Is the Ceiling the Roof?
Q1 2017 Investment Commentary
After record-setting gains in the fourth quarter of 2016, small cap stocks took a breather in the first quarter of 2017. The Russell 2000 Value Index returned -0.1% for the quarter ended March 31, 2017, as compared with a gain of over 14% for the fourth quarter of 2016. The Queens Road Small Cap Value fund returned -0.76% for the first quarter of 2017.
Investors sent stocks soaring after the Trump election on prospects of a new pro-business approach in Washington. Energy stocks lost almost 40% in 2015 but gained 37% in 2016. After losing 23% in 2015, material stocks shot up 47% in 2016. Regional US bank stocks were up over 30% in the fourth quarter alone in the hopes of a repeal of Dodd-Frank regulations and passage of a stimulus package that would drive increased loan demand.
Done Deal: President Trump has promised lower taxes, stimulus spending, a rollback in regulations, better trade deals, and a reform of our health care system. In our view, the run-up in the market reflects the hope that all of these agenda items will sail through Congress and be signed into law. With the recent failed attempt to repeal and replace the Affordable Care Act, Trump is finding that working with Congress is quite different from running his businesses. He may get slices of each of those things through Congress, but not the whole pie. Some of the enthusiasm behind the “Trump Trade ” appears to be fading as the Dow suffered an eight day losing streak in late March, its longest period of consecutive losing days since 2011.
Low Volatility: After spiking just before the election, market volatility fell to record low levels as measured by the CBOE Volatility Index (VIX). According to the CBOE, the average closing level for the VIX during the first quarter was 11.69, making it the second lowest quarterly average since 1990. The lowest quarterly average of the VIX was in the fourth quarter of 2006. It is instructive to note that one year after recording the lowest quarterly average in the fourth quarter of 2006, the VIX closed above 30 in the fourth quarter of 2007, marking the beginning of the financial crisis.
VIX’s quarterly high, low, and average closing prices by quarter back to 1990
Prices Are High: Valuations appear rich to us. We use a bottom-up, Graham & Dodd-based process that looks at fundamentals—the earnings power of each individual company. As we consider investment opportunities today, we find many wonderful companies with strong balance sheets, low debt, and proven managements that are leaders in their industries. We like everything but the price. We remain disciplined in our process and will pass if we cannot buy a company with a margin of safety.
Are We Alone? According to FactSet, companies in the S&P 500 are trading at over 21 times their past 12 months of earnings as compared with a 10-year average of 16.5 times earnings. The Shiller CAPE Ratio, which we prefer as it reflects a more accurate picture over a full market cycle, stands at 29, well above the historic average of 16.7. The only times the Shiller CAPE Ratio climbed above 29 was in 1929 and in 1999. In addition to creating the Shiller CAPE Ratio, Professor Robert Shiller, along with the Yale School of Management, have conducted surveys since 1989 of individual and institutional investors that measure investors’ confidence in the market and the likelihood of an imminent correction. Shiller reported that the February survey recorded the lowest level of investor confidence since the market peak in early 2000.
Is the Ceiling the Roof? Basketball legend Michael Jordan was a little tongue-tied at the Carolina/Duke game last month. As he announced a new athletic clothing partnership between Nike and his alma mater, the University of North Carolina, he tried to say that there is no limit to how far Carolina can go. Instead, it came out as, “The ceiling is the roof!” Folks initially poked fun at his gaffe, but Carolina fans quickly turned the phrase into a rallying cry for the Tarheels, emblazoning it on shirts, hats, signs and more. The baby blue Carolina shirts were on display everywhere during March Madness as the Tarheels went on to win the NCAA basketball championship. Below is a shot of the Carolina mascot wearing the shirt during the final game. GOAT refers to Jordan as the “Greatest Of All Time” according to Matt DeVries, analyst on the Queens Road Small Cap Value fund and proud Carolina graduate.
Source: University of North Carolina-Chapel Hill
Is there a ceiling or roof on today’s elevated prices? Despite today’s high valuations, history demonstrates that stocks may well push even higher. Consider that Federal Reserve Chairman Alan Greenspan first uttered the words “irrational exuberance” in December 1996. Despite this ominous warning from the Fed Chair, investors pushed the Dow from 6,000 in December 1996 to over 11,000 by March of 2000. Over the next 31 months, the Dow would fall to 7,500 in October 2002. The Nasdaq was trading around 1,300 in December 1996 but ballooned to over 5,000 by March of 2000. Interesting side note—according to Greenspan’s 2008 memoir, the phrase “irrational exuberance” first occurred to him in the bathtub as he prepared his speech to the American Enterprise Institute.
