QUARTERLY
Fact Sheet
QUARTERLY
Commentary
Artisan Small Cap Value Fund
As of 30 September 2014 Investor Class:
ARTVX
Investment Process
We seek to invest in cash-producing businesses in strong financial condition that are selling at undemanding valuations. Our goal is to build a diversified portfolio of companies that meet our three margin of safety criteria:
Attractive Valuation
We value a business using what we believe are reasonable expectations for the long-term earnings power and capitalization rates of that business. This results in a range of values for the company that we believe would be reasonable. We will generally purchase a security if the stock price falls below or toward the lower end of that range.
Sound Financial Condition
We prefer companies with an acceptable level of debt and positive cash flow, which we believe represents financial flexibility and strength. At a minimum, we seek to avoid companies that have so much debt that management may be unable to make decisions that would be in the best interest of the companies' shareholders.
Attractive Business Economics
We favor cash-producing businesses that are capable of earning acceptable returns on capital over the company's business cycle. Attractive business economics are an important business characteristic and we believe they are helpful in avoiding classic "value traps."
Team Overview
Our team has worked together for a long time and each member has a high level of trust and confidence in each other’s capabilities. Everyone on the team functions as a generalist with respect to investment research and the entire team works together on considering potential investments. The portfolio managers are supported by two research analysts who share a common mindset and focus on the key elements of our investment process.
Portfolio Management
Scott C. Satterwhite, CFA
Portfolio Manager
Daniel L. Kane, CFA
Portfolio Manager
James C. Kieffer, CFA
Portfolio Manager
George O. Sertl, CFA
Portfolio Manager
Investment Results(%) Average Annual Total Returns
6.77 8.19 14.29 21.26 3.93 -4.41 -7.36 Russell 2000® Index 8.02 7.25 13.02 20.61 4.13 -4.74 -8.58
Russell 2000® Value Index
9.51 7.39 8.01 11.64 -2.33 -9.87 -10.48 Investor Class: ARTVX
Inception2 10 Yr 5 Yr 3 Yr 1 Yr YTD1 QTD1 As of 30 September 2014
Source: Artisan Partners/Russell.1Returns for periods of less than one year are not annualized.2Fund inception: 29 September 1997.
Expense Ratio 1.24%
For the fiscal year ended 30 Sep 2013.
Past performance does not guarantee and is not a reliable indicator of future results. Investment returns and principal values will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than that shown. Call 800.344.1770 for current to most recent month-end performance.
Quarterly Commentary
Artisan Small Cap Value Fund
As of 30 September 2014Investing Environment
After eight consecutive up quarters for US small-cap stocks, the streak came to an end in the third quarter. The Russell 2000® Value Index fell 8.58% during the period, with the bulk of the decline occurring in September as global growth concerns came to the fore. While the US economy appears to be doing fine, China is slowing and the economies of Europe and Japan are stagnating. Small-cap stocks finished behind mid and large caps and are lagging by a wide margin YTD. The Russell 2000® and 2000® Value indices are down 4.41% and 4.74% YTD. This compares to gains of 6.87% for the Russell Midcap® Index and 8.20% for the Russell Midcap® Value Index. Large-cap stocks are up about 8% YTD.
Currency movements were a major development during the quarter as the yen and euro tumbled against the US dollar. This led to big declines in the prices of many commodities (e.g., oil, gold) as well as the stocks of commodity producers (e.g., energy companies and gold miners). The price of WTI crude oil fell from $105 to $91/bbl and gold declined in price from $1327 to $1209/oz. Stable inflation trends in the US coupled with indications of better economic growth were a recipe for US dollar appreciation. Additionally, monetary policy in the US is firming—the Fed continued winding down its quantitative easing program—whereas overseas, economic weakness has spurred further policy stimulus.
Geopolitical tensions around the world were blamed for intermittent market volatility. Russia’s involvement in Ukraine led to the US and Europe adopting economic sanctions against Russia. The impacts from sanctions on trade between Europe and Russia could further dent an already slow European economy. In the Middle East, the US announced coalition airstrikes against ISIS, a terrorist group that has seized large areas in Syria and northern Iraq. Though these conflicts received big headlines, tangible impacts on business values appear quite limited thus far.
All sectors were lower. Global cyclicals (energy, materials and industrials) were among the hardest hit. Energy stocks in particular came under pressure falling more than 20%. Utilities stocks were another area of weakness but are still up about 3% YTD. The financials, health care and technology sectors were among the stocks that held up best.
