Bedpans & Bull Markets
2nd Quarter 2017 Investment Commentary
by Benton S. Bragg, CFA, CFP®, Investment Committee Chair

I called home from college in the spring of 1989 to let my parents know that I had decided to go down to Wrightsville Beach that summer to find a job. I figured I could bus tables in a restaurant in the evenings, catch the late-night parties and hang out on the beach all day. Of course I didn't use that precise wording when telling my parents of my plans, but I thought I made a pretty good case for myself. At the time I was just finishing up my freshman year and frankly, things were going pretty darn well. I had done fine academically but more importantly (to me anyway) I had never had more fun. You likely remember it well; for the first time in life you enjoyed total freedom from adult supervision. I cherished the independence, my new friends, the parties, ACC football, road trips, and of course, all those babes at Wake Forest! Life was good. A summer at the beach would be the perfect way to keep the party going.

My father, Frank Bragg, felt otherwise. There was no discussion. "Nope. Be home the day after your last exam." My summer at the beach never materialized. My father has strong opinions on raising children. With regard to children making decisions for themselves, Dad has been known to say, "Of course my kids need to learn how to be good decision-makers. But until they reach the age and maturity that they make the same decision I would make, I'll make all their decisions for them." Apparently I was still a child. And thus it was that I found myself working as an orderly at Presbyterian Hospital during the summer after my freshman year of college. As Dad put it, "Son, you need a reality check. Life is not a party. You are not the center of the universe. I'm not spending fifteen thousand dollars a year for you to go live in a self-centered bubble."

Nancy Snapp was the beloved, long-time head of nursing at Presbyterian Hospital in Charlotte. For thirty years, our company managed the retirement plan at Presbyterian so Dad knew Nancy quite well. He apparently asked her to give me a job doing something that might bring me down a notch or two. As he put it, "Nancy, the boy needs some sensitivity training." Nancy had just the thing for me. I went to work on the sixth floor of the hospital where many of the sickest patients received care. Most of these patients were elderly and frail. Many were near the end of their lives. My duties included changing bed linens, changing hospital gowns and emptying bed pans. These patients needed to be bathed, weighed, fed, lifted and transported each day. This I did. All day, every day. For a healthy, confident, nineteen-year-old, big-man-about-campus, my summer job was like a visit to another planet. Here I was sponge-bathing a ninety-five-year-old man when my pals were hanging out on the beach! It was hard. My father loved it! And you know what? By the end of that summer I was grateful that he made me do it. Working at Presbyterian exposed me to aspects of life and humanity that I had not known. In addition I was privileged to have co-workers who were the most caring, dedicated, and hard-working individuals you'll find.

Like the over-confident, nineteen-year-old Benton Bragg, investors today need a reality check. The market has been on a roll. US stocks have done well, foreign stocks have turned up, and even bonds have contributed. Portfolios are flush. Admit it: your clients' portfolios are worth a lot more than you imagined they would be as you worried through the great recession eight or nine years ago. I wish we at Queens Road could take credit for this state of affairs, but we can't. To paraphrase famed investor Humphrey B. Neill, never confuse a bull market with brilliance. Sure, we have done what you hired us to do: carefully research companies looking for good quality that we can buy at an attractive price. And we have delivered on your expectations to protect capital during down markets and deliver strong performance over full market cycles. But like you, we've been pleasantly surprised with the market's sustained strength, the remarkable length of this rally and the relatively smooth ride we've enjoyed.

Investors have become complacent. Some have adopted a bit of the swagger of a nineteen-year-old college student. Such is the human condition. The further we get from a period of great pain, fear and uncertainty, the more we discount its significance. We explain away what happened with the benefit of hindsight. We readily accept higher levels of risk and we project the recent past far into the future. In some ways we should be thankful for this human characteristic; without risk-taking, early man likely wouldn't have emerged from the cave after his first brutal fight with the mighty mastodon. But he did emerge and he embraced risk. And just look at the remarkable progress he has made since.

