2017 Annual Letter to Shareholders
May 31, 2017
Dear Fellow Shareholders:
During the fiscal year ending May 31, 2017, the Queens Road Value Fund returned 15.31% versus 14.73% for the S&P 500/Citigroup Value Index. The Queens Road Small Cap Value Fund finished the fiscal year with a return of 7.87% versus 21.00% for the Russell 2000 Value Index.
U.S. equities continued their broad advance throughout the year as overall earnings of the S&P 500 grew, led by a sharp rebound in the energy sector. Earnings are projected to continue to grow modestly throughout the year and companies are holding record cash balances of over $1.8 trillion. We had been concerned that when the Federal Reserve began to raise interest rates it would prompt a sharp sell-off in equities such as that we experienced when the Fed hiked rates in December of 2015. Instead, prices held up well in the face of two quarter-point rate hikes during the fiscal year (December & March). The Fed has indicated they will continue to raise rates as long as economic conditions warrant. We welcome a transition from a central-bank-manipulated rate environment to one driven by market forces. We believe this will benefit higher-quality companies such as those we own in the portfolios.
The Elephant in the Room
Just when you thought it was impossible for Washington, D.C. to become more dysfunctional, our elected officials surprise us. The Trump agenda of tax cuts, regulatory reform and stimulus spending that prompted optimism and a market rally upon his election has hit several roadblocks. Even as Republicans control the White House and both branches of Congress, the inability to compromise has thwarted efforts to pass major legislation. In spite of this, large cap U.S. equity prices have continued the steady climb higher and small cap stocks, while relatively flat since Trump’s inauguration, have held on to the gains from the strong post-election rally.
Economic growth remains at the same tepid levels we’ve experienced over the decade, hovering around 2%. The lack of economic growth in the face of unprecedentedly accommodative monetary policy by the U.S. Federal Reserve Bank and central banks around the world remains worrisome. We are eight years into this economic expansion, the first ever with zero percent interest rates, and we have yet to achieve annual GDP growth above 3%. In spite of the lack of economic growth, asset prices by many measurements have reached all-time highs. On the bright side, the labor market appears remarkably robust with unemployment dropping to 4.4%. Furthermore, job openings in April of 2017 hit an all-time high of just over 6 million (compared with 6.9 million Americans unemployed). These figures show that businesses are actively pursuing employees (a good thing), but qualified employees are hard to come by. Further evidence of this can be seen in the Labor Force Participation Rate of Prime Age Men and Women. In 1990, about 94% of men and 75% of women between the ages of 25 and 54 were working or actively looking for work. Today the number for women remains approximately 75% but the rate has dropped to 88% for men. There are only two ways GDP can grow: through growth in the labor force and increased productivity. The declining trend in labor-force participation appears to be a structural one that is serving to inhibit GDP growth. Relating this back to the dysfunction in Washington, policies designed to incentivize employment and increase training programs could help reverse this trend if our elected officials could work together.
Another major concern since President Trump’s inauguration has been the debate over how to reform Obamacare. While well-intended, the Affordable Care Act in effect put 20 million more people into a broken health care system. Partially designed by the pharmaceutical and health insurance industries, the law has provided millions with insurance who wouldn’t have otherwise received it but does so in the same inefficient system rife with conflicts of interest and irrational pricing. In the U.S. we currently spend 18% of our GDP on healthcare ($10,000 per year for every American) and that number is expected to rise to 20% by 2025, according to the U.S. Department of Health and Human Services. Again, there are some common-sense reforms that could curtail this rise and increase efficiency in the delivery system if our elected officials in Washington could find a way to compromise.
We generally don’t opine about economic trends in these letters, nor do we tend to look to Washington for “solutions.” However, the current level of dysfunction in Washington is clearly having negative impacts on our economic vibrancy, and the trends appear to be structural. These trends are moving, albeit slowly, in the same (wrong) direction with no expected change in sight. Trump’s campaign promise to “Make America Great Again” was received with optimism both on Main Street and in boardrooms. But his and Congress’s inability to negotiate and compromise to make common-sense changes is frustrating.
