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2 TheEssence

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In this issue ...

P.2 Emerging Markets

P.3 Equities Strategy

P.4 Investment Activity

P.4 Fixed Income Strategy

P.5 Conclusion

I t had been a very full day, but at 8:00 pm the real excitement still lay ahead. One of our portfolio managers (PM) boarded the bus that he was told was the only practical

way to get to the stadium. The 90,000 fans the venue holds were all expected to arrive near the 9:00 pm start time. It is only a few miles away, but the bus was going to take a circuitous route so as not to get stuck.

Success! The bus got there a few minutes before 9:00 pm, our PM found his assigned area, he quickly passed by the concession stand on his way (but made note of its location) and climbed over the rows of rapidly filling seats. Section #7 is unreserved, first-come first-seated, but in the dead center of the stadium. He climbed to the very top, where a vendor selling soft drinks kindly moved his wares from seats so our PM and his friends would have a bird’s eye view of what was to come. The Aristotle PM was in Rio de Janeiro, Brazil, and the second night of the parades of Carnaval was underway at the Sambódromo (Sambadrome).

Carnaval in Rio dates back to at least 1823 and today is considered by many to be the biggest event of its kind in the world. The entire city turns into one giant party with dancing and music throughout the streets and in scores of private venues. All this takes place within a metropolitan area of greater than 14 million people – and, as our PM experienced, it was mostly well organized and peaceful. The celebration culminates in two nights of parades in the middle of the city, where a large rectangular outdoor stadium (the Sambadrome) was built specifically for this purpose. Think of the New Orleans Mardi Gras, New York Thanksgiving Day parade and Pasadena Rose Bowl parade. Combine them and multiply by a factor of five! Then one begins to understand the scope of Carnaval.

The two-evening parades are a competition of sorts. Each parade – there are 12 in total, six 80-minute parades on each of the two nights – is prepared and performed by a samba “school.” Each school has some kind of regional or other common background. There are actually more than 200 such schools in Rio but only the top 12 are in the “Special Group” that parade in the Sambadrome. Each school selects a theme (called an enredo) and works year-round designing floats, costumes, music (mostly percussion played by a band called the bateria) and other aesthetics. Each of the parades includes upwards of 3,000 participants, some of whom, over the years, have gained fame from their Carnaval performances.

While each school parade was spectacular in its own unique way, the second school on the second night caught the attention of our PM. União da Ilha (Union Island) was one of the smaller secondary samba schools until 1974. It then gained stature

The Girl From Ipanema

“I count him braver who overcomes his desires than him who conquers his enemies; for

the hardest victory is over self.”~ Aristotle ~

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and ascended to the Special Group. After falling out of the Group from 2002 to 2009, it has been performing in the Sambadrome since 2010. In 2014, Union Island selected the somewhat whimsical theme of “Games & Toys.”

Games & Toys consisted of 14 floats and was manned and surrounded by 2,300 costumed dancing / singing / or drumming participants. It portrayed youth-oriented characters from toys to movies. One of the floats was a gargantuan “box” that opened to reveal 20 doll-like ballerina dancers in exaggerated pink tutus. They “woke up” from a slumber position, did their dance (to samba music, of course) then returned to “sleep” as the lid of the box closed. This was repeated as it paraded down the center aisle of the Sambadrome. It was a mechanical and artistic wonder.

Each subsequent float portrayed a game or character. They included Rubik’s Cube, Scrabble, Pong, Toy Story, Cinderella, Star Wars, “Chucky” from the horror movie series, Wonder Woman, Batman, The Joker and more. All are likely trademarks, but unlikely to have been licensed for this event. If Disney, Warner Brothers, Mattel or Hasbro are reading this, Union Island may owe you a few Brazilian reais.

Our Portfolio Manager returned from Brazil with wondrous stories of the beaches of Rio (and nearby Cabo Frio), Sugarloaf Mountain, the Atlantic Rain Forest (dwindling and now down to only 10% of its original size), Cristo Redentor (Christ the Redeemer statue of Jesus) and, of course, Carnaval at Sambódromo. Yes, it was a spectacular experience. More importantly, “What,” our team asked, “are the implications for investments from your trip to Latin America?”

Emerging MarketsBrazil represents the “B” in the common acronym “BRICS” that many investors use to describe the largest and most impactful emerging market countries – the others being Russia, India, China and most recently added, South Africa. This quarter, our PM’s trip to Latin America encouraged us to briefly comment on our views on emerging economies and their influence on investments.

