One-Way or Round-Trip?

Q1 2019 Investment Commentary

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

Kiplinger senior associate editor John Waggoner identified Queens Road Small Cap Value as the “best fund, round trip” in the Small-Cap Value category during the recent market decline and recovery.

Using Morningstar data, Waggoner screened for diversified, actively managed funds to identify the best performing fund over three distinct periods during the recent volatile market.

  1. the market decline, measured from September 20, 2018, through December 24, 2018;
  2. the market recovery, measured from December 24, 2018, through February 22, 2019;
  3. and the round-trip, measured from September 20, 2018 through February 22, 2019.

In addition to naming the best performing funds, the study also identified the worst performers over the round-trip period. The results demonstrated that the typical fund performed relatively well during either the decline phase or the rally phase but not during both phases. The best performers on the upside often performed horribly on the downside. Those managers that shot the lights out during one part of the market cycle often shot themselves in the foot during the other part of the cycle.

For instance, the best performing fund in the Morningstar Small-Cap Value category during the up-market period gained 33.6% from 12/24/18 through 2/22/19. However, the same fund was ranked as the worst performer round-trip due to the loss of nearly 42% during the market decline. The same was true in the Mid-Cap Growth category with the best performing up-market fund also coming in dead last for the round-trip period.

As Graham & Dodd-style value investors, we talk a lot about full market cycles. Investors are wise to measure results over the entire market cycle from pessimism, to skepticism, to optimism, to euphoria and back again. Whether it is up or down, stocks don’t move in one direction without interruption. While there is an upward trend over time, normal functioning markets move through periods of expansion and contraction. Investors likewise move through periods when they are more willing to take risk and other times when they are more cautious or even fearful. Most serious, long-term investors are round-trip buyers, not short-term, one-way buyers.

We were pleased to see our Queens Road Small Cap Value fund ranked in the Kiplinger analysis as the best round-trip performer for the Morningstar Small-Cap Value category. While the study only looked at a five-month period, it was a period of extreme volatility in both directions; a decline of 19.4% for the S&P 500 from September 20th through December 24th, followed by a 19.2% gain from December 24th through February 22nd. The Queens Road Small Cap Value fund has a demonstrated 16-year history of offering downside protection during periods of volatility. During the volatile 4th quarter, the Queens Road Small Cap Value was down -8.52% vs. -18.67% for the Russell 2000 Value Index and -19.16% for the Morningstar Small-Cap Value category.

There are several factors that allowed the Queens Road Small Cap Value fund to outperform during this period. First and foremost is our disciplined four-step value process that we have implemented since inception in 2002. Our process looks at both quantitative and qualitative aspects of a company.

On the quantitative side, we look for solid balance sheets, companies that have strong cash flow and serviceable levels of debt and companies that aren’t reliant on the capital markets. We then look at valuation by normalizing operating margins over a full market cycle to arrive at our estimate of intrinsic value. Instead of looking at just the most recent data, we look at operating margins over a full market cycle. We want to buy good companies with a margin of safety.

On the qualitative side, we study the management and the markets in which the companies compete. We want to see managements that can lay out a strategy and execute to that strategy. We look for companies with clear and honest communication and managements that are willing to take measured risks but are also able to admit mistakes. Finally, we want to make sure that the companies we own are growing and are competing in industries that have favorable economics and aren’t overly competitive.

One additional factor that has both helped and hurt the Queens Road Small Value fund during this period is our cash stake which is currently at 20%. This is not a call on the market. It is simply a byproduct of our process. As we go through our four-step process, many companies appear to be expensive. Buying at the right price, when we can get an attractive value, is key to our long-term success. As markets declined last fall, we did find opportunities to add to some positions and to take positions in new companies. We look forward to putting more cash to work but are willing to wait patiently for opportunities to buy companies at better prices.

Thank you for joining us as shareholders in the Queens Road Funds. As a reminder, our Investment Committee, employees, independent board and family members are among the largest shareholders in the Queens Road Funds. We believe in our process and have confidence that over full market cycles, we should continue to produce returns that out-perform our peers and indices but take less risk along the way. Please contact John Bragg, CFP® at (888) 353-0261 or if you would learn more about the Queens Road Funds. ■

Queens Road Small Cap Value Fund Performance Update

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

During the first quarter of 2019 the fund was up 8.1% vs 11.9% for the Russell 2000 Value Index and 12.13% for the Morningstar Small Value category. For the previous 12 months, the fund was up 4.63% vs 0.17 for the Russell 2000 Value Index and -2.55 for the category.

