“Make one pass for a good shot, two passes for a better shot,
and three passes for a layup.”
–UCLA Basketball Coach John Wooden
The Queens Road Small Value fund finished 2016 with a gain of 15.59%. While attractive on an absolute basis, the return was well short of the benchmark, the Russell 2000 Value Index, which returned 31.74% for the period. It was a volatile year for the US stock market. After a dismal start, the market began to push higher in March after the Federal Reserve backed off its plan for multiple rate hikes during the year. Prices climbed steadily through October albeit with a temporary dip following the Brexit vote in June. Weakness and volatility just prior to the US presidential election evaporated after Donald Trump’s surprise victory; by year end, the Dow was flirting with 20,000 and the Russell 2000 was within a few points of an all-time high.
Queens Road Funds communications director John Bragg, CFP®, held a Q&A session in early January with portfolio manager Steve Scruggs, CFA, and investment committee chair Benton Bragg, CFA.
Important Performance and Expense Information
All performance information reflects past performance, is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Current performance may be higher or lower than performance quoted. Returns as of the recent month-end may be obtained by calling (888) 353‑0261.
Investment return and principal value will fluctuate, so that shares may be worth more or less than their original cost when redeemed. There can be no assurance that the fund will meet any of its objectives.
From inception to 12/31/2004 the Fund’s manager and its affiliates voluntarily absorbed certain expenses of the fund and voluntarily waived its management fee. Had the Fund’s manager not done this, returns would have been lower. The Fund’s manager and its affiliates do not intend to absorb any expenses or waive its management fee in the future.
Queens Road Small Cap Value Fund invests primarily in small-cap companies which may involve considerably more risk than investing in larger-cap stocks.
Q: I’m here with Steve Scruggs, portfolio manager for the Queens Road Funds, and Benton Bragg, analyst on the funds and chair of the Queens Road investment committee. Steve and Benton, let’s get right to the question on the minds of our shareholders. The Queens Road Small Value fund gained 15.6% for the year, but the Russell 2000 Value Index, the fund benchmark, gained over 31%. That is a wide margin of difference.
Steve Scruggs: Although our return was disappointing relative to our benchmark, the portfolio performed about the way we would expect in the type of market that we saw last year. We outperformed our benchmark significantly during the first quarter sell-off and during the brief Brexit decline. But characteristically, we trailed our benchmark as the market rallied in the second half of the year, especially after the presidential election. When emotion takes over and stocks rally hard, we tend to trail. Although it never feels good, we’ve endured periods like this before. We trailed the Russell 2000 Value Index by about 14% in 2006 as the market approached what were then record-high valuations. As painful as it was to lag our benchmark then, our discipline positioned our portfolio to outperform significantly during the financial crisis. We think it is critically important not to allow emotions to affect our decision making. It doesn’t matter how we feel—what matters is the math behind the valuation process that we use to find companies that are trading at reasonable valuations.
Q: What factors contributed to the performance lagging the Russell 2000 Value Index?
Steve Scruggs: There were two major contributors and a few minor things that contributed to our lagging the index. The first thing is the amount of cash that we are holding. Currently, it is 25% of the portfolio. In a year like last year, that hurt the fund by about 7%.
The second significant thing that hurt the portfolio was our lower allocation to financial stocks. At year-end, financial stocks comprised about 42% of the Russell 2000 Value Index. 20 of the largest 50 largest holdings in the index are financials. In comparison, only 14% of our portfolio was in financials at year-end. Small cap financial stocks were up almost 40% last year so our lower allocation hurt us by approximately 8%.
Q: The portfolio has been underweight financials for several years. Why?
Steve Scruggs: While we’ve had positions in several insurance companies, we’ve avoided banks for the most part. The smaller banks we typically consider for inclusion in the portfolio have continued to struggle with the onerous regulatory environment. They simply lack the resources of their larger competitors and the focus on compliance has crowded out a focus on profit-making activities. Weak loan demand has created a competitive race to the bottom as refinancing has accounted for a significant percentage of loan volume. Added to this, the Fed’s distortive low rate environment has squeezed net interest margins to extremely low levels.
Benton Bragg: Many of the bank stocks soared after the surprise Trump election in response to promises of a reduction in regulations, specifically a modification of Dodd Frank. Regional US banks gained nearly 30% in the final quarter of the year. We think investors may be getting a bit ahead of their skis here. At current valuations, banks appear to be priced for perfection. In this case, perfection means Trump delivers what he has promised: the trifecta of tax cuts, massive deregulation and stimulus spending. The combination of these would arguably put money into the economy and stimulate loan growth. Higher interest rates would improve net interest margins and banks could focus more on profits and less on compliance. We like this narrative and we are optimistic about the pro-business approach that Trump brings to the White House. But we are also realistic about the Washington political process which moves slowly and requires compromise. As always, we’ll resist following the crowd or focusing on macro issues such as potential legislation or the direction of interest rates. We’ll continue to focus on the valuations and investment merits of individual companies.
Q: Can you elaborate on the cash position?