Much of the “news of the day” of late has referred to issues in Syria, Ukraine, Argentina, etc. We believe there will always be trouble and “hot spots” in the world. Still, we are sanguine for the future of emerging markets as a group and

believe they will positively impact companies the world over. The following graph depicts how other investors may view investments in emerging markets.

The blue line depicts, as a group, the stock markets of emerging countries. The MSCI Emerging Market stock price index includes the BRICS countries plus South Korea and Taiwan (even though many consider these to be developed markets), Mexico, Hong Kong and Malaysia as representing about 86% of the capitalization of the index. The red line in the graph is the CRB Raw Materials price index. It tracks commodity prices including copper, lead, steel, cotton and rubber. Note the tight correlation between the two lines. Thus, many see emerging stock markets as a surrogate for commodity prices.

Indeed, many emerging market countries supply much of the world’s raw materials and therefore their economies are tightly tied to commodity prices and their stock markets reflect that. But while the tight correlation has continued, we believe that over the coming years, emerging economies could diversify away from purely cyclical ingredients and broaden out, akin to the way that many of today’s developed economies diversified away from farming and, more recently, manufacturing.

China is an excellent example of this diversification. That country is an important component of the emerging markets. Yes, its form of government is communist; yes, property rights are not quite as protected as in many developed countries; yes, transparency and corporate governance are still evolving. But the direction of the country’s economy has been, and continues to evolve, in favor of free-er markets. One recent example is the announcement by the People’s Bank of China (PBOC) to take another step in moving China’s currency toward a

Emerging Markets/Commodities Correlation

Sources: Yardeni Research; Morgan Stanley Capital International; Commodity Research Bureau

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

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CRB Raw Industrials Spot Price Index (in dollars)

Emerging Markets MSCI Stock Price Index (in dollars)

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floating system. Historically, countries (including the U.S.) have benefited from similar moves. PBOC Governor Zhou Xiaochuan remarked that “an orderly widening of the [currency] band … will give markets a decisive role in the pricing of resources, with acceleration of yuan convertibility and liberalization of interest rates ….” This mention of “market-based” allocation of resources, as opposed to historical “central planning,” is very important for us to monitor.

What may be the ramifications of this broadening out of emerging economies? Which businesses may benefit from farmers and cotton pickers moving into the middle class of urban society? Our PM noted that samba school Union Island chose its theme of “Games & Toys” as one that would be recognizable to the local populace. While rhetoric by news media may indicate otherwise, western culture (and its symbols) is embraced the world over, particularly in Brazil. Who knew that Chucky is one of Brazil’s most recognizable movie characters? How is it that more Brazilian teenagers play Scrabble than do Americans? Further, it seems like almost half of these Scrabble-playing teens wear Abercrombie (or Hollister) branded clothing.

In all of Aristotle Capital’s equity strategies, direct exposure to emerging market investments has been relatively low. Our philosophy of seeking out leading businesses that have withstood the test of time has uncovered a few – Samsung Electronics, Banco Santander (with its exposure to Latin America), Enersis, Chunghwa Telecom and Anglo American (U.K.-based, but this mining business has most of its assets in developing countries) – but they have typically represented less than 15% of our portfolios. Importantly, however, indirect exposure to emerging markets in Aristotle portfolios is significant and some companies could benefit materially from this exposure in the coming years.

For example, Hershey does little business outside of North America. But its sales of chocolate in China have every indication of becoming very meaningful one day and that, we believe, is not factored into most others’ thinking of the value of this company. Coty, due to its recent distribution agreement with Avon, is now one of the largest sellers of fragrances in Brazil. General Dynamics, via its Canadian subsidiary, recently inked a large order for wheeled armored military vehicles bound for Saudi Arabia. Daiichi Sankyo, while headquartered in Tokyo, Japan, owns 63% of one of India’s largest pharmaceutical companies, Ranbaxy Labs, and through that company may expand its generic drug business globally.

As always, our investment decisions come from individual company analysis, much more so than “top down” or macro thinking. But part of our analyses includes factoring in our expectations for what businesses may look like three to

five years ahead. Cyclical, political and other short-term or transitory factors aside, we have great confidence that many emerging economies will continue to develop, and those businesses with conservative exposure to them could benefit meaningfully. We will continue to evaluate such companies all over the world.

EQUITIES STRATEGY

One of the advantages that developing economies possess is the relative “newness” of their factories. This is no longer the case in many developed countries, including the U.S.

