It’s been a difficult couple of weeks in Charlotte, North Carolina. You’ve seen media coverage of protesters marching around the downtown area in response to the police shooting of an African-American man. While most protested peacefully, some locals and outside activists vandalized property, physically assaulted police officers, members of the press and other bystanders, and blocked interstate highways and looted stores.
We are saddened and frustrated by these events. As Charlotte natives, we care deeply about our city and have a long history of supporting efforts to build community. Twenty years ago, our firm founder Frank Bragg established a 501(c)3 called Right Moves for Youth to serve at-risk youth in our public school system. Over the years, many of our employees have volunteered with Right Moves for Youth and other non-profits as mentors, tutors and financial literacy educators. Naturally, the events of the past few weeks have been very disturbing. Despite this, we are confident the community will come together and move past this difficult period. Charlotte is a great city and an outstanding place to live, work and raise a family. Thank you to those of you who contacted us to express your concern.
Q&A with Queens Road Small Cap Value Portfolio Manager Steve Scruggs, CFA
Question: We began the year with a 15% decline in the equity markets and now, we are looking at all-time highs for stocks? Where did all the worry go?
Steve Scruggs: That is a good question. Investors began 2016 with fears of additional Federal Reserve rate increases, worries over a slowdown in China, and falling oil prices. It was the worst January in years for the equity markets. After just one rate increase last December, the Fed quickly backed off intentions of gradually increasing rates. They voted last week to hold rates at the same level, but seemed to signal that they would raise rates in December if the economy is ready. Oil prices seem to have stabilized somewhat and are well-above the lows of sub-$30 a barrel. Investors had a brief scare in mid-June with the surprise vote by the British to leave the EU, but it seemed to be a knee-jerk reaction and markets quickly recovered.
Question: How did the markets perform during the third quarter?
Steve Scruggs: It was a good summer for stocks. The S&P 500 was up about 4% and the Russell 2000 Value Index gained almost 9% for the quarter. Year-to-date, the S&P 500 is up 7% and the Russell 2000 Value is up 15%. The Dow Jones Industrial Average, the S&P 500 Index, and the Nasdaq Composite all notched a new record high last month on the same day, August 11th. The last time all three indices closed at a new record high on the same day was December 31, 1999.
The markets hit a stretch in mid- to late-summer of extremely low volatility. Volatility this low has only been seen about a dozen times over the past half century. Our fund does best when there is a little volatility or worry in the markets. Markets are trading in a very narrow range, too, with the S&P 500 barely moving between its high and low for the day. By the end of August, the S&P 500 Index had recorded the most consecutive days since 1970 with such a narrow range of trading, according to the Wall Street Journal. The second-longest consecutive stretch of days with such a narrow trading range occurred in July. We’ve seen periods of low volatility before, like early 2011 before the U.S. had its debt downgraded and in early 2007 before the financial crisis.
Question: What do you think is driving this low volatility and rise in the market indices?
Steve Scruggs: I pin almost all of it on the Central Banks, especially the Federal Reserve. Their easy money policies continue to ease the worries of investors. The old saying of, “Don’t fight the Fed,” has never been more true. Investors just don’t seem to care about market fundamentals as long as they are assured the Central Banks will jump in at the first sign of trouble and support the markets.
I think another reason for the stock market gains is the search for yield. So many small investors and larger pension and institutional investors are frustrated with the low yields on safe government bonds and have moved into stocks to boost returns.
Question: Besides the Fed policies, do you see any other signs of worry?
Steve Scruggs: I always see signs of worry. Just a few months ago, many analysts were projecting that companies would report earnings growth in the third quarter. FactSet is now predicting that companies will be reporting a sixth-consecutive earnings decline. They are estimating about a 2% contraction from a year ago. That is worrisome. Stocks can’t keep going up without some fundamental growth in earnings.
Another thing to worry about is the rising amount of debt that consumers are carrying, like car loans, college loans and credit cards. Many homeowners are falling behind on payments on their home-equity loans that were taken out in 2005 and 2006, prior to the housing bust. These types of HELOC loans were wildly popular leading up to the financial crisis, and typically only required interest payments for the first 10 years. Now, 10 years later, principal payments are required which often mean an increase of hundreds or even thousands of dollars per month.
Question: How has the Queens Road Small Cap Value fund fared during this period of continued Fed support and resulting low volatility?
Steve Scruggs: This is not the kind of market where we tend to do well and the fund has lagged the Russell 2000 Value Index over the past six months. Year-to-date through the end of third quarter, the fund is up 9% vs. 15.4% for the index. Back in mid-February when investors were paying attention to risk, we were down -5% vs. -11% for the index. So, there was a complete flip-flop over the past few months on whether investors were paying attention to risk.
Question: Have we seen markets like this before?
Steve Scruggs: Yes. We saw similar periods when investors ignored risk in 2006 and part of 2007, and again in 2012. We fell behind our peers and benchmarks in those periods as well. We fully expect to lag during periods like these when investors perceive that there is no risk in the market. While it is hard to see our performance fall behind during times like these, we hope that our process will continue to produce favorable results over full market cycles.
