IVA Funds’ letter from the portfolio managers from the annual report.
Over the period under review, October 1, 2013 to September 30, 2014, your IVA Funds continued to deliver good absolute returns (8.00% for the IVA Worldwide Fund Class A, at net asset value, and 7.05% for the IVA International Fund Class A, at net asset value, respectively), well in excess of inflation and nominal GDP growth. Even though many markets rose and, hence, valuation became even steeper during that period, we were able to find a few new opportunities, especially in Hong Kong, therefore our equity exposure actually rose in the International Fund to 60% at period end while it remained almost unchanged in the Worldwide Fund, 52% as of September 30, 2014.
IVA Funds: Low equity exposures
Still, those remain pretty low equity exposures. Why is that? Because over the past five and a half years, many asset classes and individual securities have seen their valuation go up significantly, driven in part by very low interest rates in developed countries and by a huge rebound in corporate profits for many companies around the world. Looking at thousands of individual securities globally (stocks and also corporate bonds), our 10 analysts are finding mostly fully priced securities and quite a few overpriced ones as well. We are struggling to find genuine bargains, i.e. stocks offering at least a 30% discount to their intrinsic value estimates. The “V” in IVA Funds stands for “Value” and we are willing to let the cash levels of your Funds remain at elevated levels as long as we are not able to find what we consider enough cheap new investment securities. The idea that because rates are low we should use higher multiples to value businesses and also accept modest margins of safety has no appeal to us. That idea, frankly, strikes us as being a trap, the same way so many value investors thought it was acceptable in 2006 and 2007 to buy securities that seemed cheap, yet were not safe with their excessively leveraged balance sheets. Instead of fantasizing that low rates should justify higher valuations (as in the “Fed Model”), investors should ask themselves: Why are rates so low today? Why do so many Central Banks globally need “Quantitative Easing” and “Financial Repression”? Perhaps they should read the recent report “Deleveraging? What Deleveraging?” (Buttiglione, Lane, Reichlin and Rheinhart, Geneva Reports on the World Economy, September 16, 2014) where the writers argue that “Contrary to widely held beliefs, the world has not yet begun to delever and the global debt to GDP is still growing, breaking new highs,” as the debt build up led by the developed economies until 2008 has been substituted by a debt build up in the emerging economies, in particular China but also to some extent in the “Fragile Eight” group comprised of India, Turkey, Brazil, Chile, Argentina, Indonesia, Russia and South Africa. This report came out just a few months after the Bank for International Settlements 2013/2014 Annual Report expressed grave concerns about the “limited room for maneuver in macroeconomic policy,” with “fiscal policy generally under strain…and monetary policy testing its outer limit.” So if the world remains such an imbalanced and indebted place, you could actually argue that these ultra-low interest rates should be encouraging investors to ask for a much higher equity risk premium, using moderate multiples and insisting on healthy margins of safety instead of a lower equity risk premium i.e., using higher multiples and narrower discounts.
IVA Funds: Credit bubbles in the Western economies
It is interesting to remember in 2006 and 2007 how many commentators were talking about “decoupling” i.e., trying to convince us that many western economies would probably witness a bursting of their credit bubbles while many emerging economies would keep growing nicely and “decouple,” including China. That made no sense to us as China was then (and still is today) a vast export oriented economy. It is ironic today for us to fear the opposite, i.e., the distinct possibility that “Global Markets Catch the Chinese Flu” (The Wall Street Journal article by Ruchir Sharma, October 17, 2014). We certainly do not intend to be “long term owners of cash” (Dylan Grice) but we are happy to wait patiently for genuine bargains to surface. We do not have a bunker mentality, we are always trying to identify cheap stocks and we do get excited when markets experience corrections (late January and early February 2014, late July and early August 2014, and during September 2014, the last month of the Funds’ fiscal year). These periods gave us a chance to do some “nibbling,” either finding a few new securities or adding to some existing positions. Our cash levels remain elevated in both Funds (36% in Worldwide and 25% in International). While we understand the drag on performance resulting from that cash, we are also mindful that cash has some “defensive” value as it can act as a buffer when markets correct while it also has “offensive” value as it is the ammunition that will allow us to hopefully pounce when financial assets get cheaper.
Someone was recently explaining the significant optionality value of cash, by arguing that “cash is a perpetual call option on every asset class with no strike price and no expiration.” We would reason that in the case of the IVA Funds it is even more; i.e. cash is a perpetual call option on every security in the world, small or large, stock or bond, that would qualify as being, at the appropriate price, a good investment.
IVA Funds Performance
In the Management’s Discussion of IVA Funds Performance (pages 7 to 9 in this Annual Report) we quantify for both the IVA Worldwide Fund and the IVA International Fund how their respective equity components performed during this past fiscal year ending September 30, 2014. As was the case last year, the significant outperformance illustrates vividly that individual stock picking is “alive and well,” even in today’s world of globalization and increased correlations. One thing that is striking and unusual today, and considering how pedestrian global economic growth is at this moment, is how high corporate profit margins are in so many industries and in so many countries around the world. To a large extent, stock picking is about trying to identify those companies that may maintain their high margins going forward and those that may not. This is not only due to the fact that wages may finally be able to grow in some parts of the world (in Japan, for instance) and impact margins but also due to the enormous changes that are altering the competitive landscape in so many industries. Think about the changes in retail (with e-commerce in particular), energy (with shale oil), technology (with cloud computing), consumer products (local brands challenging some of the global brands), etc. Over the past two years, one example that we have been giving of a company that was at risk to see its margins come down was Tesco, the UK based retailer. It was interesting to read Warren Buffett admit recently that owning Tesco was a “big mistake” for Berkshire Hathaway. The one country today where stock picking going forward may be about identifying companies with