We think we’ll eventually see reforms that will stimulate economic growth. Winston Churchill is credited frequently but apparently erroneously with a quote regarding U.S. policymaking decisions: “Americans will always do the right thing – after exhausting all other alternatives.” Let’s hope we are close to exhausting all other alternatives. Outside of the political arena, we are encouraged by the fact that in spite of these headwinds, the U.S. continues to have the largest, most dynamic economy in the world and is home to the most innovative companies anywhere. We’re confident that despite the lack of leadership among our elected officials, these companies and our economy have a very bright future.
As bottom-up investors, we continue to focus on the individual companies in our portfolios and our investment universe. We continue to “turn over rocks” looking for companies we believe have the best long-term prospects for creating shareholder value. But eight years into this bull market, with stock averages trading at all-time highs, we are finding it increasingly difficult to find new companies that meet our investment criteria. In fact, some of our holdings in both the Queens Road Value Fund and Queens Road Small Cap Value Fund are approaching or surpassing our estimates of intrinsic value and we are trimming or eliminating them from the portfolio. We continue to hold to our long-term view reflecting our discipline and patience and are optimistic about the prospects of the companies we own.
We appreciate the confidence you place in us to invest your capital wisely. We stand beside you as investors in our funds and are confident in the investments we hold. If you have any questions regarding our process or our portfolios please give us a call.
[one_half last=”no” class=”” id=””]Steven H. Scruggs, CFA
President, Portfolio Manager[/one_half]
[one_half last=”yes” class=”” id=””]Benton Bragg, CFA, CFP®
PORTFOLIO MANAGER’S COMMENTARY
Queens Road Value Fund
For the fiscal year ending May 31, 2017, the Queens Road Value Fund returned 15.31% versus 14.73% for the S&P 500/Citigroup Value Index.
Investments that Helped Performance
- Symantec Corp. (1.70% of the Fund) rose 77% during the period. When we purchased Symantec there was very negative market sentiment on the share price due to the outlook of its Consumer Security segment (Norton). At the time we felt the sentiment was overdone and the company was making inroads with its Enterprise segment. Much has happened since then with the divestiture of the Information Management segment (Veritas) and the purchase of Bluecoat Systems, Inc. and LifeLock Inc. and the company is focusing on being a pure-play security company. In spite of an increased debt load to fund the acquisitions, management appears to be managing this strategy adequately but current valuations are testing our estimate of intrinsic value.
- General Dynamics Corp. (3.80% of the Fund) was up 46% for the year. Defense contractor and business-jet manufacturer General Dynamics saw its share price benefited “bigly” along with other defense companies with the surprise election of President Trump last November. Following a large post-election bump, the company’s share price has steadily risen higher on expectations of increased economic growth and defense spending. Operationally, the company continues to deliver on its extensive backlog of defense contracts and is increasing production of its two newer models of Gulfstream business jets. In spite of the recent increase in share price, we remain comfortable with the company’s valuation and future prospects.
- Anthem Inc. (3.11% of the Fund) gained 40% during the fund’s fiscal year. During the last year, Anthem (the second largest health insurer in the U.S.) announced an intent to merge with competitor Cigna (the fourth). Subsequently, the merger was blocked on the grounds it would harm competition. In spite of this and the well-publicized profitability issues with the ACA insurance exchange, a major market for Anthem policies, the company performed admirably, and maintained its level of profitability. While there are challenges within the market and within the company, the higher trends in healthcare spending and Anthem’s competitive position within the market provide us with confidence in the company’s future.
Investments that Hurt Performance
- Bristol Myers Squibb Company (0.63% of the Fund) declined 23% during the fiscal year. Since shedding its non-pharmaceutical businesses over the last several years, Bristol Myers has focused on a stable of branded pharmaceuticals in a broad range of applications including HIV and hepatitis infection control, and cardiovascular and neuroscience uses. But the company’s largest focus is in the area of immuno-oncology (I-O). I-O is a rapidly growing treatment area using biologically produced compounds to work in concert with a patient’s immune system to fight cancer. Bristol Myers’ lead product in this area, Opdivo, has received both good news and bad news in some of its clinical trials over the last year. Although this market is very competitive, with other major pharmaceutical companies offering or developing competing products, we feel confident in the prospects for this blockbuster drug and the company.