Performance Summary: March 31, 2019

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 8.13% 4.63% 5.79% 5.41% 12.05% 7.11% 8.98% 324.13%
Russell 2000 Value Index 11.93% 0.17% 10.86% 5.59% 14.12% 7.24% 8.25% 278.90%

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.

During the sharp sell-off in the fourth quarter of 2018, we added to several existing positions and initiated several small positions in new companies. The sell-off appeared to hurt cyclicals and lower quality companies to a greater degree than those with stronger balance sheets.  This is one of the reasons our portfolio held up much better than the market, but it also did not allow for the wholesale buying of a lot of “cheap, good companies.”  Two of our new positions are VSE Corp and Deluxe Corp.

VSE Corp (VSEC)  is a logistics company that receives most of its revenue from the US government (US Postal Service and Department of Defense) and also provides maintenance services to the aviation industry.  After making two sizable acquisitions over the last eight years, the company has been diligent in reducing its debt levels and increasing operating efficiencies.  Over the past 18 months the company’s share price fell from an all-time high of $59.13 to a low of $28.20.  We initiated a position during the 4th quarter with an average cost of $31.36 per share. VSE continues to have a debt level higher than we would like but given our estimate of normalized free cash flow of approximately $45 million and the size and nature of its extensive backlog, we believe the company offers a compelling value.

Deluxe Corp (DLX) has historically been known as a check printing company and still generates a substantial amount of revenue through check sales. In recent years, Deluxe has grown its marketing and business services segment to over 42% of their revenue.  The company uses its historical relationship with financial services customers to market its portfolio of business services which include marketing solutions, email marketing, payroll services and fraud/security services, among others.  As the check business continues its secular decline, the company is replacing lost revenue by shifting focus to higher growth markets primarily through acquisitions.  Deluxe is executing this strategy while maintaining what we believe is a healthy level of return on invested capital which results in high levels of free cash flow. Over the course of 2018 the company’s share price fell from around $77 to a low of $37 in December.  We initiated a position with an average cost of $42.37.  While the company is subject to economic and execution risk, we believe the valuation is very attractive.

Companies that Helped Performance

Fabrinet (FN) rose 67% over the last 12 months. This contract manufacturer of complex optical components was founded in 2000 by Seagate Technologies co-founder Tom Mitchell and went public in 2010.  The company continues to increase utilization rates at its new manufacturing facility while gaining new customers.  The transition to 5G wireless networks and the advanced architecture they require should continue to benefit Fabrinet’s business. The stock price is approaching our estimate of fair value and we have trimmed our position during the period.  We really like the company’s prospects but are keeping a close watch on price.

Deckers Outdoor, Corp. (DECK) rose 63% during the last 12 months. Best known as the makers of Ugg, Teva and Hoka One One footwear, the company has continued to perform well, posting strong earnings, and increasing guidance. In the face of a very challenging retail environment, management continues to execute its strategic plan as revenues and margins continue to grow. While the Ugg brand (80% of sales) performed well, growing according to plan, the Hoka One One brand continued its meteoric growth with revenues increasing 79% during the last quarter.  During the period we trimmed our holding of Deckers as it had grown to over 4% of the total portfolio.  It remains one of our top holdings.

Companies that Hurt Performance

Tenneco, Inc. (TEN) dropped 60% over the last year.  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. During the year, Tenneco acquired auto parts manufacturer Federal Mogul from Carl Icahn for $5.4 billion.  Prior to the transaction the company announced that they planned to split into two separate companies in a tax free spin-off.  One company will be a pure-play ride control and after-market parts company, and the other will be a pure-play powertrain company.  The separation is scheduled to occur during the second half of 2019.  Tenneco’s shares have been under pressure throughout 2018 as the auto parts sector has sold off.  Additionally, the debt load resulting from the Federal Mogul acquisition is substantial.  The separation plan the company announced makes a lot of sense and we believe the two separate companies will be worth more than the combined company.  Carl Icahn seems to agree as he has indicated he plans on holding on to his significant stake that he received in the buyout.