Steve Scruggs: We’ve talked about cash in previous communications, but let me restate our thinking about cash. Holding cash is never a market call. It is always a result of our investment process. We use a Graham & Dodd based, bottom-up process to find good companies that we can buy at attractive prices. Our process leads us to buy high-quality companies: those with strong balance sheets, consistent cash flow and low debt. Today, quality companies look expensive. Back in 2008 and 2009, we were able to find lots of wonderful companies at great prices and we bought them. In the spring of 2009 we took cash down to approximately 3%. With today’s valuations, it’s more challenging. We may find an attractively priced company but often it is due to some negative announcement such as an accounting restatement, a management change or the loss of a significant customer. We’ve taken positions in some of these cases but even these opportunities are becoming scarce.
Q: John Wooden, famous UCLA basketball coach and winner of ten NCAA basketball championships, once said, “Make one pass for a good shot, two for a better shot, and three passes for a layup.” Do you feel like you are “passing” a lot more these days?
Steve Scruggs: Yes, the “lay-up” that John Wooden preferred is exactly what we found in abundance back in 2008 and 2009. Continuing with the basketball analogy, I guess I’d say we now find ourselves passing up well-defended, 40-foot three-point opportunities. Even Steph Curry, two-time NBA MVP and lights-out three point shooter for the Golden State Warriors, would pass up that shot! We look for a margin of safety with everything that we buy. If we cannot feel confident that we are getting a discount to intrinsic value, we will pass to look for a better opportunity. This has resulted in our holding more cash.
Q: Were there other sectors that helped or hurt the portfolio?
Steve Scruggs: Relative to the index, we were underweight in materials and energy last year and both sectors had strong performance. Materials were up over 50% and energy stocks were up about 37%. As we have discussed before, we have traditionally been underweight in energy and materials. In our view, an investment in these companies is essentially a bet on the price of the underlying commodity. An oil company may have a great balance sheet and a wonderful management, but if the price of oil falls dramatically, so will the stock price. Similarly, when commodity prices go up a lot, even the worst managements look good. Instead of trying to forecast the price of oil or other commodities, we choose to look at sectors that are less driven by the supply and demand of a basic commodity. We know this approach will hurt us at times and help us in other times. Last year as the price of oil rose, it hurt us. The previous year as oil dropped below $30 per barrel, it helped us significantly.
Q: Did you have any individual positions that helped or hurt the portfolio last year?
Steve Scruggs: A few companies come to mind: Synaptics and Orbital were down, but we did well with Oshkosh and Ducommun. With Synaptics and Orbital, we studied the issues that caused the decline and felt confident in our assessment and thesis and we added to these positions.
Synaptics (SYNA) hurt us last year, falling from $77 per share to the mid-$50’s. When you press the thumbprint sensor or swipe the screen on your Iphone or Samsung smartphone, you are likely using Synaptics technology. Investors punished the stock last year in reaction to slower sales of the iPhone 7 and worries over the possible loss of some Samsung contracts. We think the market is overreacting. The company’s touch technology is best-of-class in our view and is found in many of the latest touchscreen and mobile devices. Synaptics recently signed an agreement with Huawei, the largest smartphone maker in China, to provide the touchscreen sensor. The company has a strong balance sheet, experienced management and is currently trading at multiples of earnings and free cash flow that we find attractive.
Orbital ATK (OA), our second largest holding, detracted from performance last year. The stock declined by approximately 20% in August after management disclosed an accounting error related to a military contract. Orbital makes rockets and parts that are used in defense, space and flight systems. In addition to launching satellites and making missile defense systems, they also make the rocket systems used to resupply the international space station. We’ve owned Alliant Tech Systems (which merged with Orbital in 2015) on and off since 2002 as we liked their balance sheet, cash flow, valuation and management. The company announcement back in August dealt with improper accounting of revenue and expenses on a specific contract. While the restatements were not significant to their overall profits, the restatement cast some doubt on management and investors punished the stock. We studied the issue at length and were pleased with the action that management took to correct the error. We think investors overreacted to the news and we remain comfortable with our assessment. Orbital continues to be our second largest holding in the portfolio.
Oshkosh Corp (OSK) was up 68% last year. We’ve owned them for over 10 years and know the company and management really well. They have four divisions that all make heavy equipment from fire and rescue trucks to cement mixers and construction equipment to light, medium and heavy duty trucks and haulers for the military. The company did well last year as both presidential candidates promised infrastructure spending and Trump’s comments on defense spending gave an extra boost to the stock.
Ducommun (DCO) was up 58% in 2016. The company was started in California in 1849 and was an integral part of the birth of aircraft industry. Today they provide highly specialized parts for the aircraft, defense and aerospace industries and have a significant backlog of contracts with Boeing and Airbus. The next time you are sitting on a plane, check out the upturned winglet at the end of the wing. Ducommon makes these winglets that help with lift and fuel efficiency. We have owned Ducommun since 2008 and are glad that we remained patient as the stock fell 35% in 2015 partly due to sequester-related cuts in defense spending. We studied the financials closely and held on to our position and are pleased with the recovery in price in 2016.