But this risk-taking characteristic also makes us vulnerable to making decisions that lead to loss. Ironically, risk is greatest when there is no perception of risk. We're at our most vulnerable when markets are high, when the headlines are positive, when portfolios are flush, when there is no "fear premium" in the market and when investing is "easy." That's where we find ourselves today. Recently I read a headline from the New York Times that read: "Fed Chair Yellen Expects No New Financial Crisis in Our Lifetimes." I found that statement less than reassuring as I recalled then Fed Chair Ben Bernanke's comment on the eve of the financial crisis in 2007: "We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system." Janet Yellen's proclamation is one of many "good-news" headlines we've read lately. In contrast, recall the headlines in 2008 and 2009. Recall your own fears and emotions back then as the market fell 55%, the economy slowed, the banks failed and job losses mounted. Fear was acutely prevalent. But hindsight makes it clear that we should have "backed up the truck" as my dad likes to say and loaded up on stocks. That was the time to be bullish.

But no one wanted to be bullish back then. Even our bravest clients who always "bought the dips" were in retreat back then. Some sold even as markets were down 30-40%. I'm not being critical – I'm just making the point that we're all human and emotion is a powerful force. Our humanness was on display back then and we must acknowledge that it is on display today as we enjoy brimming portfolios and worry far less about our financial position.

So once again, a reality check from Queens Road. Are we suggesting that a market decline is nigh? We are not. We of course can't see the future; the bull might run for months or even years. Likewise, it might not. We are suggesting that for the last eight years we've enjoyed a sustained one-direction market with very few declines of any significance. Normal markets are volatile and we should tell ourselves that the good times won't last forever. At Queens Road, we'll continue to do what we know how to do- carefully turn over rocks looking for quality companies at bargain prices.

On behalf of the whole team at Queens Road, thank you for choosing us for your clients. Please contact John Bragg at (888) 353‑0261 or john@queensroadfunds.com if you have any questions or would like to set up an update call. Have a wonderful summer!

Sincerely,

Benton Bragg, CFA, CFP®
Benton S. Bragg
Chairman

Queens Road Small Cap Value Fund Performance Update

The Queens Road Small Cap Value fund returned 1.31% vs. 0.67% for the Russell 2000 Value Index for the second quarter ended June 30, 2017. Over the past five years as the market recovered from the financial crisis and reached new record highs, the fund trailed the index. The fund out-performed the Russell 2000 Value Index over the longer term ten-year and fifteen-year periods that reflect a full market cycle.

Performance Summary: June 30, 2017

YTD 12
Months
Avg.
Annual
3-Year
Return*
Avg.
Annual
5-Year
Return*
Avg.
Annual
10-Year
Return*
Avg.
Annual
15-Year
Return*
Since
Inception*
Lifetime
Cumulative
Queens Road Small Cap Value Fund 0.53% 10.19% 5.57% 10.82% 6.20% 9.58% 9.56% 294.86%
Russell 2000 Value Index 0.54% 24.86% 7.02% 13.39% 5.92% 8.75% 8.93% 262.21%
Performance as of June 30, 2017; gross annual operating expenses 1.26%
*Performance annualized since June 2002 inception.

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.

Valuations remain high. At the end of the second quarter, the trailing 12-month P/E ratio for the S&P 500 Index was 23.56 as compared with the long-term average of 15.66. The Shiller Cape ratio stands at 30.06 as compared with a long-term average of 16.76. The only other times the Cape ratio climbed above 30 was during the tech bubble in the 1990’s and in 1929 before the Great Depression. At these elevated prices, we have been hesitant to buy stocks. Our feeling is that we would much rather make an error of omission right now than an error of commission.

Markets are unusually calm. On May 9th, the CBOE Volatility Index (VIX), a measure of market fear or volatility, reached its lowest level since 1993. The average closing level for the VIX during the month of May was the lowest recorded monthly average since the VIX was created over 25 years ago. Investors have shrugged off worries of political turmoil, a sluggish economy, and rising interest rates, and have pushed valuations higher.

Bargains are scarce. We are finding it difficult to identify quality companies trading at a discount to intrinsic value. After the massive gains from the market lows of 2009, these opportunities have become quite scarce. Thus far in 2017, we’ve taken only one new position in the portfolio. We have been taking profits in a number of our holdings and our cash stake now stands at 19% of the portfolio. With plenty of dry powder at the ready, we look forward to a day when prices look more attractive.

