“There cannot be a crisis next week. My schedule is already full.”
Dear Fellow Shareholders:
Three main factors created uncertainty for investors during the first part of 2016. We began the year with worries over the falling price of oil. This was followed by the historic vote by the British to leave the European Union. The third factor creating uncertainty was our ongoing presidential election process as Democrats and Republicans completed their primaries and narrowed the field to two candidates. This uncertainty will continue into the fall with what promises to be an ugly campaign season. One might compare it to passing a car wreck on the highway. We tell ourselves to keep both hands on the wheel and our eyes on the road ahead, but we can’t help but look.
- Falling Oil Prices: Just a few short months ago, oil dominated the news with headlines of doom and gloom about crashing oil prices and the impact they were going to have on the world economy. Fortunately, a global economic crisis did not materialize as a result of low oil prices. As soon as oil began moving up, other bogeymen quickly appeared to take the place as the crisis du jour.
- Brexit: The UK vote to leave the European Union is undoubtedly an important issue, but it is not likely to be the nightmare that some have predicted. If the UK does leave the EU, it will be done over a long period of time and in as orderly a fashion as possible. There will certainly be some dislocations (e.g. many finance jobs moving from London to the Continent), and perhaps a temporary economic slowdown, but it should not present structural problems to either the UK economy or the remaining countries in the European Union.
- U.S. Presidential Election: As the U.S. presidential election heats up, some say that a Donald Trump presidency will send the world into a global depression. Others have predicted a booming economy fueled by increased government borrowing, similar to the period in the 1980s. As independent investors we don’t take sides in these debates, which happens to be very convenient in this election. We are confident that whether Trump or Clinton wins the presidency (or an unlikely dark-horse candidate), it will not cause the world economy to fall into a depression. There will be much rhetoric and hand-wringing as both sides throw mud during their nominating conventions in July as they attempt to motivate their folks to get out and vote. The market will likely gyrate a bit in the short-term, but over the longer term, the global economy will continue its slow but steady growth.
Earnings Pressure: As the global economy continues its slow expansion, operating margins are finally starting to feel pressure. The cost-cutting and rationalization that have been going on for the last several years appear to have reached their limits, broadly speaking. Companies and analysts alike are projecting tepid earnings growth for the near future. Additionally, we are seeing an increased reliance (and increased creativity) in “adjusting” GAAP earnings to ones that “management feels better represent the financial performance of the company”. We also see continued record share repurchases that provide immediate benefits to earnings per share numbers by reducing the outstanding share count. These share repurchases are often undertaken instead of increasing capital purchases, such as buying new plants and machinery. While the share buybacks provide the one-time pop of increased earnings per share due to a lower share count, we prefer to see companies that make capital investments that have the potential to provide sustainable long-term profit growth.
Late-Stage Bull Market? While these are worrisome signs, they aren’t unusual in the later stages of a bull market. Lest that sound like a call on the market, we think it is important to note that this bull could keep running for a while. Likewise, it may not. As bottom-up investors, we try to avoid making predictions about near-term equity market performance. Instead we focus on the portfolio. Currently we see pressure on earnings and above average valuations, but our portfolios are made up of companies that we believe have sound risk/reward prospects over the next three to five years. Our bottom-up analysis focuses on the individual companies, their business models, their managements, and the attractiveness of the industries in which they compete. Relative to the amount of risk that we are taking, we feel confident that collectively, the companies we own will prove to be a good investment over the long-term despite the uncertainty we face.
Thank you for entrusting your and your client’s money to Queens Road. Please call us if you have any questions about the portfolio or our investment philosophy and process.
President, Portfolio Manager
PORTFOLIO MANAGER’S COMMENTARY
Queens Road Value Fund
For our fiscal year ending May 31, 2016, the Queens Road Value Fund returned 1.74% compared to a return of 0.44% for the S&P 500 Citigroup Value Index, the fund’s primary benchmark.
Investments that Helped Performance
- Constellation Brands Inc. (2.32% of the Fund) rose 29% during the fiscal year. The third-largest producer and marketer of beer in the U.S. continued its recent strong performance with its marquee brands Corona and Modelo and expanded its presence in the craft brew marketplace with the acquisition of Ballast Point Brewing. This year marks the fifth straight year in which the company’s beer brands gained market share in the U.S. The company’s other segment, wine and spirits, continues to show lackluster growth. This well-managed company has demographic trends in its favor for its major brands and remains one of the fund’s largest holdings.
