2018 Annual Letter to Shareholders
May 31, 2018
Dear Fellow Shareholders:
During the fiscal year ended May 31, 2018, the Queens Road Value Fund returned 9.25% versus 8.94% for the S&P 500/Citigroup Value Index. The Queens Road Small Cap Value Fund finished the fiscal year ended May 31, 2018, with a return of 7.55% versus 16.35% for the Russell 2000 Value Index.
As the bull market which began in March of 2009 continues to plug along, two of the biggest factors on the forefront of investors’ minds are increasing short-term interest rates and a potential global trade war. Short-term interest rates are on the rise with the Federal Reserve (the “Fed”) raising rates six times since December 2015. These moves have pushed interest rates higher, but the current rate level is still relatively low as the Fed’s neutral rate is around 3%. The Fed has hinted that they expect to have a total of four hikes during 2018—a sign they expect continued economic growth and are not putting too much stock into predictions of a full-blown trade war. The unemployment rate stands at 3.8% as of May’s reading—the lowest rate since 1969—and is still trending lower across all areas of the labor market. Any further improvement in the labor market may result in wage pressures and a pick-up in inflation, which could signal that the economy is beginning to overheat as it usually does late in the economic cycle. This may prompt the Fed to raise rates at a faster pace and even overshoot the 3% neutral rate. As the Fed has steadily raised rates, the difference between short- and longer-term Treasury yields has narrowed. Historically, when the three-month Treasury yield has risen above the yield of the ten-year Treasury (referred to as a yield curve inversion), it has been a reliable warning sign of an impending recession. When the curve has inverted, a recession has generally started within two years. We aren’t there yet, but it is something we are watching closely. In the interim, the Fed will likely keep pushing interest rates higher as long as the economy and the stock market continue to do well. That raises borrowing costs for everyone but doesn’t necessarily mean stock prices will fall as a result. In fact, the stock market generally rises during periods when the Fed is hiking rates, as you can see in the accompanying chart. It shows market returns during periods when the Fed raised rates by more than 1% over the past 35 years.
While tariffs on hundreds of billions of dollars’ worth of imports have been discussed by the Trump administration, thus far, tariffs on just $34 billion in Chinese imports have been enacted since the March steel tariffs. As retaliation, China enacted their own tariffs, in this case on $34 billion worth of US exports. While a large number, it equates to less than 0.2% of our GDP. Though we are currently talking trade on three fronts—China, Mexico and Canada (North American Free Trade Agreement – NAFTA), and Europe—we haven’t yet devolved into an all-out trade war. As you see from the world map of global tariff rates, the US has a long way to go before we are truly considered a protectionist country and trade restrictions have a major impact on our economy. The back-and-forth rhetoric is having an effect, however, as many businesses are delaying new projects and wage increases due to trade worries. The Atlanta Federal Reserve Bank recently cut their previous Gross Domestic Product (GDP) growth estimate for the second quarter from 4.8% to 3.8% as a result. The trade situation is likely far from over. We are still hoping for a negotiated resolution because we’ve learned from history that no one tends to win in a prolonged trade war.
In our view, earnings growth is built into market prices. According to Factset, S&P 500 earnings are expected to grow by 20,5% in 2018. And yet the S&P 500 Index is up just 2.7% for the year. In what may seem like a contradiction, stock returns are usually lower when earnings growth is high. Conversely, returns are usually higher when earnings growth is low or negative. This is because the stock market is forward looking. Expectations for future earnings are usually already reflected in current market prices. The stock market detests uncertainty, so we are likely to continue to see bouts of volatility while the trade situation plays out. The first quarter of 2018 provided an excellent example of volatility created by uncertainty. A better-than-expected wage-growth report in early February created enough uncertainty regarding inflationary pressures to set off a 10% correction for the S&P 500. The correction brought an abrupt end to an exceptionally strong rally that marked the first four trading weeks of 2018. A high level of uncertainty (fear) may mean that market participants see an above-average probability of a pending recession or slowing earnings growth but this uncertainty also creates an environment where unexpected good news can potentially move stock prices higher.
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 nine years into this bull market 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=””]Matt DeVries, CFA
PORTFOLIO MANAGER’S COMMENTARY
Queens Road Value Fund
For the fiscal year ending May 31, 2018, the Queens Road Value Fund returned 9.25% versus 8.94% for the S&P 500/Citigroup Value Index.
Companies That Helped Performance
- Intel Corp. (3.35% of the Fund) rose 57% during the fi scal year. The world’s largest semiconductor manufacturer continued to produce better than expected financial results as the company’s transition from being PC-centric to Data-centric bears fruit. Demand for data center products continues to grow rapidly and Intel’s focus on this segment has made them a clear leader. In spite of the recent surge, the stock still trades below our estimate of intrinsic value.
- T. Rowe Price Group, Inc. (2.24% of the Fund) returned 77% for the fiscal year. The company continues to fight the trend of money flowing from active managers to passive investments as assets under management increased to just under $1 trillion. The company has a proven investment philosophy that has generated outstanding long-term performance and provided them with one of the best reputations in the business. The solid performance of the company has allowed them to raise their dividend for 31 consecutive years. Although we are confident in the firm and its management, the current stock price is testing our estimates of fair value.