This graph depicts the average age of U.S. private fixed assets from 1965 through 2013. This would include industrial factories, office buildings, equipment, communications infrastructure, power plants and transmission equipment, computers and other IT equipment, etc. Throughout the 1970s and 80s, industrial development was significant in the U.S. The power grid was built out, fixed-line telecommunications equipment crisscrossed the country, skyscrapers changed the landscape of cities, auto factories were built and other infrastructure was put into place. In the 1990s and 2000s, “outsourcing” became all the rage and so most new factories (and the equipment that goes into them) were built elsewhere – mostly in the developing world. A brief interruption in this trend occurred leading up to “Y2K,” but since then, our country’s plants have aged. Even the resurgence of the economy of late does not seem to have altered this trend.

The Bank Credit Analyst points out that “Five years of spending restraint has caused the private-sector capital stock to grow at the slowest rate since the Great Depression. Given that [corporate] profit margins are at record levels and borrowing rates are near historic lows, our model points to a cyclical pickup in capital spending over the coming years.”

We would like to agree with this optimistic statement. But, thus far, we see plans for new capital only in a few selected

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Sources: BEA; Haver Analytics; DB Research

Average Age of Private Fixed Assets

21.75

21.00

20.25

19.50

18.75

Years

65 70 75 80 85 90 95 00 05 10

Significant IT investments in the late 1990s lowered the average age of capital stock

industries such as energy and chemicals. Our power grid is aging, natural gas pipelines are bursting and even some healthcare-related facilities are falling into disrepair. While the graph shows private assets only, public assets (airports, roads, bridges, parks, etc.) are following a similar trend.

While we do not wish to fall into a trap of “wishful thinking,” we do believe that at some point, perhaps in the not-too-distant future, capital investments could accelerate. We shall carefully monitor this trend.

INVESTMENT ACTIVITY

Microsoft and IBM: This past quarter we sold an investment we had long held and purchased one we had long studied but not owned. This past quarter we sold IBM and purchased Microsoft. In our assessment, both of these businesses are of superior quality due to (i) high and sustainable market shares in the core businesses in which they compete, (ii) high percentage of predictable and recurring revenues, (iii) superior margins and returns on invested capital and (iv) FREE cash flow that has averaged nearly 10% of each company’s market capitalization. Further, our calculation of the intrinsic value of both enterprises, particularly in recent years, has left room for appreciation of the companies’ stock prices. So what’s new?

For IBM, the business transformation that began under the leadership of CEO Lou Gerstner in 1993 (shortly before our initial purchase for those clients who have been with us since that time) has run a long course. The mainframe hardware company of then is now more than three-quarters a software and services company. While revenue growth has not been robust, profits have consistently increased more than 10% annually through good times and bad. Greater than 100% of the cash generated by IBM has been returned to shareholders in the form of dividends and share repurchases. So, what was once a nearly debt-free business is now about as levered as it can be. From here, cash to generate additional hefty buybacks would have to be generated internally (including the sale of some of its lower margin businesses). This may not be sustainable throughout our typical three- to five-year investment time horizon. The bottom line is that the myriad of catalysts we identified long ago have largely been fulfilled.

Microsoft could very well be today where IBM was from a business standpoint back in the mid-1990s. Like then, others are calling for its break up to unleash near-term value for shareholders. However, newly appointed CEO Satya Nadella may resist the urge for short-term satisfaction just as Mr. Gerstner (and his successor Sam Palmisano) did 20 years ago. Instead, he may hone each business, focusing on bringing synergies between them, increasing market share in a select few segments and generating significant cash for shareholders along the way. By our estimates, when one purchases a share of Microsoft stock today, one is “paying” for only its valuable operating system and Office application businesses. It could be that Azure (cloud services), Lync (video conferencing and instant messaging), Great Plains (accounting software), Xbox (games and consoles), Bing (search), Skype (IP-based video telephony), Surface (tablet computing) and the Windows phone operating system are all “free” options, available for further development.

What is new for IBM is its catalysts running their course. What is new for Microsoft is our identification of and belief in many new catalysts still to be realized.

FIXED INCOME STRATEGY

In prior editions of The Essence we have discussed how emerging market countries (and China in particular) have increased their ownership of U.S. assets. The following graph shows this to be acute when evaluating U.S. Treasury debt.

