In Like a Lion, Out Like a Lamb

Q4 2018 Investment Commentary

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

In a year that began with optimistic fervor on lower taxes, 2018 ended instead with a painful stock market decline. After a 2.7% drop on Christmas Eve, the S&P 500 had fallen 19.8% from its high of September—very close to the 20% threshold considered a bear market. So while the nearly 10-year-old bull market may still be alive, it’s only by the smallest of margins.

Other indices, such as the technology-heavy NASDAQ (-23.6% from peak to trough) and the Russell 2000 Small Cap Index (-27.2%), did actually fall into bear market territory. A strong rally in the final week of the year lessened the pain somewhat but the S&P 500 still trimmed 13.5% in the fourth quarter to end lower by 4.4% for the full year. 2018 was the first negative calendar year for the S&P 500 since the decline of 37% in 2008.

Index 4th Quarter 2018 3 Years 5 Years 10 Years
S&P 500 (US Large Cap) -13.5% -4.4% 9.3% 8.5% 13.3%
Russell Midcap (US Mid Cap) -15.4% -9.1% 7.0% 6.3% 14.0%
Russell 2000 (US Small Cap) -20.2% -11.0% 7.4% 4.4% 12.0%
MSCI ACWI X-US IMI Net (Foreign Equity) -11.9% -14.8% 4.4% 0.9% 6.9%
MSCI EM (Foreign Emerging) -7.5% -14.6% 9.3% 1.7% 8.0%
Barclays Aggregate Bond 1.6% 0.0% 2.1% 2.5% 3.5%
Barclays Muni Bond 1.7% 1.3% 2.3% 3.8% 4.9%

Past performance is not an indication of future performance.

Providing some relief, government and high-quality corporate bonds held up well despite another Federal Reserve rate increase. The Fed’s 0.25% Fed Funds rate hike in December marked the fourth such increase in 2018 and the ninth in three years.

Click image to enlarge

Higher Interest Rates

One driver of the selloff is the prospect of (and reality of) higher interest rates. If the ultra-low interest rate environment of the last decade contributed to higher prices for risk assets like stocks and real estate, it stands to reason that higher rates will serve as a headwind to further price increases for these assets going forward. Interest rates remain quite low relative to history but they are significantly higher than several years ago, especially for short-term borrowers. Corporations that typically borrow for five years or less will face higher interest expenses, negatively impacting earnings.

Politics in Focus

In last quarter’s commentary, we said that Republicans would likely lose control in the House which would lead to more of a stalemate in Washington. We just didn’t think it would happen before the newly elected politicians took office on January 3rd. The US government began a partial shutdown on December 22nd without a new funding bill in place. Government shutdowns like this aren’t unheard of but the third in a single year is unusual. We are at the point (around two weeks) where shutdowns begin to hamper the economy. While President Trump and Congress dig in over the border wall issue, the effects will trickle down to more and more Americans. We don’t think this will have a lasting effect on the market.

On another front, President Trump continues to fight for fair trade with China. He and Chinese President Xi agreed to a 90-day truce on trade tariffs back on December 1st while they work toward a sustainable long-term solution. China already announced tariff cuts while the US delayed tariffs on over $200 billion in imports. China even pledged to resume buying soybeans—to the great relief of US farmers. The first face-to-face negotiation will occur in the second week in January. The outcome of these talks will impact the global economy in 2019 and beyond.

EU and UK leaders continue to deal with their own political battles related to Brexit. The two-year waiting period for the UK to leave the European Union ends in March. UK Prime Minister Theresa May successfully negotiated withdrawal terms with EU officials but canceled a final vote by the UK Parliament after it became clear that the terms of the agreement would not be supported. As March approaches, three outcomes are emerging: Brexit with May’s deal (least likely), Brexit with no deal (creates significant disruption in trade and movement of people across borders) or another referendum for British citizens to vote again on staying in the EU (unclear if another vote would be legal). Brexit will likely loom large in 2019. It appears that markets are bracing for Brexit with no deal given that time is short.

