Bernard Horn’s Polaris Global Value Fund letter to shareholders for the second quarter 2014.
Dear Fellow Shareholder,
Global equity markets experienced another solid quarter of performance, as evidenced by the MSCI World Index, which was up 4.86%. The Polaris Global Value Fund (“the Fund”) returned 2.23%. Stocks across many developed markets rallied as Russian/Ukraine tensions eased (if only momentarily) and global growth concerns receded. European markets were bolstered by Norway, Spain and the UK. Asia-Pacific markets were robust, with positive results from Japan and Hong Kong. Many emerging markets stocks advanced. The U.S. market continued its upward trajectory, with the S&P 500 showing the longest streak of quarterly gains since 1998.
Year to date, Polaris Global Value Fund continued to exceed the MSCI World Index, up 6.73% vs. 6.18%. We believe that the outperformance year-to-date and over longer annualized periods can be attributed to Polaris’ deep value orientation, flexibility to invest anywhere in the world and methodical fundamental stock analysis conducted by an experienced investment research team. Benefiting from expanded research capabilities and screening systems, Polaris has already reaped the rewards with recent stock additions, Tullow Oil plc (LON:TLW) (OTCMKTS:TUWOY) and Yara International ASA (ADR) (OTCMKTS:YARIY) (STO:YARO), which have contributed measurably to Polaris Global Value Fund’s gains this year.
Polaris Global Value Fund: Portfolio holdings
During the quarter, Polaris Global Value Fund achieved absolute positive performance across all 10 sectors; however, benchmark returns in energy, information technology and consumer discretionary sectors surpassed Polaris Global Value Fund’s corresponding sector results. On an individual stock basis, more than two thirds of Fund holdings had absolute positive results, led by Duni AB (STO:DUNI) (OTCMKTS:DUNIY), Yara International ASA (ADR) (OTCMKTS:YARIY) (STO:YARO), Tullow Oil plc (LON:TLW) (OTCMKTS:TUWOY) and Loomis AB (STO:LOOM-B). German ATM manufacturer Wincor Nixdorf AG (ETR:WIN) (OTCMKTS:WNXDY), Italian engineering firm Trevi-Finanziaria Industriale SpA (BIT:TFI) and Italian lottery operator GTECH SpA (BIT:GTK) detracted.
Yara International (OSL:YAR), purchased in the first quarter of 2014, was the top performer in the materials sector. The Norwegian fertilizer maker reported first quarter results with record deliveries of value-added products at premium pricing. Yara detailed solid European and Latin American order books for the remainder of the year, and alluded to better operating margins on declining European natural gas prices. Among other sector gainers was German flavors/fragrance maker Symrise AG (ETR:SY1), which conducted a capital raise to finance its planned acquisition of French food ingredient maker Diana Group. While the market lauded this strategic initiative, the same could not be said for German chemical company Lanxess AG (ETR:LXS), which also conducted a capital raise. LANXESS issued new shares equivalent to 10% of its equity capital (thereby diluting existing shareholders) to fund restructuring. Although investors deemed this as negative news, we expected such measures and were pleased to see action initiated by the well-respected former CFO who recently returned as CEO.
High energy prices in combination with merger & acquisition activity in oil exploration and production helped boost energy sector returns. The MSCI World Index energy sector was up nearly 12% for the quarter, driven by performance of mega-cap integrated oil companies. However, the double-digit returns from three Fund holdings, Tullow Oil, Maurel & Prom (EPA:MAU) and Marathon Oil Corporation (NYSE:MRO), weren’t enough to beat the sector benchmark. We purchased Tullow Oil plc (LON:TLW) in late 2013 on the expectation that political turbulence in oil producing nations will continue and the resulting supply disruptions will sustain higher oil prices; this theory held merit, as oil prices remained firm in the second quarter of 2014. Tullow’s reserves have nearly tripled in the past seven years and the company has a large position in Ghana, Uganda and Kenya, where it helped discover vast oil and gas resources.
Japan’s Asahi Group Holdings Ltd (TYO:2502) and MEIJI Holdings Co Ltd (TYO:2269) buoyed the consumer staples sector. Asahi Group is gaining market share for beer in Japan and its soft drink margins continue to improve.
Five of seven healthcare sector holdings posted positive returns for the quarter, led by Forest Laboratories and WellPoint Inc. Forest Laboratories, Inc. (NYSE:FRX) continued to benefit from the news of its acquisition by Actavis PLC (NYSE:ACT), the world’s second largest generic drug maker. Expanded Medicaid enrollment and premiums gave a boost to managed care companies including WellPoint (WLP), which posted strong first quarter results and raised full year guidance. The world’s largest provider of medical testing services, Quest Diagnostics Inc (NYSE:DGX), saw its share price rise after announcing its partnership with Memorial Sloan Kettering in New York to screen patients’ cancer genes for genetic mutations. Transgene SA (EPA:TNG) dropped after Novartis declined to exercise an option to fund Transgene’s TG4010 targeted cancer immunotherapy for treatment of metastatic non-small cell lung cancer. Transgene is attempting to form another partnership by year-end, as there are three other interested parties.