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Sources: Federal Reserve Board; Haver Analytics; DB Research

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Holders of U.S. Treasuries(% outstanding)

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Household/Corp Mutual Funds Foreign FedBanks and Brokers Pension Insurance Other

As recently as the 1970s, the vast majority of U.S. Treasury debt was held domestically. Households and corporations (directly), mutual funds, U.S. pensions and the Federal Reserve owned 90% or more of our Federal debt. The graph on the previous page (with data from January 1990 through January 2014) shows that today this ratio is nearly reversed. Half of U.S. debt is held abroad, up from only 15% in 1990. While we can be proud that our assets are highly regarded, and while some of this increase may be accorded to increased trade flows, the trend does have its risks.

When we analyze companies, we prefer those in control of their own destinies. We often avoid pure commodity sellers or companies whose input costs or selling prices are subject to the vagary of markets outside their control. When we do invest in these types of businesses, we seek out those with competitive advantages, such as access to unique materials or a very low (and sustainable) cost structure. It is this “control” that the U.S. gives away when it relies so heavily on the finances of others. This heavy reliance on external debt (historically often provided by the U.S.) was a factor in the volatility of emerging market economies in the past. Now that many emerging markets have sufficient capital to finance their own needs, they are investing some of their excess in U.S. financial instruments.

For now, we are not overly worried by this. But being indebted to others to an extent greater than one is able to pay off quickly transfers some control to the creditors. As part of our process to evaluate risk wherever it may be, we shall monitor not only the level of U.S. Treasury debt, but the control of it as well.

The characters described and stories told herein are often, but not always, based on true incidents. Poetic license is taken to dramatize a point about an investment topic. Not all securities

mentioned herein are necessarily owned in all Aristotle portfolios. Differences due to restrictions, tax considerations, cash flows and other factors may have impacted the decisions to buy and/or sell certain securities at specific times. Inclusion does not imply that investments in these securities have been profitable. A list of at least five contributors to and five detractors from performance is available upon request.

CONCLUSION

So who was “Garota de Ipanema” (The Girl from Ipanema)?

“Tall and tan and young and lovely, the girl from Ipanema goes walking And when she passes, each one she passes goes – ah. When she walks, she’s like a samba that swings so cool and sways so gentle That when she passes, each one she passes goes – ooh…”

Sung with a very familiar bossa nova rhythm, this song, almost by itself, made the beach, and its surrounding neighborhood, at Ipanema, Brazil famous. It was written in 1962, with music by Antônio Carlos Jobim and Portuguese lyrics by Vinicius de Moraes. English lyrics were written later by Norman Gimbel. Frank Sinatra recorded the hit as a duet with its composer. You will instantly recognize the rhythm. In the U.S., it was a number one hit and it is believed to be the second-most-recorded popular song in history, after The Beatles’ “Yesterday.”

The Girl from Ipanema could have been any one of the thousands who have paraded over the years for her school in the Sambadrome as part of Carnaval. She was energetic, graceful, wildly costumed and, of course, beautiful. She epitomized Brazil, an increasing part of emerging market countries that are, themselves, an increasingly important part of the global economy. We shall continue to study this topic with vigor.

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We are delighted to welcome Aristotle Credit Partners, LLC as an affiliate organization to Aristotle Capital. Formed by MetWest Ventures, ACP is focused on value-oriented

credit strategies, including High Yield Bonds, Bank Loans, High Grade Corporate Credits and custom fixed income strategies. We look forward to benefiting from their

insight as viewed from a credit-oriented perspective.

11100 Santa Monica Blvd., Suite 1700Los Angeles, CA 90025

(310) 478-4005Info@AristotleCap.com

The Essence is published by the investment management team at Aristotle Capital Management, LLC. This report is published solely for information purposes and is not to be construed as the solicitation of an offer to sell or an offer to buy any security. The report is based on data obtained from sources believed to be reliable but is not guaranteed as being accurate and does not purport to be a complete summary of the available data. Officers and employees of Aristotle Capital Management, LLC, its affiliates or members of their families may have a position in securities mentioned herein. Past performance is not indicative of future results.

This material is not financial advice or an offer to sell any product. Not every client’s account will have these exact market exigencies at the time of investment. Aristotle Capital Management, LLC reserves the right to modify its current investment strategies’ characteristics. The information provided in this report should not be considered a recommendation to purchase or sell any particular security. Recommendations for the past twelve months are available upon request.

Aristotle Capital Management, LLC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Aristotle including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.

20 Pacifica, Suite 1050Irvine, CA 92618(949) 681-2100www.AristotleCap.com

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