Fundamentals Stable, Growth Slowing

Despite all the political handwringing across the globe, the US economy is growing. Once all the numbers are in, US GDP growth for the year is projected to come in at a healthy 3%. It is important to note that 2018 GDP enjoyed a nice boost from the tax cut passed in December of 2017; the impact of lower tax rates will be of less significance in 2019. Estimates for GDP growth in 2019 are positive though slightly lower at around 2%-2.5%. At 3.7%, the unemployment rate is the lowest it has been since 1969. Fed officials cited this strong economic data in raising rates again in December, even as stock market investors signaled (by selling stocks) that another rate increase was not needed. Fed officials say they don’t consider the stock market in rate decisions but in practice, raising rates during falling markets is extremely rare. Chairman Powell explained that the Fed will be more careful or “data dependent” going forward but reiterated that Fed officials would not have supported the recent rate hike if they believed the next recession was imminent.

Of course, what moves the stock market is corporate earnings growth and 2018 brought spectacular earnings growth. Earnings for the S&P 500 companies are expected to have grown by over 20% in 2018, the best year since 2010. Much of the increase is attributable to the reduction in the corporate tax rate and there won’t be a similar boost for 2019. FactSet currently estimates S&P 500 earnings growth of 7.9% in 2019. Since 1950, every US recession has been marked by falling corporate earnings; investors will be watching closely for revisions to 2019 estimates.

Seeing the Forest Through the Trees

2018 Q4 Forward P/E Ratio chart

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We begin 2019 with the economy and corporate earnings on seemingly stable footing. Growth may be slowing for both, but they are still moving in the right direction. And after the market sell-off, stock valuations are lower than they’ve been in several years.

2018 Q4 Intrayear Declines chart

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Higher interest rates, the government shutdown, trade wars, and Brexit all pose real risks to growth but the greatest risk may be that falling sentiment becomes a self-fulfilling prophecy. Measuring this risk is difficult of course; there has been no shortage of worrying and dire predictions throughout the current bull market and yet the market has continued its climb until only recently. The recent volatility might turn out to be a clearing of the brush to make way for new growth or it may turn out to be a sign of more declines to come…we just don’t know yet. One thing we do know: recessions, corrections and bear markets are normal. The chart above makes this clear and is a good reminder of the importance of owning a portfolio that is appropriate for your risk tolerance, your need for liquidity and your need for growth. ■

Queens Road Small Cap Value Fund Performance Update

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

“Patience is bitter, but its fruit is sweet.”

The Queens Road Small Cap Value Fund significantly out-performed its benchmarks and peer group with a total return of -8.52% vs. -18.67% for the Russell 2000 Value Index and -19.16% for the Morningstar Small Value category for the volatile 4th quarter of 2018. For the full 2018 year, the fund returned -5.66% vs. -12.86% for the Russell 2000 Value Index. The fund has a four-star overall rating from Morningstar and finished in the top 5% of the Morningstar Small Value category for 2018. The risk-adjusted returns for the longer-term 5-year, 10-year and 15-year average returns are in line with or exceed our benchmarks.

Performance Summary: December 31, 2018

Since Inception* Lifetime Cumulative
Queens Road Small Cap Value -8.52% -5.66% 4.90% 3.88% 9.93% 7.19% 8.61% 292.23%
Russell 2000 Value Index -18.67% -12.86% 7.37% 3.61% 10.40% 6.91% 7.65% 238.53%

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.

Patience rewarded. The momentum-based market gains over the past several years tested our patience and that of our fellow shareholders. It requires a great deal of discipline to successfully implement a value process over a full market cycle. We look for high-quality companies with manageable debt levels that are run by proven managements. Buying these types of companies at the right price is very important. Sometimes prices are very attractive, but fear pervades the markets and it requires courage to buy when others are selling. Other times, when valuations are stretched, it requires patience to wait for more attractive investment opportunities. We work hard to ignore the macro noise, set aside emotion and maintain our focus on valuation. It is rewarding to see our process work and our fellow shareholders benefitting from our discipline as we outperformed the Morningstar Small Cap Value category by over 10% during 2018.