Companies Added to the Portfolio

  • Tenneco, Inc. (TEN) – Tenneco is a manufacturer and distributor of automotive parts for new vehicles and the repair/replacement market. Primarily, it makes ride suspension systems including shocks and struts, and clean air systems like catalytic converters and emission control systems. Its products are used by GM, Ford, Toyota, Lexus, Land Rover, BMW, Daimler and other auto manufacturers. It has a solid balance sheet and has been consistently growing earnings and profitability over the past eight years. There is some worry over the current new car sales cycle getting a bit long in the tooth. While this is a serious concern, we believe that the demand for cleaner, more efficient emissions systems is growing globally. We began to build a position in March at around $62 per share.

Companies Trimmed or Cut from the Portfolio
With rising valuations, we took some profits this spring in a number of our largest holdings. These are great companies that we continue to hold, but we trimmed them as their size has grown above our target of 2.5-3% of the portfolio.

  • Orbital ATK, Inc. (OA) – Orbital is a maker of aerospace, defense and aviation products for the US government, allied nations and private companies. We bought it in 2012 at around $20 per share and sold some shares in June at $98.
  • Graco, Inc. (GGG) – Graco makes pumps and sprayers for the paint, powder coat, chemical and other material application markets. We bought it in 2009 in the low to mid-20’s and sold some shares in May and June 2017 for $110 per share.
  • Horace Mann Educators Corp. (HMN) – Horace Mann is an insurance company that provides life, auto, homeowners to the K-12 teacher marketplace. We bought it in 2008 at $5 per share, added to our position in 2010 at $16 per share, and sold some shares in June 2017 at $38 per share.

Our thoughts on fashion retailers
The future for brick-and-mortar retail continues to look very challenging. Our four-step investment process considers 1) balance sheet and cash flow, 2) valuation, 3) management, and 4) industry and sector outlook. While the retailers that we owned have strong balance sheets, good cash flow, and valuations appear attractive, we don’t believe that they are in a favorable environment to continue growing as consumers shift to online retailers and operating margins are pressured. We cut two holdings from the portfolio.

  • Cato Corp. (CATO) – Cato operates 1,300 value-oriented retail fashion stores in 33 states, mostly in the southeastern US. We bought it in 2011 at $23 per share, added to position in 2016 at $37 per share, and sold in Jan/Feb 2017 at $25 per share.
  • Urban Outfitters, Inc. (URBN) – Urban Outfitters operates over 600 clothing stores targeting younger shoppers under brand names of Free People, Anthropologie and Urban Outfitters. We bought it in 2015-16 at a range of $22-$27 per share, and sold it in March 2017 at $22 per share.

Additional Portfolio Sales

  • Hurco Companies, Inc (HURC) – Hurco makes and sells computerized machine tools in the metal-cutting industry. This has been a long-term holding for the fund. Unfortunately, the company operates in a segment that has become increasingly more competitive and results have not met expectations. We bought shares in 2006-2011 at a range of prices from the mid-teens to over $40 per share, and we sold throughout the spring 2017 at a range of $27-$33 per share.
  • Vista Outdoor, Inc (VSTO) – Vista makes consumer products for outdoor sports and recreation under brand names such as CamelBak, Bell helmets, Bolle sunglasses, and numerous ammunition and hunting accessory brands. With the large number of brands that it has acquired over the past few years, we have concerns that it overpaid for some and may be facing margin pressures from online sales and never-ending increases in promotional activity. We bought it throughout 2016 at a range of $38-$47 per share and sold it at a loss in March 2017 at $20 per share.
  • Astronics Corp (ATRO) – Astronics makes products for aerospace, defense and commercial airliners, including components installed in airline seatback entertainment and connectivity systems. Despite a boom in these markets, the company has struggled to grow revenue and profits. We bought it in 2016 at prices ranging from $25-$33 per share and sold it in March/May 2017 for $30-$34 per share.

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 June 30, 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 June 30, 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.) As of 06/30/2017, the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree.