She Looks Good, But Is She Seaworthy?

Q1 2018 Investment Commentary

By Steven H. Scruggs, CFA
Portfolio Manager, Queens Road Funds

“Don’t confuse the lack of volatility with stability, ever.”
–Nassim Nicholas Taleb, author of The Black Swan

For my latest project, I am building a stand-up paddleboard. My family has been spending some time down at the South Carolina coast and I was looking around for something to keep my four teen-age daughters outside doing something instead of inside staring at their phones. According to my girls, stand-up paddleboards, or SUPs, are all the rage in outdoor recreation and fitness. Whether it is stocks or socks, I am certainly not one to follow fads, but this seemed like something they might enjoy. It would have been much easier just to buy a paddleboard at our local REI, but I am a project guy. I like rolling up my sleeves and digging in to figure something out.

I learned a lot from the mistakes that I made a few years ago when I built a beautiful canoe that ultimately looked much better than it floated. I was determined to get it right this time. I did some extensive research on paddleboards and finally ordered a kit that came with lots of strips of wood, glues, clamps and varnishes, and a complex set of instructions. After I spent several nights and weekends cutting, gluing, clamping and sanding, it is actually beginning to look like a paddleboard. I look forward to the maiden voyage as soon as I finish applying the final coat of varnish.

Strip-built Stand-up Paddleboard Strip-built Stand-up Paddleboard

My daughters are excited about the paddleboard. Over the course of the project their refrain has gone from, “Dad, why don’t you just buy a paddleboard?” to “Wow, Dad. It’s beautiful!” I included a picture and hope you agree. My greater concern is whether or not the darn thing will float. Will it be seaworthy? How will it handle the waves, wind and rough water of the Atlantic Ocean? Perhaps even more important than the question of how the paddleboard will handle rough water, is how the paddler will respond. In this case the paddler will be one of my teenage daughters. Will she respond well to some wave action? Will she panic, change direction or even jump off? Or will she remain calm, stay on course, maintain form and ultimately reach her destination. I guess we’ll find out.

Remaining calm, staying on course and maintaining form was required of investors during the volatile days of the first quarter of 2018. The smooth seas of 2017 ended abruptly on January 23rd as choppiness returned to the market with a vengeance. The severity and duration of the declines of the quarter weren’t enough to end the bull market, but they certainly reminded us that risk is alive and well.

Queens Road Small Cap Value Fund Performance Update

By Steven H. Scruggs, CFA
Portfolio Manager, Queens Road Funds

The Queens Road Small Cap Value Fund slightly out-performed during the first quarter of 2018, with a total return of -2.50% vs. -2.64% for the Russell 2000 Value Index. The Fund lagged the index in early January as the Trump tax cut rally continued, but made up for it during the decline. From the market peak on January 23rd through the low on Feb 8th, the Fund declined -7.09% vs. -9.52% for the Russell 2000 Value Index. The three-year average lags the Index a good bit, reflecting the momentum-based rally after the Trump election. The risk-adjusted returns for the longer-term 10-year and 15-year average returns are more attractive.

Performance Summary: March 31, 2018

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
QRSVX -2.50% 4.00% 5.59% 8.28% 7.91% 10.09% 9.26% 305.34%
Russell 2000 Value Index -2.64% 5.13% 7.87% 9.96% 8.61% 10.85% 8.79% 278.25%

Gross annual operating expenses 1.18%
*Performance annualized. Fund inception June 2002.

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.

Volatility is our friend. Volatile markets can often offer us opportunities to buy good companies at more attractive prices. As investors become fearful and head for the exits, our disciplined, unemotional approach can take advantage of their fear. While we saw some brief declines in market prices during the first quarter, nothing quite reached a valuation level where we felt good about buying with a margin of safety. Just because something costs less than before does not mean it is now a bargain. Like a baseball player after a long inning that finally gets a chance to step up to the plate, we could swing wildly at the very first pitch, or wait for a better pitch that we can hit. Our watch list is quite long and we would love to put some cash to work, but we will not make buying decisions unless we feel like we are making a good investment.