Outperformance in the telecom sector was due to Deutsche Telekom AG (ETR:DTE) (OTCMKTS:DTEGY), which continued to gain traction on speculation that Softbank Corp (TYO:9984) (OTCMKTS:SFTBF) may acquire DT’s T-Mobile USA subsidiary, and KDDI Corp., the Japanese telecom carrier which is expected to introduce flat rate plans.
Among financials, Texas-based International Bancshares Corp (NASDAQ:IBOC) reported healthy first quarter 2014 results, with a 55% rise in net income and 54.8% increase in diluted earnings per share compared to the prior year period. The banking institution pointed to rising net interest margins, attributable to higher net interest income from its investment portfolio, an increase in outstanding high quality loans, and a decrease in interest expense on securities sold under repurchase agreements. Dun & Bradstreet Corp (NYSE:DNB), Norway’s largest bank, posted positive first quarter results with lower loan losses from shipping, deposit growth and increased lending in the Baltics and Poland. Similar to IBOC, Ameris Bancorp (NASDAQ:ABCB) reported improved net income, higher interest margins and additional revenues from the acquisition of The Prosperity Banking Co. The company also reinstituted the dividend that they eliminated during the 2008- 2009 credit crisis, repaid TARP and completed another acquisition. Yet, the stock price dropped more than 7%; we can’t ascertain any fundamental reason for the decline.
Polaris Global Value Fund’s utility holdings outperformed the sector benchmark, led by double-digit returns in Hong Kong water utility Guangdong Xnbo Elctl Applns Hldgs Co Ltd (SHE:002705). The company instituted quarterly reporting, signaling greater transparency for investors, and announced wastewater expansion initiatives. Water tariff increases are also anticipated during upcoming contract renegotiations.
Loomis AB was the top contributor to industrial sector results, up more than 20%, on good earnings, increasing margins and a new contract with Bank of America. The agreement states that Loomis will manage cash processing and check imaging services for 30 locations in the U.S., which is expected to generate more than $20 million in annual revenue for Loomis, while lowering costs for Bank of America. General Dynamics Corporation (NYSE:GD) was up on positive earnings news, with growth in the aerospace sector and a hefty backlog in combat and marine systems. Detracting from industrial returns was Italian engineering firm Trevi Finanziaria , as it reported lackluster earnings and lower profit margins for the first quarter of 2014, while increasing spending for new rigs. Although short-term performance looks weak, Trevi announced a 24% increase in new orders during the quarter, which bodes well for further business development.
Many of Polaris Global Value Fund’s U.S. information technology companies posted healthy results, including Xerox Corp (NYSE:XRX), Hewlett-Packard Company (NYSE:HPQ), The Western Union Company (NYSE:WU) and Microsoft Corporation (NASDAQ:MSFT). These returns couldn’t mitigate declines at Wincor Nixdorf as the company announced lower revenues due to slowing emerging European market (Turkey, Russia) sales. Nevertheless, the CEO reassured investors that 2014 growth targets were still attainable.
Swedish table napkin maker Duni (OSTO:DUNI)’s stock price was up more than 20%, which helped offset subpar performance among other consumer discretionary holdings. Duni’s operating profitability improved in the first quarter of 2014, and the company was able to gain market share in the moribund European market. Duni also announced the acquisition of Paper+Design Group, a German company with a dominant position in designer napkins sold in consumer markets throughout Europe. Regal Entertainment Group (NYSE:RGC)also posted double-digit returns for the quarter, benefiting from summer blockbusters, and the recently introduced “Regal Super Ticket” for the $100 million opening debut of Transformers. At the other end of the spectrum, Italian lottery/gaming operator GTECH (MIL:GTK)’s stock price dropped after rumors emerged of a potentially expensive acquisition of a casino machine equipment manufacturer, which would add more debt to GTECH’s balance sheet. In addition, U.K. homebuilders were weak due to concerns that regulators were trying to dampen the housing market. However, at quarter end, the Bank of England came out with relatively benign lending guidelines already being followed by the banks, and share prices rebounded.
Polaris Global Value Fund: Investment Environment and Strategy
Although we appreciate the global market gains over the past few quarters, we are concerned that such upward mobility may be partially due to greater liquidity and loose central bank monetary policy. The Bank for International Settlements noted that such fiscal policy could create asset bubbles and increase debt harmful to long-term economic prosperity. We concur with this assessment, and are careful to identify signs of economic weakness, including the recently contracting U.S. gross domestic product and slowing development in select Asian markets.
We also see pockets of growth throughout the world, with marginal improvements in some European countries, India, China and select emerging markets. Even the U.S. has positive indicators (rising home sales and better U.S. manufacturing activity) that we believe may indicate sustainable momentum. However, these macro-economic conditions do not drive our investment approach. Our main focus remains on fundamental analysis – seeking to identify the most undervalued stocks that may be capable of growing stronger in difficult economic environments, while performing admirably in growth cycles too.
Bernard R. Horn, Jr., Portfolio Manager