Q: The portfolio selection process at Queens Road Funds emphasizes quality companies characterized by strong balance sheets and recurring cash flows from operations. Much has been made of the fact that higher quality companies did not perform as well as lower quality companies last year. Is there anything on the horizon that would suggest a shift to quality companies?
Steve Scruggs: That is correct. While there are some exceptions, our portfolio is dominated by higher quality companies. Generally speaking, higher quality companies, those with stronger balance sheets and lower levels of debt, did not do as well last year as highly levered companies. We think two things might shift investors towards higher quality companies.
The first is Fed action. In December, the Federal Open Market Committee of the Federal Reserve finally took a second step to raise interest rates. The original move was back in December 2015 and the market reaction then was negative; the broad market declined by about 10% over the next 60 days. That market slide ended abruptly in March of last year when Fed Chair Janet Yellen stepped in to reassure investors that future rate increases would be delayed. Fast forward 12 months and it appears that the excitement over a pro-business Trump administration has overshadowed any worry about higher interest rates. News of the Fed’s second rate hike has largely been ignored by equity markets. In our view, the lofty valuations of financial assets (stocks, bonds, real estate) we see today have in part been driven by the easy-money policies of the Fed over the last nine years. It therefore doesn’t seem to be a stretch to conclude that tighter monetary conditions would pose a headwind for asset prices going forward. With the Fed projecting 2-3 more rate increases in 2017, we anticipate highly levered companies (lower-quality companies) faring worse than those companies with less dependence on debt.
The second shift we have seen is a decrease in the correlation of performance of individual stocks. During momentum-driven bull runs, the correlation of returns tends to be very high as all stocks regardless of quality move higher. After the election, the correlation of the stocks of the S&P 500 Index dropped to its lowest level since before the financial crisis. This should bode well for active managers that pay attention to risk.
Q: We often remind current and prospective shareholders that we “eat our own cooking” at Queens Road. Our portfolio managers, analysts, trustees, employees and family members are significant shareholders in our funds. In light of the recent under-performance vs. our benchmark, what can you say to reassure shareholders?
Benton Bragg: In a word, patience. We’ve been here before. Sometimes the market is focused on fundamentals—the math behind arriving at the proper value of a company based on expected future earnings. Sometimes, investors seem to ignore valuations. It’s as if reality is suspended. While the suspension is always temporary, these periods can last a long time and it requires discipline to stay the course. Eventually, the market always returns to fundamentals. Over full market cycles we think that our disciplined process will reward the patient investor.
Steve Scruggs: We are now beginning the 9th year of a bull market. This bull has stumbled a few times over those nine years, but by and large, it has gone straight up. Since the bottom in March of 2009, there have only been three quarters when the Russell 2000 Value Index lost 10% or more.
Take a look at the chart below. It shows the last ten losing quarters for the Russell 2000 Value Index. Our focus on high-quality companies leads us to strong, often “boring” companies that will lag when stocks go straight up. However, when investors are paying attention to risk, when there is some worry and fear in the markets, our fund has a demonstrated history of out-performing our benchmark and peers.
Q: The long term record over the past ten years and since inception shows the Queens Road Small Value fund out-performing the Russell 2000 Value Index. How does it look so strong when the shorter term three-year and five-year performance lags the benchmark?
Steve Scruggs: The shorter term three and five-year performance reflects the massive bull market run from 2009 to the present. The 10-year performance captures the period of 2007-2016 which includes the market decline and subsequent bull run. To reiterate, when stocks go straight up, we typically lag our benchmark and we have done just that over the three and five-year period. Over a full market cycle, however, which is clearly captured over the 10-year and since inception periods, we have produced a return greater than the index and done so with significantly less risk.
Below is another chart that shows our lower volatility and higher returns vs. the Russell 2000 Value Index and the Morningstar Small Value peer category.
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Morningstar Risk/Reward graph plots the return and risk (measured by standard deviation) for a selection of securities and a benchmark index for the trailing period identified in the report. The table beneath the graph identifies the specific risk and return plot points for the graphed securities and the benchmark index. The returns noted for a security reflect any sales charges that were applied in the illustration over the time period selected, but do not reflect impacts of taxation. If impacts of taxation were reflected, the returns would be lower than those indicated in the report. The return plotted in the graph is mean geometric return. Standard deviation is a statistical measure of the volatility of the security’s or portfolio’s returns in relation to the mean return. The larger the standard deviation, the greater the volatility of return in relation to the mean return.
Q: Do you have any final thoughts?
Steve Scruggs: I will echo Benton’s words and encourage my fellow shareholders to have patience. I know it is hard during periods like this. I recall the period in the late 90’s when hot growth funds soared past boring value managers that used math to value companies. Suddenly, it looked like math didn’t matter and earnings didn’t matter when it came to putting a price on a company. It was hard then, and it is hard now. Hang in there. Markets always return to fundamentals and this one will at some point, too. We aim to take full advantage of the opportunity when the time comes.
Thank you for joining us as shareholders in the Queen Road Funds. Please know that we remain available for update calls with our partners in the RIA community. Thank you for your confidence in our process and our firm. We look forward to serving you in the new year.
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 January 24, 2017, 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 January 24, 2017, 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.)