Risk-awareness is increasing. Investors may be paying a bit more attention to risk, but the sell-off in the first quarter appeared to be across the board. Market correlations for stocks in the S&P 500 surged from a low of 9% in early January to 52% as stocks sold off. This suggests that much of the decline was driven by investors pulling money out of ETF or other passive products which trade indiscriminately. Investors have yet to separate the high-quality companies from the lower-quality companies. We will continue to be patient as we wait for opportunities to buy at better prices.

Discipline and patience are required. We thank you for joining us as shareholders in the Queens Road Small Cap Value Fund. While we have trailed our benchmark during this nine-year historic bull market, our risk-adjusted returns remain attractive. We have been in this position before and while it’s never easy, we have learned to stay the course. It’s the smart thing to do. When we started the fund more than 15 years ago, we had a clear value investment process that we expected to deliver good risk-adjusted performance over the long term. We expected our relative performance to compare very well during periods when a healthy respect for risk was evident in the market. We also expected to see sometimes-long stretches of under-performance during extended bull markets (see mountain chart below). These stretches of lagging performance test our discipline and patience as an investor and as a portfolio manager.

S&P 500 Index At Inflection Points

Click image to enlarge

Has Buffett’s secret sauce gone bad? One pundit recently wrote that legendary value manager Warren Buffet’s secret sauce has expired as Berkshire Hathaway has under-performed the S&P 500 Index over the past 10 years ended 12/31/17. As we look to other disciplined value managers who use similar investment philosophies, we see similar lagging performances. Maybe it is a case of misery loves company, but it gives us some comfort to see other highly regarded value managers paddling the same stream. We will remain disciplined in our process and look forward to a time when we have the wind at our back.

Please contact us should you wish to set up an update call. John Bragg and I will have a booth at the Morningstar Investment Conference in Chicago in June. Please stop by to say hello and pick up a fresh jar of North Carolina peanuts. We appreciate your investment in the Queens Road Funds and we look forward to serving you and your clients in the years ahead.

Companies that helped performance during the first quarter

  • DST Systems, Inc. was up 40% during the quarter as SS&C Technologies announced on January 11 that it would purchase the company for $84 per share. The all-cash deal is scheduled to close in the second quarter of 2018. We started buying DST in 2010 in the mid-$30 per share range.
  • Deckers Outdoor, Corp. rose 21.4% during the period. 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 ecommerce 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, Deckers continues to inspire confidence in its long-term prospects. We began buying Deckers Outdoor in 2015 and have an average cost of $53 per share. It is now trading at $94 per share.
  • Plantronics, Inc. rose 20.9% during the first quarter. Primarily a maker of headsets for office and consumer use, the company continues to transform its business to include software and analytics offerings as large businesses are requiring integrated communications systems that combine technologies to optimize collaboration and increase user productivity. To this end, in late March the company announced plans to acquire Polycom, a leading maker of conference phones and video conference products. The combined company will offer a breadth of products that should compete effectively in this growing market segment. We’ve bought and sold Plantronics a few times since 2003 as the price became attractive and later rose to our estimate of full valuation. Our average cost is $37 per share and it is now trading at $64 per share.