Greenbrier (GBX) fell 36% during the last 12 months.  In spite of near record railcar deliveries, Greenbrier’s stock fell in the face of declining rail traffic.  Although the company faces margin pressure and concerns over an economic slowdown, the company’s international and product diversification efforts combined with its substantial backlog and pristine balance sheet gives us confidence in the company’s long-term prospects. ■

Lost in the Woods: Q1 2019 Investment Commentary

By Benton S. Bragg, CFA, CFP®
Investment Committee Chair

On a recent Saturday morning, my youngest son, Charlie (11), announced that he was going on a solo expedition in the woods on our farm. We were enjoying our family breakfast when he filled us in on his plans for the day. “I’m gonna build a shelter, shoot my BB gun and do some exploring.  I’ll be gone all day but I’ll take some snacks and you don’t need to worry about me.” My wife, Alice, immediately protested, “Gone all day? By yourself? It’s 34 degrees out there! Where exactly will you be? How far from the house? How will I know you’re okay? What if you get lost out there?” While our other kids and I traded amused glances, Charlie and his mother tussled over his plans for the duration of our pancake breakfast. Finally they settled on a compromise. Charlie doesn’t have a phone so Alice supplied him with a whistle. “When you hear me yell from the front porch, just blow this whistle to let me know you are okay. If you don’t blow the whistle, I’ll be coming out there to find you.” Charlie agreed.

I was scheduled to be away from the house for an event that day. When I walked outside to get in my car, Charlie was piling his provisions in his old Radio Flyer wagon. Among other things, his stash included his BB gun, a hatchet, some twine, a hammer and a few nails, a pair of binoculars, his slingshot, an old blanket, a camouflage hunting stool, his Harry Potter book and a squirrel call. His snacks consisted of an apple, some vanilla wafers and a can of Cheerwine (my wife is from Salisbury, Cheerwine’s headquarters, so there is always a six-pack in our fridge). Charlie was wearing his boots, jeans, camouflage jacket and his blaze orange hunting cap. He had two knives on his belt and I did note that he had the whistle on a string around his neck. He was definitely the tough little man in that moment and I could tell he was pumped up for his big day.

Late that afternoon I was making my way back home on I-77 when my phone rang. It was Alice. “You will NOT believe what happened!”

Charlie had been true to his word. He’d dragged his wagon into the woods at 9 a.m. that morning and was still gone four hours later. The whistle-blowing arrangement had worked fine. Alice would step out on the porch every thirty minutes or so and yell at the top of her lungs, “Chaaaarlieeeee!” And he’d blow his whistle. All was good. But then around 1 p.m.—I think you know where this is going—she called for him and got no response. “I immediately panicked,” Alice said. “Before I could get my shoes tied I had decided that he’d been dragged off by some scary man in the woods. I NEVER should have let him go into the woods alone!” As Alice described it, she bolted for the woods in the direction of his latest whistle calls. She didn’t go far before she found his campsite. He had built a shelter—a basic lean-to, made mostly from dead oak branches that he had leaned against the trunk of an old fallen cedar. Inside the shelter, she saw his book, apple, slingshot, empty Cheerwine can and binoculars, all spread neatly on the old blanket he’d used to make a floor. His BB gun was leaning against a tree, his blaze orange hat was hanging on a broken tree limb, and the topper: there was a small campfire beside the shelter. I said, “A campfire?” “Yes! And it was still burning!” Alice said. “What in the world,” I thought. “How did the little guy know how to build a fire?”

As you have likely surmised, our fearless frontiersman was nowhere to be found. Of course Alice had been yelling for him non-stop since his original failure to blow the whistle. Alice told me that she had proceeded to dash around the campsite in ever-widening circles, stumbling over brush and fallen logs with her heart in her throat. After a few minutes that probably seemed like much longer, she heard the faint sound of a whistle. And then, there was Charlie, trudging toward her through the woods with his little hatchet in his hand, smiling. “Calm down, Mama. What is wrong with you?”