- VF Corp. (1.76% of the Fund) dropped 11% during the period. VF Corp. owns a portfolio of some of the world’s most well-known clothing brands, including The North Face, Lee jeans, Timberland, and Nautica. The apparel market is in a stage of rapid transition. The much-discussed market share gains e-commerce sales have taken from traditional apparel retailers are causing a great deal of disruption in the markets. We feel VF Corp. is doing a good job of managing through this with its efforts to ramp up its “direct-to-consumer” channel. Though we expect continued turbulence in the industry, we believe VF Corp. is positioned to maintain its leading position.
- T. Rowe Price Group Inc. (1.30% of the Fund) fell 6% during the period. Asset manager T. Rowe Price benefited from rising equity prices over the year that increased its assets under management (AUM); however, redemptions from their actively managed mutual funds more than offset this to leave net AUM lower for the year. Although the company’s mutual funds in general have provided attractive returns versus their benchmarks over the last several years, the trend towards ETFs and passive investing has hurt the near-term performance of the company. We feel this trend is cyclical as it is commonly seen in the later stages of bull markets. We have confidence in the company’s long-term ability to provide investors with the benefits of active management.
Queens Road Small Cap Value Fund
For the fiscal year ending May 31, 2017, the Queens Road Small Cap Value Fund returned 7.87% compared to 21.00% for the Russell 2000 Value Index.
Investments that Helped Performance
- Ducommun Inc. (0.95% of the Fund) rose 88% during the period. The aerospace and defense company reported strong earnings numbers and backlog as the major commercial aerospace platforms they supply continued to increase build rates throughout the year. Additionally, the defense segment stands to benefit from increased military spending under a Republican White House. Management appears to be making progress on its efforts to move towards higher value-added (and higher margin) solutions. While we are pleased with the share price-performance, we have some concerns over current valuation and continue to monitor the company closely.
- Oshkosh Corp. (2.15% of the Fund) was up 39% for the period. The maker of military trucks, commercial vehicles and access equipment rallied on the hopes of increased defense and infrastructure spending. The company has been increasing deliveries on a major defense contract for its Joint Light Tactical Vehicles but continues to face headwinds in the Access Equipment segment, which makes aerial work platforms. This is one of our longest-held investments and we have confidence in management based on its long-term track record.
- Greenbrier Companies Inc. (2.42% of the Fund) gained 58% during the fund’s fiscal year. We began buying Greenbrier in 2016 as the company’s stock price had declined almost 65% since peaking in 2014. The maker of railcars faced a poor industry outlook in the face of lower oil prices and declining revenues. As we analyzed the company with a long-term view, it appeared that the market had over-reacted to what looked like a cyclical downturn in the rail industry. Confident that this leading manufacturer with a diversified backlog would weather the downturn, we began buying shares in April of 2016 and are pleased that the industry and company’s outlook has improved significantly. Management’s international expansions appear to be on track to deliver future growth.
Investments that Hurt Performance
- Vista Outdoor Inc. (0.28% of the Fund) dropped 58% during the period. Vista was recently spun off from long-time holding Alliant Techsystems, and competes in two segments, Shooting Sports and Outdoor Recreation. The company has recently made two sizeable acquisitions in helmet-maker, Bell Sports, and hydration-products company, Camelbak Products. The company competes in a broad line of retail segments that have been hurt recently by stagnant sales and increased promotional activity has been crimping margins. We are closely following the company’s progress in capitalizing on its extensive portfolio of brands to get back to historical levels of profitability. We feel this could be very challenging.
- Synaptics Inc. (2.58% of the Fund) fell 18% during the period. A leading maker of touchscreen sensors, controllers and biometric sensors, Synaptics has struggled as smart phone sales have stalled globally. The company remains a technology leader and we anticipate increased adoption of both touchscreens and biometric authentication in markets beyond smartphones. However, revenue has been stagnant over the last couple of years and gross margins continue to be pressured as competition in this sector has ramped up. The company remains very dependent on Samsung from whom it derives over 50% of its revenues. This risk profile is causing us to closely examine this investment. We hope to see management making more tangible progress with its strategic initiatives and new product introductions.
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, 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 May 31, 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.)