Question: What has been doing well in this market?
Steve Scruggs: The top performing sectors during this period were cyclical focused sectors such as energy and financials. We do not have much exposure to those types of companies which hurt the fund’s performance. We have been overweight in utilities and industrials which performed well during the volatile early part of the year, but have not done as well as risk tapered.
Question: What do you expect from the markets for the remainder of the year?
Steve Scruggs: That is a great question. And one that we think about a lot, but don’t attempt to take action on. Based on the worry at the beginning of the year, you would have thought markets were headed for a second losing year in a row. The Federal Reserve’s GDPNow forecasting tool is calling for 3.5% GDP growth for the third quarter, well ahead of the abysmal 1% rate in the first half of the year. The U.S. presidential election will create some uncertainty as well.
Question: How do you feel about market valuations?
Steve Scruggs: Companies look expensive to us. We have felt that for some time and have trimmed a number of holdings in the portfolio. Nobel Prize winning economist Robert Shiller’s CAPE ratio (cyclically adjusted price/earnings) is a longer term valuation indicator that looks beyond just a forward-looking P/E ratio. It is based on the S&P 500’s current price divided by its average earnings over the past 10 years adjusted for inflation. The CAPE ratio currently stands at 27.1, well above its long term average of 16. In fact, today’s valuation falls into the top decile of historical observations based on data dating back to the 1880’s.
Question: Has the amount of cash you hold increased as you have trimmed some positions?
Steve Scruggs: Yes. Our cash currently stands at about 25% of the portfolio. This is not a “call” on the market. We do not attempt to predict when the market will go up or down. It is simply a by-product of our bottom-up valuation process. Our process begins with a series of screens on the Russell 2000 Value Index. Screening narrows the list down to about 200 companies. Our quantitative analysis includes looking for solid balance sheets, good cash flows, and manageable levels of debt. Our quantitative process continues as we study management and sector and industry.
Today, we are finding two types of companies. The first type of company meets all of our criteria- great balance sheets, low debt, strong cash flow, with experienced managements, but they are way too pricey. The second type of company meets some of our criteria, but they have some issue or some event has caused the company to stumble. While some of these initially look attractive, they require a lot more study of the factors that caused them to stumble. Sometimes, we can get comfortable that investors have over-reacted to bad news and we can buy a good company at a great price. We are finding fewer and fewer of these opportunities in this current market environment.
Question: Have you added any new positions to the portfolio recently?
Steve Scruggs: Yes. The sharp sell-off after the surprise Brexit vote gave us a nice opportunity to add some new names to the portfolio. Timken had been on our watch list for some time and we took a position in June. Timken makes ball bearings and other friction reducing products for a wide range of heavy equipment industries including aerospace, transportation, construction, oil, gas and mining.
The company generates about $250 million in free cash flow, has a reasonable level of debt, $125 million in cash on the balance sheet, and is trading at about 12x free cash flow. Timken started out making ball bearing for mule wagons over 100 years ago and has a stable management. They, along with a lot of other heavy equipment manufacturers and suppliers, have been hurt over the past 5-6 years with the slowing economy, especially the slowdown in China. Their revenue is down about 50% from its peak before the financial crisis and their stock price is down about 50%, too.
To deal with the market softness, management laid out a clear strategy to close some plants and reduce costs and is moving steadily in that direction. The company has made what we think are smart bolt-on acquisitions while successfully implementing their cost-cutting program. They’ve maintained positive operating margins through this process, protected their healthy balance sheet and generated significant free cash flow. The global ball bearing business is about a $70 billion dollar business and Timken should benefit when global growth picks up in the years to come. We feel that the company will be worth much more in three to five years than it is today.
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The Queens Road Funds investment committee recently spent time with the Morningstar Investor Research team and the Charles Schwab Investment Advisory due diligence team. Both were conducting due diligence reviews of the Queens Road Small Value fund. Their process considers both quantitative and qualitative factors such as risk, returns, management, expenses, investment process, and more. We were pleased to be named to the Schwab OneSource Select List. We were also added to the Morningstar Prospects List. Please visit the News page to see recent news and learn more.
As always, we thank you for your interest and investment in the Queens Road Funds. Our investment firm is owned and managed by four family members. All of us and our investment committee, our board, and our employees are among the largest shareholders in the Queens Road Funds. We believe in our process and we have seen it work over full market cycles. The family ownership of our firm and our funds allows us to take a much longer-term view as we manage the Queens Road Funds. Thank you for joining us as shareholders in the funds. We look forward to serving you and your clients.
Please contact John Bragg or call (888) 353‑0261 to learn more or to schedule a call with your firm. We will be riding a booth at the Schwab Impact conference in October. Please come by to say hello to Steve and grab a fresh jar of our famous North Carolina peanuts.
President, Portfolio Manager
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 September 30, 2016, 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 September 30, 2016, 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 09/30/2016, 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.