Speaking of being lost in the woods, the recent behavior of the stock market has many investors feeling that way. Wouldn’t it be nice if we could blow a whistle to stop the action long enough to figure out what’s going on? I went back and read my commentary of just six months ago (Q3 2018) when the market was near an all-time high (the high was on September 20th of last year). That commentary included excerpts pulled from the commentaries written during the dark days of the financial crisis of 2008/2009. My intention in sharing all that gloomy financial-crisis history was to encourage investors of today to keep their emotions in check and to remember that not all markets are bull markets. Just three months later, my Q4 2018 commentary was the polar opposite! As you’ll recall, the market plunged almost 20% from the September high to its close on Christmas Eve—“Merry Christmas,” right? That Q4 commentary encouraged investors to keep the discipline, stay the course, don’t get scared out of the market, etc. And now here we are three months later at the end of Q1 2019 with the market up more than 20% since the December low and within spitting distance of its all-time high again. I suppose the case can be made for again reprinting the gloomy commentaries of the financial crisis. But I’ll spare you.

The rally-decline-rally behavior of the market has many investors asking questions. Specifically, where are we in this long business cycle? Are we nearing the end of the ten-year advance in the stock market or does the bull have room to run? What’s all this conversation about an inverted yield curve? Will the trade dispute with China have a major impact on the US economy? How worried should we be about Brexit? Why the abrupt about-face on rate increases by the Fed and what does this mean for market predictions? While we think Yogi Berra was right when he said, “It’s tough to make predictions, especially about the future,” here are a few thoughts that might be helpful as you ponder the many questions out there.

Chart: Length of economic expansions and recessionsOld Age? At 117 months, this is the second longest economic expansion in recorded history. Even older, the bull market has been running for 120 months now, the second longest run in history. Is the end near? Possibly. But expansions and the bull markets that accompany them usually end as a result of economic events, not as a result of old age. In most cases recessions (defined by the US Bureau of Labor Statistics as two consecutive quarters of negative GDP growth), are caused by economic events including inflationary pressures, spiking interest rates, commodity price shocks, deflating asset bubbles or excessive levels of consumer, government or corporate debt.

Inverted Yield Curve: You may have heard that the Treasury bond yield curve became briefly inverted last month and that historically this has been a good predictor of an economic recession. An “inverted yield curve” is a complicated way of saying that shorter-term interest rates (on two-month borrowing, for example) are higher than longer-term interest rates (for ten years, for example).  When shorter-term rates are below longer-term rates (a normal curve), banks can lend profitably as they borrow at lower, short-term rates and lend at higher, longer term rates. But once the curve inverts, the absence of profitability leads to a reduction in lending, contributing to a recession. In today’s environment, shorter-term rates have been pushed up by the actions of the Fed while longer-term rates have fallen primarily as a result of market participants predicting a weaker economic environment going forward. As Matt DeVries briefly discusses in Market and Economy, this indicator has been pretty reliable. Our takeaway from this data and from the fact that the Fed abruptly pulled the plug on its rate increases is that we are in the later stages of our current expansion.

The Other Stuff: As for Brexit, the China trade dispute, weakness in Europe, domestic politics and the kitchen sink of other issues we are currently worried about, we hang our hats on the fact that the market is usually efficient. That is, most of what can be known about these issues is already factored into stock prices. As they say, “If it’s in the headline, it’s in the price.”

Corporate Earnings: Ultimately market prices are driven by corporate earnings. And of course earnings are impacted by everything mentioned above. After growing at a frenzied pace over the last three years, S&P 500 earnings peaked in the third quarter of 2018 and now are expected to decline slightly in the face of moderate wage inflation, higher input costs (including higher interest costs) and friction resulting from trade disputes. First quarter market action points to investor confidence that companies can continue moving forward. We’re watching closely.

We hope these comments are helpful. Spring is here! Enjoy those dogwood, redbud and cherry blossoms but don’t get lost in the woods! ■

Market and Economy

By Matthew S. DeVries, CFA
Analyst, Queens Road Small Cap Value Fund

After suffering through the painful market decline of the fourth quarter of 2018, investors saw market indices bounce back in the first quarter of 2019. Investor confidence rebounded sharply as the S&P 500 posted a 13.6% gain and all the major asset classes rose. We aren’t quite back to September’s highs, but the S&P 500 has recovered over 80% of last year’s decline.

March 9th marked the tenth anniversary since the stock market lows were reached back in 2009. Over that time we’ve seen gains of over 300% in US stocks. A big part of those returns has come as a result of the Fed’s stimulative policies that have inflated asset prices even as real GDP growth has crept along at fairly low levels.

Chart: Debt payments as % of disposable personal incomeConsumers take care of business

The US consumer is doing well. Unemployment is down to just 3.8% and the percentage of working-age people who are employed or looking for work is near its highest level since 2010. Strong job figures for March saw 196,000 new jobs created, after just 33,000 were added in February.

