Polaris Global Value Fund fourth quarter letter to shareholders.
Dear Fellow Shareholder,
Global equity markets returned to positive territory in the last quarter of 2014, as evidenced by the 1.01% return in the MSCI World Index (net). The positive result for the quarter was almost exclusively due to the 4.6% U.S. gain, partially offset by losses in nearly all non-U.S. markets. By comparison, the MSCI EAFE Index, net returns were 1.8% in local currency; however, the return in U.S. dollars terms was -3.6% due to the decline in most currencies versus the dollar.
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The Polaris Global Value Fund (“the Fund”) outperformed the MSCI World Index, net benchmark in the quarter, up 2.39% while the Index advanced 1.01%. Notwithstanding declines in all energy and some materials companies, overall results were driven higher by solid earnings results in a number of companies.
At the start of 2014 we reflected on the strong equity market returns in 2012 and 2013 and felt investors should be pleased if equity markets advanced in 2014, and if so, single-digit returns should be appreciated. In fact, the MSCI World Index, net advanced 4.94% in 2014, while the EAFE Index, net dropped -4.9% in 2014, due to foreign exchange rate declines relative to the dollar. For the year 2014, the Fund was up 3.68%, lagging the MSCI World Index’s return of 4.94%. The Fund’s underweight positions in the U.S. and overweight in Europe were primarily responsible for the annual result.
In the fourth quarter, the Fund’s top 10 contributors were diversified across country and industry. Positive contributions were realized from companies including Greencore Group PLC, an Ireland-based producer of convenience foods; U.S. utility Allete; two U.S. banks; two U.K. homebuilders; Duni AB, a Swedish tabletop paper products supplier; U.S. based UnitedHealth Group; MEIJI Holdings, a Japanese dairy products company; and Symrise AG, a German maker of ingredients in the beverage, food and fragrance industry. Detractors were more concentrated among energy and material sector stocks impacted by the commodity price declines, including Sasol Ltd, Maurel et Prom and Tullow Oil PLC, as well as Canadian methanol producer Methanex Corp.
Eight of 10 sectors were in absolute positive territory, headed by consumer discretionary, consumer staples, financials and information technology. The majority of the consumer discretionary holdings produced robust returns because of good earnings. Encouraging sales and profit numbers at Duni were attributable to organic growth, recent product launches, the completion of a recent acquisition and efficiency programs that have effectively strengthened margins. The four U.K. homebuilders in the Fund announced healthy results, on increased demand due to improved mortgage availability. Land bought inexpensively during the recessionary period is now coming into production, which should result in higher-margin house sales in the coming quarters. French tire maker Michelin was added to the consumer discretionary sector during the quarter. With lower gas prices, increased driving mileage may boost the demand for replacement tires.
Consumer staples holding Greencore reversed course from last quarter’s decline, adding double-digit gains after reporting results that reflected its participation in food-to-go (FTG) business, the fastest growing segment in UK grocery sales. The company also announced plans to build out its U.S. FTG business with the acquisition of Lettieri’s LLC and new site construction in Rhode Island and Washington State. In Japan, MEIJI Holdings Co Ltd. reported healthier margins and rising profitability. The integration of the 2009 merger of its dairy and pharmaceutical divisions is finally achieving better results. The company has successfully reorganized the business, implemented structural reforms and increased overseas operations. With an aging population eating more probiotics, MEIJI’s dairy division more than offset Japanese drug price cuts impacting the pharmaceutical division. We expect that the decrease in oil prices will have a beneficial effect on disposable income, leading to further consumer demand in Japan, and in all non-oil producing countries.