Queens Road Small Cap Value Fund Performance: As you can see in the chart below, the year-to-date performance of the Queens Road Small Cap Value fund is in line with the index, while the 12-month performance has lagged the benchmark. Nearly all of the trailing performance occurred during the “risk-on ” market rally that began in March 2016. We fully expect the fund to trail the index during periods when investors ignore risk. Historically, when the market is volatile and investors are fearful, we have seen the fund outperform the index. The last time the markets showed any signs of weakness was first quarter of 2016 as investors worried over lower earnings, falling oil prices, and a slowdown in China. By mid-February 2016, the Russell 2000 Value Index was down -11.5% vs. -5.1% for the Queens Road Small Cap Value fund. The Federal Reserve Bank jumped in to rescue the markets in March, promising to delay any further rate increases. Markets immediately rallied as investors tossed their worries to the wind and embraced the Fed’s continuation of easy money policies.
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 during that period. The Fund’s manager and its affiliates do not intend to absorb any expenses or waive its management fee in the future.
The Queens Road Small Cap Value fund invests primarily in small-cap companies which may involve considerably more risk than investing in larger-cap stocks.
We can point to three factors that have caused the fund to trail during this “risk-on” rally that began in March of 2016.
First, we seek to own higher quality stocks. Our process leads us to companies with strong balance sheets, low debt and consistent cash flows. History shows that companies with these characteristics tend to outperform during periods of market uncertainty. According to a study conducted by AQR, higher quality companies outperformed lower quality companies by over 20% during the financial crisis. During the “risk-on” market of last year however, lower quality companies led the way by a wide margin. If stocks hit a rough patch down the road, we expect to see quality companies again outperform. As shown in the chart below, the Queens Road Small Cap Value fund has a demonstrated history of outperforming our primary benchmark during market downturns. While not assured, we hope this pattern will continue.
Second, we hold a smaller percentage of financial stocks than the index. Financial stocks including the real estate sector represent 42% of the Russell 2000 Value Index. The Queens Road Small Cap Value fund holds less than 15% in financial stocks. Bank stocks looked fully valued to us before the election, but look really expensive today. Investors pushed up bank stock prices after the election to reflect the anticipated passage of a massive rollback in regulations and a significant stimulus package that would increase demand for loans. While some of Trump’s agenda will likely make it through Congress, we have doubts about the magnitude.
Finally, we hold about 22% in cash. Our cash stake has been an obvious drag on performance as equities have continued their run. As discussed above, if we cannot buy with a margin of safety, we will hold cash. Our cash stake has been elevated for some time and currently stands at 22%. This is not a call on the market. We underline that statement because we do not attempt to predict market movements. The cash that we now hold is purely a result of our bottom-up process. We buy when prices look cheap. We sell when things look expensive. We would much rather put this cash to work, but we refuse to buy at today’s elevated prices. Should we see a downturn in the market, we look forward to taking full advantage as others are selling.
The Virtue of Patience: We urge our fellow shareholders to have patience. This isn’t easy when markets are surging. Our family, our employees, our investment committee and our independent board are collectively among the largest shareholders in the Queens Road Funds with over $10 million invested right alongside our shareholders. We are eating our own cooking. We look forward to a market where fundamentals matter.
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Morningstar Magazine Interview: We invite you to read an excellent in-depth profile of Queens Road which appears in the April issue of Morningstar magazine. Portfolio Manager Steve Scruggs, CFA, and Investment Committee Chair Benton Bragg, CFA, sat down with Tom Lauricella of Morningstar magazine to discuss our investment philosophy and process, our firm, and recent investment results. The Queens Road Small Cap Value fund was named to the Morningstar Prospects List in 2016 and Morningstar chose to feature Queens Road for their Undiscovered Manager profile in the April issue. You can also see a great pic of Steve and Benton on our family farm just north of Charlotte.
Speaking of Morningstar, we will be packing our bags for the Morningstar Investment Conference coming up April 26-28 in Chicago. Steve, Benton and John will be in our Queens Road booth for the conference and invite you to come by, catch up and grab a fresh jar of our North Carolina peanuts.
Please email John Bragg or call (888) 353‑0261 any time you have questions about the fund or would like to talk with Steve. We remain open and fully committed to the independent RIA community and welcome the opportunity to talk with you. Thank you again for choosing Queens Road Funds for your clients. We look forward to serving you.
[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®
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 March 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 March 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.) As of 03/31/2017, 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.