As a result, consumers are directing less of their paychecks towards debt payments in recent years than at any other point since Federal Reserve started tracking it in 1980. If the American household was a stock, we would like seeing this kind of strengthening balance sheet.

Policy issues are still all talk

Though the stock market is delivering strong returns, many of the same questions about the economy we had in December have yet to be resolved. At the macro level, trade talks between the US and China are progressing but have yet to result in a new agreement. And though the partial government shutdown came to an end in January after 35 days, the divisive domestic debate over a border wall continues.

In Europe, the UK’s exit from the European Union (known as Brexit) is quickly approaching without a formal plan in place. EU members voted in March to extend the deadline until April 12th if no deal is reached, or May 22nd if the UK Parliament can reach an agreement on a plan. A “no deal” Brexit would likely be the most disruptive scenario for the world’s fifth-largest economy—particularly for people who live and work along the Ireland/Northern Ireland border. At this point, it is hard to predict how Brexit will end up as lawmakers scramble for a deal, and what its ramifications for trade partners will be.

Chart: Strength of economic expansionsFederal Reserve calls a time out

Closer to home, one major shift since December is the Federal Reserve’s retreat from monetary tightening. The Fed Funds rate, which influences interest rates across the financial system, was raised eight times by the Fed from December 2016 to December 2018, with another two or three additional hikes planned for 2019. At its March meeting, the Fed backed away from planning any increases in 2019 and may possibly consider only one next year. On top of halting rate hikes, Fed Chairman Jerome Powell announced the Fed will also stop shrinking the Fed’s portfolio of Treasury and mortgage bonds accumulated over three “quantitative easing” programs that injected over $4 trillion into financial markets.

Chairman Powell cited slower economic growth as the reasoning behind the shift. US GDP growth is indeed expected to slow in 2019 compared to last year’s 2.9%. A slow growth rate would be in line with recent trends; “slow and steady” has been the best description of the US economy since the financial crisis ten years ago.

Indeed, the current economic cycle (the light blue line on the nearby chart) has seen the slowest pace of growth compared with all other economic expansions since World War II. Perhaps this chart can explain why the last decade has often been called “the most unloved bull market of all time.” Real growth has never accelerated enough to allow investors to have full confidence in the economy.

Recession signal flashes red

Meanwhile, bond markets sent a potentially ominous signal in March when interest rates on longer-term bonds (the 10-year Treasury bond) fell below that of shorter-term bonds (the three-month Treasury bill) for nearly a week. This type of inversion of the yield curve has happened prior to every recession over the past 50 years. The gray areas on the chart on the next page represent US recessions.

Recessions have taken time to begin after inversions in the past—usually beginning six to 24 months after inversion. So do the data say the next recession could be imminent? The Atlanta Federal Reserve is projecting a 2.1% growth rate for GDP in the first quarter, which suffered from the impacts of the extended government shutdown and the cold weather from the polar vortex.

Earnings growth slows as margins return to trend

Company earnings growth is in fact slowing down compared to last year. S&P 500 earnings for the first quarter are projected to fall by 3.9% even while revenues are expected to grow by 4.8% according to FactSet. This result for earnings probably reflects the fading impact of last year’s corporate tax cut and profit margins returning to traditional levels. Yet despite the tougher first quarter, corporate earnings are still expected to grow enough to post another year of record earnings in 2019.

Chart: 10-Year Treasury Bond Rates minus 3-Month Treasury Bill Rates

Needless to say, the Fed’s actions on interest rates have major implications for Main Street and Wall Street and for the first time in a long time, it is really difficult to guess what the Fed will do next. The President is loudly advocating for interest rate cuts and additional quantitative easing. Chairman Powell has left the door open to go in either direction from here.

Though the yield curve inversion sparked worries of an impending recession, one is not quite showing up in the data yet. True, inversions have been a strong indicator in the past but one thing I’ve learned about investing is that the more people believe an investing rule “truism,” the less power it tends to carry in the future. Moreover, yields have been trending this way for several years, so it’s unlikely the Fed changed course as a result. While inversion is a significant event, it’s just part of the equation. So just like the Fed, we’ll have to wait and see. ■

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, 2019, 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, 2019, 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 03/31/2019, 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.