- Cisco Systems, Inc. (3.74% of the Fund) increased 40% during fiscal year. Cisco is a leader in switching and routing which is at the core of network management and the internet. The explosive growth in data center and cloud computing has benefited the company and should continue to in the foreseeable future. The company has also been successful in making significant
acquisitions and integrating them effectively and expanding its product lines. With over $50 billion of cash on its balance sheet, we expect this trend to continue. While not the bargain it was when we began purchasing it, we feel the company remains fairly valued.
Companies That Hurt Performance
- Symantec Corp. (0.58% of the Fund) fell 31% during the fiscal year. In May, the company announced it is investigating its non-GAAP reporting which may have resulted in improper executive bonuses. On the day of the announcement, shares fell 33% even as the company also announced they didn’t expect the investigation would have a material adverse impact on its
historical financial statements. While the selloff has made the stock look attractive on a valuation basis, we are concerned with management’s lack of candor and the risk that other issues may come to light from the investigation. We are following this closely.
- Procter & Gamble Co. (1.51% of the Fund) dropped 14% during the fiscal year. After years of acquisitions, the well-known consumer products company is in the midst of a long-term transition in which the company plans to reduce its brand portfolio by half. This is occurring during a period of rapid change in the consumer staples sector, where both consumer preferences appear to be changing as well as distribution channel changes (i.e. shelf space is not as valuable a commodity as it used to be.) In addition to rationalizing brands and markets, the company is also focused on an extensive program to revitalize the remaining product lines through re-engineering, packaging updates and innovation. Many of these initiatives are being pushed by activist Nelson Peltz who recently was appointed to the board of directors. We continue to watch closely for signs that the strategic plan they are executing is going to lead to improved financial results.
Queens Road Small Cap Value Fund
For the fiscal year ending May 31, 2018, the Queens Road Small Cap Value Fund returned 7.55% compared to 16.35% for the Russell 2000 Value Index.
Companies That Helped Performance
- Deckers Outdoor, Corp. (3.21% of the Fund) rose 63% during the fiscal year. Best known as the makers of Ugg, Teva and Hoka One One footwear, the company has continued to perform well, posting strong earnings, increasing guidance, and providing a favorable update from management on the progress of its strategic restructuring plan. In the face of a very challenging retail environment, management has done an exemplary job of transitioning to an omni-channel strategy that balances sales across retail, wholesale and e-commerce channels to drive growth and increase operating margins. While the Ugg brand (81% of sales) performed well, growing 4% last year, the Hoka One One brand continued its rapid growth topping $100 million in sales for the first time, up from less than $10 million in sales four years ago. With a pristine balance sheet, reasonable valuation and capable management, we are confident in the company’s long-term prospects.
- Syntel, Inc. (2.21% of the Fund) increased 80% during the fiscal year. Syntel is an information technology and business process outsourcing provider. The company’s 22,000 employees help clients build IT applications that increase efficiency, expand capabilities, and reach new markets and customers. With over 75% of its billable workforce in India, the company is a big beneficiary of the US’s H1B work visa program. The current administration while initially in favor of cutting the program has since backed off. We think this provided investors with confidence and is a main driver in the recent stock move. The company also faces concentration risk with roughly half of their revenue coming from the financial services industry and
American Express accounting for about 20% of revenue. While this is a concern, the company has a strong record of renewing contracts and switching costs are high assuaging our fears. With the recent stock price appreciation, the stock is now trading near our estimate of fair value.
- DST Systems, Inc. (0.00% of the Fund) was up 39% for the period as SS&C Technologies announced in January that it would purchase the company for $84 per share. The all-cash closed in April of 2018.
Companies That Hurt Performance
- Synaptics, Inc. (1.51% of the Fund) fell 24% during the fi scal year. Synaptics continues to struggle as it transitions from its heavy reliance on smartphones (primarily touchscreen sensors and controllers) towards a more diversified revenue mix by expanding its presence in the Internet of Things (IoT) market (touch, voice and audio sensors). According to management, almost every top automotive display manufacturer is building panels with their touch controller products. While this transformation has been bumpy, we are encouraged by the higher margins their IoT product commands. This is borne out in the higher gross margins the company has reported recently and we believe this trend will continue. This long-term holding has clearly tested our patience but we are seeing slow but concrete progress and remain confident in the company’s long-term future.
- Anixter International, Inc. (1.58% of the Fund) fell 19% for the fiscal year. Anixter is a wire and cable distributor serving the security, electronics and utility industries. The company aims to reduce clients supply chain costs by providing technical and logistics expertise on the 600,000 products it offers. They have seen sluggish organic growth in their largest segment, Network and Security Solutions but that should correct with the signing of a new supply agreement with an existing large customer. The company maintains unique capabilities and serves industries with a large addressable market. We like management’s focus on Return on Tangible Capital and the free cash flow it generates.
- Tech Data Corp. (2.70% of the Fund) declined 10% during the fiscal year. Tech Data is a distributor of technology products selling over 150,000 products through over 125,000 resellers in over 100 countries. Their global footprint and extensive technical capabilities have created an enviable position in the market. The company made a major acquisition in 2017, acquiring
the Technology Solutions business from Avnet giving them a significant entry in the Asia market. Technology Solutions is in a similar business as Tech Data but with a focus on data centers. We believe management will run the combined company with the consistent execution we have seen historically. Although a slow grower and in a thin margin business, we believe the
company will continue to produce consistent and significant free cash fl ow and an acceptable return on invested capital.
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, 2018, 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, 2018, 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.)