Selling high and buying low…or lower. While we have been carrying unusually high cash balances in the portfolio over the last several years, the recent decline in prices has presented us with some attractive buying opportunities. Our watch list is loaded with quality companies that we like but they have been trading at unrealistic valuations. As prices declined this fall, we were able to add to take positions in some new companies as well as add to some existing holdings which had gotten beaten down in the broad market downturn.

The volatile 4th quarter provided us an opportunity to invest some of our cash at very compelling valuations. For the first time in several years we are seeing attractive opportunities to deploy cash across a wide variety of industries. During the quarter we initiated two new positions and added to existing holdings as the correction drove stock prices down to undervalued levels.

New Positions

VSE Corp—During the 4th quarter we began to accumulate shares in VSE Corp, a global logistics company with segments in supply chain management, aviation and federal services. VSE’s share price fell approximately 40% over the course of 2018 as revenues softened in its federal services group, its largest segment by revenue. Although revenue growth has been constrained, the company derives over half of its revenue from contracts with the US government which provide a healthy backlog of recurring revenue. Also, as a profitable company that derives 100% of its revenue in the US, the company stands to benefit from recently reduced corporate tax rates. We see the recent price decline as a market over-reaction and a great opportunity.

CSS Industries—The share price of CSS Industries fell approximately 65% over the course of 2018 and we began buying shares in October. CSS competes in three segments–seasonal (wrapping paper/ribbons), gift (wedding, graduation, etc.) and crafts (sewing accessories). Arguably boring and under the radar, CSS has a long history of strong free cash flow margins and has a cash balance roughly equal to half of its market capitalization. We have studied the issues facing the company and feel good about its long-term outlook and believe the stock is currently significantly undervalued.

Additions to Existing Positions

The volatility of the 4th quarter of 2018 also provided us with attractive opportunities to add to several of our current portfolio holdings.

Colfax—2018 was a transformational year for Colfax as the company announced an exit from the air and gas handling business while making a $3.1 billion acquisition of orthopedics manufacturer DJO Global, a maker of joint implants and rehabilitation products. The share price of Colfax declined 47% over the course of the year as worries about the increased debt load resulting from the DJO acquisition weighed on investors. We also have concerns about the level of leverage but remain positive as the company will use the sale price from the sale of its air and gas business to reduce debt. Furthermore, the non-cyclical nature of DJO Global’s markets allows the company to support higher leverage.

Greenbrier—The US-based freight car manufacturer fell 24% during 2018 on fears of the cyclical nature of the railcar business. The company has done well to mitigate cyclical concerns through international diversification. The company’s European, Saudi Arabian, and South American segments continue to experience strong growth as 30% of railcar orders for 2018 were international orders. With no net debt and a substantial backlog of orders we believe near-term cyclical concerns are overblown.

Prestige Brand Holdings—We had reduced our position over the past 12-24 months in this long-time holding on rising valuation concerns. As the stock fell by over 30% during the year, we took advantage of the decline by adding to our position in December. Prestige has a diversified portfolio of over-the -counter healthcare products. With recognized brands like BC/Goodys, Chloraseptic, Dramamine, and Compound W, among others, the company has been on an acquisition spree over the last decade, leaving the company with a higher debt-load than they typically carry. However, given the strong positions of their brands and their broad distribution strategy, we are confident that the shares offer an attractive investment opportunity at these lower prices.

In closing, we are pleased to report such strong relative results to our fellow shareholders. Our portfolio managers, independent board and employees are among the largest shareholders in the Queens Road Funds. We’re invested right alongside your clients.

Please contact us if you have any questions about our process or performance. John Bragg and I will have a booth at the Morningstar Investment Conference in Chicago in May. 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. ■

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 December 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 December 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 December 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.