Performance Discussion
Our portfolio lagged the Russell 2000® Value Index in the third quarter. Relative exposures in the energy and financials sectors offset positive stock selection in the consumer discretionary and industrials sectors. In a reversal from Q2, energy was the worst performing sector in Q3. Our big weighting in it—averaging roughly 18% and about triple the Index’s weight—was a significant headwind. Financials are a big part of the small-cap indices (39% in the Russell 2000® Value Index and 23% in the Russell 2000® Index). Our financials weighting is significantly lower, averaging 9% during the quarter. Banks and
property REITs are big components in the indices, and we own very little in both those areas. We think of banking as a mediocre business, and banks face a number of issues from changing capital
requirements to increased regulations. In REITs, we find valuations expensive.
Similar to the Index, our energy holdings averaged 20%+ percentage declines and were the source of many of our biggest detractors. In fact, eight of our ten bottom contributors to return were energy stocks. Among these were fuel logistics provider World Fuel Services, offshore marine services companies Tidewater and GulfMark Offshore, coal miner Cloud Peak Energy, and exploration and production company Approach Resources. Our ownership in the energy sector has been built bottom-up as we’ve responded to opportunities in individual names. From a top-down perspective, we think it’s worth noting that the energy sector has meaningfully lagged the Index over the past one-, three-and five-year time periods. Broadly speaking, we believe prices have undershot values in the sector, and that goes a long way toward explaining our overweight position.
World Fuel Services sold off despite an earnings report that was in line with expectations. Strong performance in the Aviation segment was offset by margin pressure in the Land segment. The price reaction seems overly done, but it’s a large enough position in the portfolio that we didn’t add to it. We think it’s possible there were growth investors involved in the stock that looked primarily to the Land segment for their growth investment case. We continue to like the stock. The company has produced strong free cash flow over the past two years, much of which has gone toward its acquisition program that we believe is value additive, and the balance sheet
remains strong.
Shares of Tidewater and GulfMark Offshore along with other energy services stocks are out of favor due to oversupply concerns that are weighing on utilization and dayrates. Shares of Cloud Peak Energy were down with other US coal-mining stocks. Industry weakness can be attributed to persistently low international pricing, a strong rebuild in natural gas storage levels, and continued rail supply issues. Approach Resources generated better-than-expected production, but new well production rates were below what some were expecting leading to concern about future growth rates.
Our biggest detractor outside of the energy sector was H.B. Fuller, a specialty chemicals company. The company reported a big earnings disappointment due to a confluence of factors, including excess costs associated with its European business integration, challenges with the implementation of an SAP system, and higher raw material costs. We’ve owned H.B. Fuller since 2008, and it is one of our largest positions. We believe the concerns are overdone as some of the issues appear transitory.
Our consumer discretionary holdings did well this quarter as four of our top five contributors came from the sector. These were DreamWorks Animation, American Eagle Outfitters (AEO),
Rent-A-Center and Shutterfly. We’d note that two of the names—AEO and Shutterfly—were recent purchases added in Q2. DreamWorks Animation, an animated feature films producer, is reportedly in discussions to be acquired at a 39% takeout premium. AEO, an apparel retailer, reported better-than-expected EPS and comp sales, but fundamentals remain weak with comps down 7% and EPS declining meaningfully versus last year. The company’s inventory position was conservative at period end, and management is committed to managing inventories tightly. The stock rallied on the news, possibly due to short covering. The turnaround remains in the early stages, and the stock price looks cheap against longer-term earnings power. Shares of Rent-A-Center, a rent-to-own retailer, benefited from improved sentiment. Recent management changes, the closure of underperforming stores and the rollout of smartphones in its stores are generating hope of improved business results. Shutterfly, an Internet-based seller of photo-related services, was up strongly on takeover speculation. We sold our stake in Shutterfly as the deal rumors heated up.
Portfolio Activity
Our new purchase activity continued to be on the light side. As we commented in recent letters, bargain prices remain scarce. The portfolio comes about one stock at a time. Of late it's become really difficult to find that one stock at a time. Frankly, we don't like the current environment. We hate it. And it has nothing to do with our performance outcome. It has everything to do with the idea that we’re focused on buying businesses at interesting prices, and right now that’s a difficult task. It's not that we think that everything is overvalued, although valuations are less attractive in small caps than toward the larger end of the market cap spectrum. Instead our complaint is that too many things are fairly valued. We don't like buying fairly valued or close to fairly valued businesses. It's buying businesses at outlier valuations that we believe leads to real money being made. Our process relies in part on individual names, industries, sectors, or even the whole market getting kicked around. We've been on an extended bull run of late, so bargains are few and far between and that's frustrating. As we write this letter in October, recent volatility has started to provide us with cheaper prices, which should hopefully result in increased opportunities.
