value Index


  • Largest position in the quarter and the best-performing name, returning 19.51% for the 3 months
  • Began the year trading at $15.39, which represented more than a 40% discount to our estimate of its $26 private market value and about 9x estimate of its forward earnings
    • Rare for a company of KKR’s quality to trade at such a large discount without some clear short-term problem or clearly-identified bear case
  • Some say that KKR’s financial statements are too complex – because LBO funds often own controlling stakes in dozens of companies, these acquired companies are generally consolidated into KKR’s filings
    • Filings show tens of billions of dollars in debt and one-time non-cash charges resulting from takeover accounting
    • Anyone familiar with the economic structure of an LBO partnership can arrive at a value of KKR’s fees and carried interest
    • KKR breaks out its economic net income (essentially its stockholders’ share of its fees and carried interest, plus changes in the fair value of the assets on its balance sheet)
  • Others believe the market and Ariel do not see eye-to-eye when estimating the value of KKR
    • KKR’s balance sheet holds billions of dollars of investments – mostly consist of seed investments in its own funds, positions in companies which its funds have taken public and various debt funds
    • KKR calculates the fair value of these investments per share of stock – at year-end 2016, this value was about $12/share; as such, in our view, for the $15 stock price we were getting KKR’s $12 in investments and paying only $3 for all of KKR’s future fees and carried interest (our value of future fees and carried interest is $14/share)
    • One prominent explanation is that some investors simply do not agree with the fair value “marks”: admittedly, there is some risk KKR is overvaluing these investments
  • We hear KKR’s low stock price reflects its partnership structure as an LLC and that this structure prevents index funds, sector funds and ETFs from owning its shares
    • We believe the inability of passive investors to own the stock is the best explanation for why KKR trades so far below our calculation of fair value
  • Normally, we do not require a visible catalyst to close the discount between a company’s stock price and our calculation of its intrinsic value – in this case, we do have a catalyst
    • KKR’s partnership structure is a function of US corporate tax rates in excess of 36%
    • If marginal corporate rates fall to roughly 28%, it would be advantageous for KKR to restructure as a C Corp – such a move would likely ensure its addition to index funds
    • As a precedent, we would note that Berkshire Hathaway (BRK.B) had substantial returns in 2010 when it was added to S&P 500 Index

Morgan Stanley

  • We sold all our shares in Morgan Stanley in the first quarter
  • Our view is that investment bank shares should not trade for less than the tangible book value of its balance sheet – investment bank’s assets consist overwhelmingly of liquid stocks and bonds which are relatively easy to value
  • We have always believed buying an investment bank at 80% of tangible book is like paying 80 cents for a dollar bill – and getting the bank’s M&A fees and asset management fees at no cost
    • Such a situation presented itself through much of 2015 and 2016 with MS culminating in a price of $23 in June 2016 after the Brexit vote sent bank stocks down sharply
    • In a very sharp reversal of market sentiment, November’s US elections radically changed the market’s outlook for investment banking: investors became convinced that bank regulations would decline, taxes would be reduced and interest rates would rise
    • Morgan Stanley’s stock rose from $23 last June to $46 in mid-February; as such, company went from trading at a sharp discount to tangible book to a 40% premium in less than 9 months
  • If sentiment regarding MS changes again quickly, you should not be surprised to see this quality company return to the portfolio
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