Companies that hurt performance during the first quarter

  • Meredith Corporation fell 22% during the first quarter, essentially correcting the big jump in price that occurred last year after announcing the acquisition of Time, Inc. In 2017, Meredith announced that it was purchasing Time, Inc. with the intent of improving the Time brands that fit into their portfolio and divesting ones that are non-core. After the news, the stock price surged from $51 to $71 in a little over a month. Meredith is a media company with a well-diversified portfolio of brands including People, Sports Illustrated, and Better Homes and Gardens, as well as 17 local television stations and a strong on-line digital portfolio which focuses on food, lifestyle and entertainment that primarily targets female millennials.During the first quarter, the company announced earnings that beat estimates but commented that ad revenue trends were continuing to weaken, especially in print. Additionally, the company failed to give forward guidance, resulting in a 13% drop in the stock price on that day. Management has a proven track record of profitably managing and growing brands and has been very adept at transitioning them from print to the digital age.We have owned Meredith for over ten years and feel confident in our assessment of the company and the abilities of management. We are confident the company will be able to integrate the acquisition, wringing out duplicate expenses and better leveraging the valuable brands acquired in the merger. Our average cost per share is $42 and it is currently trading around $52 per share. As one of our largest holdings, we chose to not add to the position despite the decline in price.
  • RPX Corporation dropped 20.6% during the first quarter. RPX provides services designed to rationalize the process of patent licensing. In short, it provides protection from patent trolls (entities that acquire patents for the primary purpose of suing others for the infringement on those patents). The company also provides services that help manage the eDiscovery process for corporate legal departments.We took a position at $9.80 in 2016 and saw the price rise to $14 on news that the CEO was pushing to take the company private. The board fired the CEO in 2017, but announced in January 2018 that it had hired an investment bank to explore strategic alternatives, including potentially selling to a private equity firm. The company is currently trading at $11.40 per share.We agree that this company could be a good candidate for privatization as it has a unique business model that is difficult to value conventionally. We think the company is potentially undervalued, but due to changes within its business model and uncertainty around management, we are not adding to the position.
  • Oshkosh Corporation was down 11.7%% for the period. The maker of military trucks, commercial vehicles and access equipment declined despite strong reported earnings on concerns of increased steel and aluminum prices due to recently announced tariff hikes. While higher priced inputs would have a negative impact on operating margins in the near term, we are confident management will effectively navigate these uncertainties. In spite of the margin concerns related to higher input costs, all segments except defense are experiencing strong growth following a long period of sluggish demand. Our average share cost is $24 per share and the company is currently trading at $81, down from a high of $96 per share. Oshkosh is one of our largest and oldest holdings and we remain confident in the company’s long term prospects.

Top-Ten Holdings as of March 31, 2018

Security % of Total Net Assets
Deckers Outdoor Corp. 4.02%
Orbital ATK, Inc. 3.71%
Meredith Corp. 3.61%
Vishay Intertechnology, Inc. 3.48%
Fabrinet 3.26%
Graco, Inc. 3.06%
Oshkosh Corp. 2.85%
UGI Corp. 2.78%
RLI Corp. 2.74%
Tech Data Corp. 2.72%

Market and Economy

By Matt DeVries, CFA
Analyst, Queens Road Small Cap Value Fund

On the heels of one of the least volatile years for the stock market in the last century, 2018 is proving to be something very different. A very strong 5.7% gain for the S&P 500 Index in January was entirely wiped out just three trading days into February. Since that point, we have seen significant swings up and down. After falling nearly 10% in February, the NASDAQ was able to rally enough to make new all-time highs in March before again pulling back.

In the end, stock market losses were moderate considering the wild swings of the first quarter. The decline of 0.8% for the S&P 500 in the first quarter is just the second down quarter since the 4th quarter of 2012. Even with the recent volatility, the index is still up over 100% since then. February’s drop also broke a 15-month streak of monthly gains for the S&P 500.

Most major asset classes moved slightly lower during the quarter. Of note, after a bang-up 2017 and a great start to the first quarter, foreign stocks ended up with the largest decline among equity asset classes. The MSCI All-Country World Index (excluding the US) fell 1.1%. But bonds were the biggest disappointment with the Barclays Aggregate Bond Index down almost 1.5% for the quarter as interest rates inched higher.

Strong report brings inflation concerns. The stock market has been on quite a run since President Trump’s election victory. His economic policy promises—regulation reform, tax reform, and infrastructure spending—boosted investor confidence and drove stocks ever higher throughout 2017 and to an all-time high in late January of this year. Then some better-than-expected economic reports halted the climb and sent stocks lower in early February as investors worried about an overheating economy and the potential for higher interest rates.

Chart: Consumer Price Index for All Urban Consumers

Click image to enlarge

The Labor Department’s jobs report for January showed a 2.9% average hourly earnings gain for private-sector workers—a larger gain than was expected. The S&P 500 fell over 6% in just two days on fears that rising wages may finally start to push inflation above the Federal Reserve’s 2% target (fears we’ve been hearing about since the Fed first started its quantitative easing program back in 2008). Inflation has been hovering just above 2% recently but this report reignited worries that inflation could start to pick up as labor costs rise and consumers with higher incomes ratchet up their spending.