- McDonald’s Corp. (1.31% of the Fund) advanced 30% during the period. The company has benefited greatly from its all-day breakfast menu, its reorganized discount menu (the McPick 2 platform) and its global refranchising initiative. We believe that management’s recent initiatives will continue to benefit the company’s bottom line.
Investments that Hurt Performance
- Anthem, Inc. (2.46% of the Fund) fell 20% for the year. The health benefits company formerly known as Wellpoint announced last July that it would acquire health insurer Cigna in a stock and cash deal. The deal has yet to close, but Anthem has continued to slide. Higher revenues were not enough to offset higher claims and costs and profits suffered. Although we think the merger with Cigna is positive, the current health insurance market is very uncertain. Anthem announced that it would remain in the Obamacare exchanges; however, we think there is a strong likelihood that this may change after the Cigna merger is consummated.
- Leucadia National Corp. (1.33% of the Fund) tumbled more than 25% as the company continues to transform itself after the retirement of its two founders. Current CEO Richard Handler, who also serves as CEO of the Leucadia subsidiary Jefferies, has evolved the company’s business model towards more merchant banking. The company engages in uniquely structured and often opaque transactions that take more time to pan out. Under prior management, the firm’s track record was impeccable. We are closely watching to see if the current management is capable of similar results.
Queens Road Small Cap Value Fund
For our fiscal year ending May 31, 2016, the Queens Road Small Cap Value Fund returned 3.37% compared to a return of -2.75% for the Russell 2000 Value Index.
Investments that Helped Performance
- Fabrinet (2.04% of the Fund) was up 94% for the period. This manufacturer of complex optical components was founded in 2000 by Seagate Technologies co-founder Tom Mitchell and went public in 2010. The company continues to increase utilization rates at its new manufacturing facility while gaining new customers. Demand for its technology and highly specialized manufacturing processes is increasing, and it is finding new applications for this technology as well.
- Piedmont Natural Gas Co. (0.00% of the Fund) increased 56% during the period. On October 26, 2015, the company announced it had reached an agreement with Duke Energy to be acquired for $4.9 billion in cash. This amounted to an approximate 40% premium above Piedmont’s previous closing price.
- RLI Corp. (1.97% of the Fund) returned 42% in fiscal 2016. RLI is an A+ rated specialty insurer that focuses on unique and hard-to-place risks. The company continued its streak of consecutive dividend increases, which now stands at 40 years. This conservatively-run, well-managed insurer remains one of the fund’s top holdings and we are very confident in its long-term prospects.
Investments that Hurt Performance
- Ducommun Inc. (0.81% of the Fund) fell 28% for the period. A California-based manufacturer of aerospace structures and electronic and mechanical assemblies, Ducommun is a key supplier to OEMs in many of the world’s most advanced aeronautical programs. Significant revenue reductions due to changing U.S. defense spending priorities hit the company hard, resulting in significant decreases in operating income. In addition, the company took a charge to refinance outstanding debt, which will reduce debt levels and future interest expenses. Management does not appear to be very confident that demand will pick up in the near term and is focusing on cost control. We also have demand concerns and have been reducing our exposure.
- Synaptics Inc. (2.13% of the Fund) fell 32% during the year. The company believes it is the leader in human interface technology for smartphones, tablets and touchscreen applications. The company posted weak earnings and guidance during the period, as it faced headwinds from slowing smartphone sales growth. Though the company had been reported to be in buyout talks with a Chinese firm, it was later reported that these talks have broken down. In spite of the recent underperformance, we are confident in the company’s products and long-term prospects.
The Fund continues to be invested in a defensive position, and holds 25.78% in cash equivalents as of May 31, 2016.
The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Queens Road Funds at May 31, 2016, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds’ portfolios and Queens Road Funds’ investment intentions with respect to those securities reflect the portfolio manager’s opinions as of May 31, 2016, and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Queens Road Fund-managed portfolio in the future.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. The prospectus contains important information on the Fund’s investment objectives, risks, and charges and expenses. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap stocks which may involve considerably more risk than investing in larger-cap stocks. (Please see “Primary Risks for Fund Investors” in the prospectus.)