Two of our bigger new purchases this quarter were Powell Industries and Knowles. Powell Industries designs, manufactures and services custom engineered equipment and systems for the management and control of electrical energy. Its primary end market is the oil and gas industry. Our opportunity to buy the stock was due to a large earnings miss that resulted in a large downgrade to earnings expectations for this year and next. 2014 is expected to be a down year earnings-wise,
a fact that is dealt with harshly in this environment. The earnings miss was due primarily to the timing of project work and inefficiencies associated with the ramp of a new manufacturing plant in Canada. The longer-term macro view is quite positive—energy infrastructure trends remain strong, including new pipelines, petrochemical plants and greater production, particularly offshore where Powell has a high market share for equipment. Also, investments in the nation’s electric grid are needed. The balance sheet is very strong with roughly $6 per share in net cash with minimal long-term debt. Selling at about 15X-16X our view of normalized earnings, the stock is not cheap in an absolute sense, but we think it is on a relative basis. We think it’s a better-than-average company at a better-than-average price. Knowles is a maker of acoustic components that was spun-out of Dover Corp., a diversified equipment company, earlier this year. The company has a large market share in the global MEMS
(micro-mechanical electrochemical system, or in layman’s terms miniature microphones) market. MEMS are used in a range of devices from smartphones to hearing aids. Knowles’ end markets have changed over the last decade. Today the largest end market is mobile devices, which account for 50% of sales. With Apple about a quarter of total sales, customer concentration is a key risk, but Knowles also has patents on its designs and the ability to manufacture at scale which create large barriers to entry. We believe the company is
well-positioned to take advantage of the growing MEMS market due to unit growth and rising content. Besides the opportunity on the top line, margins have the potential to increase as the company is reorganizing its manufacturing footprint. At the time of our initial purchase, shares were selling for about 10X-11X our view of normalized earnings.
Besides Shutterfly, we also sold QLogic, a supplier of storage networking and connectivity solutions, and Lexmark International, a printing solutions provider. QLogic has to be considered a failed idea as business results never got back to our view of normalized earnings levels. We’ve owned Lexmark International since mid-2009 and over much of that period the stock lagged. Since 2012 however, the stock has powered higher as results have turned around. We sold it as its price reached our target selling range.
Perspective
Due to our bias toward quality, the portfolio has historically done well in down periods. To give some perspective, the portfolio has outperformed the Russell 2000® Value Index in roughly three of every four down-market quarters since its inception (15 of 21). So while it is uncommon for our portfolio to underperform in down periods, it does happen from time to time.
One way we think about sources of relative performance is to look at three influences. The first is to examine whether our style is in or out of favor. Markets rotate style preferences over time. Growth,
momentum, value and quality are a few of the broad dimensions, and there are a number of fundamental and quantitative factors that can be used to understand where a stock falls along these dimensions at any given time. In the current environment—one characterized by market complacency and low interest rates—the important elements of our process (i.e. margin of safety criteria) have not been favored. We believe that maintaining our discipline has hurt returns. In essence, we have an anti-momentum process. We’re selling what’s doing well and buying what’s out of favor where there’s some fear and uncertainty with the mindset that the discount to intrinsic value will close over a three- to five-year horizon. So we have been out of sync with the market.
A second consideration is to examine how our portfolio is different from the benchmark. We are benchmark agnostic, and the makeup of the benchmark does not influence portfolio construction. We believe that letting the benchmark influence decision making can hinder success. The goal is to build a portfolio that reflects the judgment and experience of the investment team—not the characteristics of an index. We own a significant number of holdings that are not components of the Russell 2000® Value Index. In the third quarter, 24 of our holdings, making up approximately 28% of the portfolio weighting, were non-benchmark names. These stocks trailed the Index with average returns of approximately -12%. Among our biggest declining non-benchmark holdings were previously discussed World Fuel Services and Tidewater and gold miners Alamos Gold and AuRico Gold. Another way to look different is sector allocation. Our positioning vis-à-vis the energy and financials sectors proved a detriment in Q3.
A third factor is to assess our hits and misses. These are stocks that did substantially better or worse than the average stock during the period due to fundamental reasons—company-specific or industry
drivers—rather than due to style preferences in the market. H.B. Fuller is an example from the third quarter. When one’s style is in favor, the misses tend to be less glaring. Conversely the misses are magnified when headwinds exist from the market environment.
