Vltava Fund commentary for the second quarter ended June 30, 2016; titled, “Investing In An Environment Of Declining Company Earnings.”

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Dear shareholders,

In the second quarter of 2016, the Fund’s NAV decreased by 8.9 %.

Vltava Fund

The earnings cycle

Our long-term investment philosophy is based on acquiring company shares at prices much lower than their values. A company’s value today is the present value of all future cash flows the shareholders may receive from today until Judgement Day. The more money a company makes the higher is its value. That is scarcely an earth-shattering revelation, of course. How individual companies’ earnings develop markedly differ from one another, however, and the collective profitability of all companies on the market also follows an irregular course. Nevertheless, a certain cyclical pattern can be observed. Let’s take a brief look at the phase of the earnings cycle we are in currently.

Let’s begin with the US market. According to data from Standard and Poor’s, the total reported earnings per share in the trailing 12 months for all those titles in the S&P 500 index combined peaked for the current cycle in the third quarter of 2014 at USD 105.96. The most recent earnings data, from the end of Q1 2016, put that number at USD 86.44. As is apparent, then, for more than a year and a half we have been living in an environment of declining company earnings and in that time profits have decreased by 18.4%. To put this into even better perspective, the two previous earnings cycles peaked in summer 2007 (at USD 84.92) and in September 2000 (at USD 53.7).

The earnings development for European companies is also cyclical, although the cyclicity has not been very apparent of late. According to data from Bloomberg, earnings per share of companies in the STOXX Europe 600 have been more or less unchanged for approximately 5 years, are lower than their high of 9 years ago, and are approximately at the level of 2005. European and US earnings had begun discernibly to diverge in 2010, after which time earnings in the US continued substantially to rise while those in European did not. Several factors may have contributed to this, including differences in the way the indices are structured, as well as poorer business conditions in Europe or a weaker focus there on creating shareholder value.

When companies’ profits are generally and significantly growing, investing is easier and company value literally grows before one’s eyes. In the declining phases of the earnings cycle, things are much less clear-cut and a little more complicated. Hand in hand with this, however, there occur more marked price fluctuations, and these can be exploited. Here are several basic rules to which we endeavour to adhere in times like these.

The equity market is a market of individual titles

Just because the earnings of companies generally are decreasing does not of course mean that profitability of all companies is falling. Even in this phase of the earnings cycle there are plenty of companies which are still growing their earnings – and sometimes by quite a lot. At such a time, however, investing requires very careful selection of individual investments. In a strongly bullish market, it oftentimes scarcely matters what one buys because everything an investor touches goes up. This is not the case today. Most equity prices have been below their highs for the past year and a half, often by tens of percentage points. The European index is about one-quarter below its all-time high while the US index is only barely so, although it should be said that the latter is held up by a handful of large (and also not very profitable) companies, and beneath the surface there lurks a skulking bear market.

The US market as a whole is trading on a P/E of 24.2 if its current level is measured against the last known earnings from March 2016. Although this is a relatively high multiple, not all equities are this expensive – not by a long shot. The situation can look quite different if we exclude all those companies having large weightings in the index but almost no earnings (Amazon) or only rather small profits (Facebook), as well as companies that are perpetual loss-makers (Salesforce, LinkedIn, Tesla) and the entire energy sector, which is currently in loss and has a 7.4% weight in the index. After stripping these out, what remains is far less expensive. Then, too, the European stock market is always open to us, and it is much less costly as a whole.

Numbers quality

When profits go down, company managers have stronger incentive to cook the numbers. Almost every company today reports two sets of numbers – one according to the accounting standards (reported earnings) and the other according to its own, frequently very loose rules (operating earnings). Operating earnings exclude a number of expenses that, according to the managers, conceal (i.e. decrease) a company’s real profitability. Although management’s proclaimed objective is to provide investors with a clearer picture of the actual profitability, in fact this is almost exclusively an effort to make themselves look better. The most frequently excluded expenses consist of what are termed one-time, extraordinary, and restructuring expenses but which in fact recur more or less every year; remuneration to employees paid in shares which are said not to be expenses at all; and one-time asset-value write-downs which are in fact admissions either that past reported profits were overstated or a promise that future profits will be overstated.

To illustrate how much the reported and operating profits differ, consider that while the most recent reported earnings per share in the US were USD 86.44 (as noted above), the most recent operating profits were USD 98.61. The difference is 14%. In many companies, this difference is even much greater. Meanwhile, there are a number of other companies which do not engage in such manipulation. In any case, we at Vltava Fund always make our own judgement regarding a company’s true profitability and take care not to be misled by what management tells us.

Reasonable expectations

Most entities involved in capital markets have a predisposition towards unreasonable optimism. This can be due in part to people’s natures, but also it can have a lot to do with looking out for one’s personal gain. Managements often tend to present the situation and outlook of their companies as better than they actually are, doing so not only because their own remuneration depends on investor expectations but frequently so, too, do the companies’ operations, results, and sometimes even their survival. Analysts and brokers are usually overly optimistic, as well. Sometimes they themselves believe the overly rosy scenarios which they portray, but sometimes they embellish things intentionally because it brings in the business.

Again to illustrate: a year ago, the consensus of analysts’ earnings expectations for the first quarter of 2016 was 29% higher than what it turned out in fact to be. The consensus earnings forecast for the full year 2016 was 18% higher a year ago than what it is now. For the full year 2017, analysts expect 17% growth in earnings. Both of these estimates will probably prove to be unreasonably optimistic.

Although we do not have our own forecasts

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