Charles de Vaulx’s semi-annual IVA Funds letter to the shareholders from the portfolio managers.
Over the period under review, October 1, 2013 to March 31, 2014, your Funds continued to deliver strong absolute returns, in excess of inflation and nominal GDP growth. Importantly, this result was achieved with less than 55% invested in equities, on average, and a large cash position throughout the period that resulted in good principal protection in times of market weakness, particularly in January of this year.
Our relentless quest for strong risk-adjusted returns has been complicated in the last few years by soaring valuations for most asset classes. This appreciation was driven in part by very low interest rates in developed economies. This era of “quantitative easing” (read manipulation of prices of government bonds by central bankers) may be ending in the U.S., but continues unabated in Japan and may be coming to Europe in the near future. While the effect on the economy is hard to quantify or even demonstrate, clearly quantitative easing had a positive effect on asset prices. We are living through a very unique time in financial history.
Charles De Vaulx: Bull market in the U.S. is now aging
The current bull market in the U.S. is now aging, entering its sixth year; flows into equity products (mutual funds and exchange traded funds, ETFs, combined) are large; the high yield bond market remains very lax and accommodating; margin debt in the US, as a percentage of market capitalization, is at a record high; some pockets of exuberance are possibly appearing (biotech companies and a few “social media” stocks, for instance, come to mind); corporate earnings are far from depressed despite tepid economic growth globally, and most importantly, one must consider price when making an investment. On that front, the discounts to intrinsic values, when available at all in the stock market, remain in general, unappealing. Of note is the fact that market capitalization to GDP in the US is now well past the 2007 level.
Your equity investments are, for the most part, in well capitalized companies, where healthy balance sheets can help mitigate adverse business developments or recessions. In particular, the Funds own stock in a number of companies we consider very high quality (Astellas Pharma, Danone, Eutelsat Communications, Nestlé, and Sodexo come to mind for both the Worldwide and International Fund; and US names such as Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), Aon Plc (NYSE:AON) and Mastercard Inc (NYSE:MA) for the Worldwide Fund only). Smart, shareholder friendly managements, coupled with good businesses (moderate to high organic top line growth over the economic cycle, high barriers to entry, high returns on capital employed, low to reasonable capital intensity, some inflation protection or ability to raise prices, little to no political interference) could provide reasonable, but not stellar, returns in the years to come, given the prices these companies trade at. With high cash levels in both Funds, we have plenty of ammunition to buy more of these companies if their share prices fall, and are prepared, with the help of our ten talented analysts, to seize upon similar investment opportunities when they present themselves.
In Europe and Asia, the Funds also own a number of smaller companies that we believe are reasonably valued. In sharp contrast, American small and mid-cap stocks are very expensive, both in absolute terms but also relative to large capitalization companies, in our opinion.
Charles De Vaulx: Funds exposed to the japanese economy
The Funds are exposed to the Japanese economy through a collection of mostly obscure, yet highly profitable, holdings trading at reasonable prices. We note with some trepidation that Japan may be nearing the end of a very long deflationary period. The corporate sector has been deleveraging for well over a decade (in fact the vast majority of our holdings in Japan carry no debt, and some carry large net cash positions) and the labor market appears tight, as demonstrated by a declining working population and the growing participation rate of women in the Japanese workforce. This situation could eventually lead to higher wages, and hence the end of deflation. We monitor these developments closely as the Japanese Central Bank is, at the same time, implementing a very aggressive quantitative easing program. A nascent current account deficit, coupled with very heavy government debt in Japan, makes the situation a bit tricky. Large foreign exchange reserves held by Japan, however, may make this situation sustainable for a while. The future is more uncertain than ever for Japan! But we hedged a substantial part of our currency exposure, in an effort to mitigate some of the risks associated with this situation.
Valuations in Japan remain reasonable and could even turn out to be cheap if companies implement the right reforms, such as returning excess capital to shareholders or engaging in mergers and acquisitions to mitigate potential pressure on wages and lack of available labor. We construct the portfolio one company at a time, and continue to take advantage of valuation discrepancies between some Japanese businesses and similar businesses around the world, while controlling risks as much as possible.
Charles De Vaulx: Participating in emerging market growth
Emerging markets have been going through a rough patch lately. Over recent years, we chose to participate in emerging market growth through developed market companies like Nestle SA (ADR) (OTCMKTS:NSRGY), Bollore SA (EPA:BOL), or Sodexo SA (ADR) (OTCMKTS:SDXAY), which earn a substantial portion of their profits from emerging markets, but were trading at reasonable valuations. These investments turned out to be highly profitable for our shareholders over the last few years, despite the poor performance of emerging markets in general. Despite our efforts, it remains difficult to find good value in emerging market stocks, although some small Hong Kong listed equities are cheap, in our opinion.
In fact for the International Fund, we found a number of small companies exposed to China over the period, listed in Hong Kong, of decent to good businesses trading at very reasonable valuations. Price versus value takes precedence at IVA over concerns regarding the Chinese economy as a whole. None of these businesses are controlled by a local region or government, all are well managed in our opinion, sport solid balance sheets and appear to be shareholder friendly, although some may be subject to abrupt changes in regulations (Phoenix Satellite Television Holdings comes to mind).
We continue to hold a position in gold bullion in both Funds, as a hedge against extreme outcomes. Since the beginning of the year, fear has flared up from time to time, periodically due to the annexation of Crimea by Russia, or due to recurring fears of an economic slowdown and defaults in China. During these bouts of increased fear, gold has generally acted as we would hope, going up while equities were going down.
Patience is a necessary virtue for value investors; patience to see the market recognize some value it was previously ignoring; or, more to the case now, patience to wait for the fat pitch, free of the short-term vagaries of benchmarks. Cash, while seemingly offering little appeal today, with barely positive nominal yields (and negative yields after inflation is accounted for), has two powerful advantages: cash will act as a buffer in your Funds should markets correct, and cash will also provide