While we are disappointed with our relative returns, we have captured about 74% of the upside since the 2009 market bottom in what has been one of the strongest bull markets in history. And although the quarter ended down, the reality is we are only a few months removed from all-time highs in small-cap stocks. We believe assessing our performance over a full market cycle—one that includes both bull and bear phases–has shown the value of reduced drawdown risk. If you run a pension or are managing your life’s savings, it is the drawdown that can wreak havoc. Even if the drawdown proves temporary (likely), it doesn’t mean you get to escape the negative effects as it is happening (e.g., company may have to step up funding the pension; you may have to cut back on your standard of living; increased odds that you panic and withdraw funds). Point-in-time wealth matters.
While lagging behind your neighbors during bull runs may be no fun, it sure beats needing to have a yard sale during nervous time periods. We’ve experienced frustrating periods before in our investment careers. It’s uncomfortable while it’s occurring, but we’ve found that the best course is to remain true to one’s investment discipline. That’s what we will continue to do.
For more information:
Visit www.artisanpartners.com | Call 800.344.1770
Carefully consider the Fund’s investment objective, risks and charges and expenses. This and other important information is contained in the Fund's prospectus and summary prospectus, which can be obtained by calling 800.344.1770. Read carefully before investing.
Securities of small companies tend to have a shorter history of operations, be more volatile and less liquid and may have underperformed securities of large companies during some periods.Value securities may underperform other asset types during a given period.
The Russell 2000® Index is an index of about 2,000 small US companies and the Russell 2000® Value Index is an index of those small companies included in the Russell 2000® Index with lower price-to-book ratios and lower forecasted
growth values. Both indices are unmanaged, market-weighted indices whose returns include net reinvested dividends but, unlike the portfolio’s returns, do not reflect the payment of sales commissions or other expenses incurred in the purchase or sale of the securities included in the indices. An investment cannot be made directly into an index.
This summary represents the views of the portfolio managers as of 30 Sep 2014. Those views may change, and the Fund disclaims any obligation to advise investors of such changes. For the purpose of determining the Fund’s holdings, securities of the same issuer are aggregated to determine the weight in the Fund. The holdings mentioned above comprise the following percentages of the Fund's total net assets as of 30 Sep 2014: World Fuel Services Corp 3.4%; Tidewater Inc 1.6%; Gulfmark Offshore Inc 1.5%; Cloud Peak Energy Inc 1.3%; Approach Resources Inc 0.9%; HB Fuller Co 3.0%; DreamWorks Animation SKG Inc 1.4%; American Eagle Outfitters Inc 0.8%; Rent-A-Center Inc 2.4%; Powell Industries Inc 0.8%; Knowles Corp 0.6%; Alamos Gold Inc 0.7%; AuRico Gold Inc 0.4%. Securities named in the Commentary, but not listed here are not held in the Fund as of the date of this report. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual securities. All information in this report, unless otherwise indicated, includes all classes of shares (except performance and expense ratio information) and is as of the date shown in the upper right hand corner. This material does not constitute investment advice.
Attribution is used to evaluate the investment management decisions which affected the portfolio’s performance when compared to a benchmark index. Attribution is not exact, but should be considered an approximation of the relative contribution of each of the factors considered.
The Global Industry Classification Standard (GICS) was developed by and is the exclusive property and a service mark of MSCI Inc. (MSCI) and Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. (S&P) and is licensed for use by Artisan Partners. Neither MSCI, S&P nor any third party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability and fitness for a particular purpose with respect to any of such standard or classification. Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.
Russell Investment Group is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. This is a presentation of Artisan Partners. Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in Artisan Partners’ presentation thereof.
Earnings per Share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. Normalized Earnings are earnings that are adjusted for the cyclical ups and downs over a business cycle. Margin of Safety
is the difference between the market price and the estimated intrinsic value of a business. The concept was developed by Benjamin Graham and is believed to be an important measure of risk and appreciation potential. Artisan Partners U.S. Value team also incorporates a company's financial strength and certain business quality measures into its margin of safety estimates. A large margin of safety helps guard against permanent capital loss and improves the probability of capital appreciation; however, a margin of safety does not prevent market loss. All investments contain risk and may lose value. Free Cash Flow is a measure of financial performance calculated as operating cash flow minus capital expenditures. Artisan Partners Funds offered through Artisan Partners Distributors LLC (APDLLC), member FINRA. APDLLC is a wholly owned broker/dealer subsidiary of Artisan Partners Holdings LP. Artisan Partners Limited Partnership, an investment advisory firm and adviser to Artisan Funds, is wholly owned by Artisan Partners Holdings LP.
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10/15/2014 A14712L_vR
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