So while this jobs report was good news for the average American and does not indicate a recession is looming, it could signal that the end of the bull market is at least edging closer. Inflation typically picks up later in the business cycle as unemployment falls and the pace of wage gains quickens. In a normal economic cycle, tight labor markets and rapidly-rising incomes prompt the Federal Reserve to raise interest rates to help manage rising inflation.

The Fed has a statutory mandate established by Congress: Full employment, stable prices and moderate long-term interest rates. Absent the need to keep interest rates low with US unemployment at a historically low level of 4.1%, the Fed could see a need to begin raising rates more quickly than planned. This would lead to higher borrowing costs and slower economic growth. Some of February’s inflation fears were soothed by the February jobs report which showed private-sector average hourly earnings rose just 2.6%. But by then, a new issue had taken center stage.

Tariffs and a trade war could impact global trade. The tariffs on imported solar panels and washing machines announced by President Trump in January didn’t garner much of a market reaction. It turned out he was just getting started. In late February, reports came out that the President would announce tariffs on steel and aluminum imports and this news sent the S&P 500 lower by 3.7% in the three days prior to the official announcement on March 1st.

Tariffs of 25% on steel and 10% on aluminum went into effect in late March. Temporary exemptions were granted to Canada and Mexico which may help spur negotiations to revamp NAFTA that have stalled over the past year. While these tariffs may boost steel and aluminum production domestically, they’ll also push up input costs for domestic manufacturers or other companies who use these commodities in production. Home building is by far the largest industry that will be affected. We may see higher home prices and fewer new homes being built if these tariffs persist.

Chart: US Trade Surpluses and Deficits with Major Partners, 2017

Click on image to enlarge

Steel has long been a target of protection and the US has had several steel tariffs over the years to promote US steel production, even as recently as 2002 under President George W. Bush. The Bush tariffs were short-lived as the World Trade Organization deemed them illegal and the retaliation from other countries proved very costly for US exporters in other industries. The justification for the new tariffs is different, however, as the Trump administration imposed them on the basis that domestic steel is vital to national security. The WTO has not yet ruled on the matter and it is still unclear what kind of backlash there will be from trading partners or from those US companies that stand to lose as a result of higher costs.

The market fell again a few weeks later when President Trump announced another round of tariffs directly targeting up to $60 billion in annual imports from China; this move stoked fears of an all-out trade war with China. China’s officials responded with their own tariffs on 128 US products, though they only account for about $3 billion worth of US exports.

For the moment, the market appears to have calmed down on reports that the US and China have been having closed-door talks on how to resolve the current dispute. The US trade deficit with China is by far the largest among any countries in the world. Any kind of long-term disruption of the relationship could be costly for both sides. That’s not to say that the recent protectionist actions by the Trump administration aren’t warranted to some degree. It has been obvious for some time that China has used anti-competitive policies that have benefited Chinese industries at the expense of competitors around the world.

Chart: GDP Growth

Click image to enlarge

Global economy still has a firm footing. Looking at the fundamentals, the global economy is still on solid footing. The table above, posted in March by the Organization for Economic Co-operation and Development, shows expectations for global growth are not only widespread but have been rising in recent months.

For several years we’ve estimated that stocks have been, at least, fully valued and that stock prices have run ahead of earnings. Based on what we saw in the first quarter, 2018 may be a year where the fundamentals outperform stocks. This doesn’t necessarily mean stocks need to fall. It may just be a back and forth kind of year as earnings hopefully catch up with, and justify, the prices we’re seeing.

Historically we’ve see that it usually takes a recession to put an end to a bull market despite what market prices do in the short term. While the strong projections in the nearby chart of GDP projections could be overly optimistic, there is good evidence to support a continuing expansion. Risks remain of course. Rising inflation which results in higher interest rates, tough talk on trade that escalates into a trade war, or one of those “unknown risks” could put an end to the party. Our advice as always is to remain diversified and to use these bouts of volatility as a good opportunity to rebalance your portfolio. ■

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, 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 March 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.) As of 03/31/2018, 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.