All of the Fund’s U.S. financial holdings were in absolute positive territory this quarter. The end of the Federal Reserve quantitative easing program signaled the potential for higher interest rates (and possibly improved net interest margins) in 2015; many investors looked favorably on this prospect. However, this trend has yet to materialize, with several banks still reporting stagnant net interest margins at the end of 2014. Increasing loan balances and decreasing loan loss provisions buoyed net income at financial institutions over the past few quarters. In addition to these metrics, U.S.-based BNC Bancorp, Ameris Bancorp and Independent Bank Corp capitalized on recent acquisitions or realized synergies from integrations. U.S. reinsurer The Chubb Corp. posted satisfactory returns, due to better renewal pricing and fewer catastrophic losses. In similar fashion, German reinsurer Hannover Re: announced fewer catastrophe losses in 2014, while gaining subscribers to its life and health business. During the quarter, the Fund’s position in Univest Corp of Pennsylvania was sold as it reached its valuation limit.
Norwegian banks, Sparebank 1 SR and DNB Bank ASA, declined on oil-related concerns, although neither institution holds more than 10% of loan books in direct oil- and gas-related businesses. We believe that the stock price drops are more magnified than warranted. Although Norway is an oil-producing country, it has a very different structure for oil proceeds. In most OPEC countries, oil is the only resource and money from oil revenues is spent on current government programs. In Norway, oil revenues collected by the government are sequestered in an oil fund, which is explicitly banned from use to bolster the domestic economy. In our opinion, the Norwegian economy is fairly insulated by declines in oil prices, but might be affected at the margins.
Seven of eight information technology stocks were up, as many reported respectable earnings for the September 2014 quarter. Hewlett-Packard Co. was the sector’s top performer, after announcing plans to split into two publicly traded companies: one that will focus on enterprise technology, storage, service and cloud platforms and one that will focus on consumer-driven products and printers. In an effort to reposition itself in the business-to-business space, Xerox Corp. struck a deal to sell its information technology outsourcing business to France’s Atos for $1.05 billion. At Samsung Electronics, Lee Jae Yong has taken the reins of the company since his father’s hospitalization. During his short tenure, he has already proposed a $2 billion buyback and disposed of stakes in chemicals and defense businesses. The market is optimistic that such restructuring will also lead to better corporate governance and a renewed focus on core markets, including consumer televisions, smartphones and smart home software. We look to new cell phone models from Samsung’s research & development labs to lead its low-cost competitors.
All utility sector holdings had double-digit returns for the quarter. Allete’s third quarter earnings were up, due to cost recovery revenue related to wind energy expansion and retrofit of an electric unit. In addition to capital expenditure projects coming to fruition, the company announced strong demand from its important industrial customers in the region. Hong Kong water utility Guangdong Investment Ltd. renewed its contract to supply water to Hong Kong, with higher-than-expected tariff increases of approximately 6% per year for each of the next three years.
Mixed performance characterized the industrial sector, with positive performance in two thirds of the holdings offset by YIT OYJ and Trevi Finanziaria. Finnish elevator/escalator manufacturer Kone OYJ was the top industry contributor, with double-digit gains after generating healthy results and order intakes. With an established foothold in China, Kone is expected to capitalize on relaxed Chinese real estate policies and the announcement of another 7 million affordable housing units. Italian ground engineering firm Trevi continued its downward trajectory. We believe that the company’s stock depreciation is overdone. The company conducted a capital raise in the second half of 2014 to expand its oil drilling business. While lower oil prices may cause less drilling in certain locations, Trevi has yet to have any order cancellations. Company management recently announced all-time high order books for oil drilling and improved financial metrics for the nine months ended September 2014.
The European telecom sector generally produced better-than-expected earnings in the September 2014 quarter. In the Fund’s portfolio, German telecom and web content provider Freenet AG reaffirmed its outlook for 2015, and noted increased subscribers. Deutsche Telekom’s stock price was up on news of merger & acquisition transactions, including BT Group’s potential purchase of British wireless venture EE, currently owned by DT and Orange S.A. DT’s T-Mobile remained an attractive asset for potential suitors, with Dish Network Corp. expressing interest. T-Mobile gained the most subscribers in the U.S. for 2014, although it is still struggling to turn a profit.
Commodity-driven sectors, namely materials and energy, were the main detractors to Fund performance for the quarter. In materials, German fragrance, additives and flavors producer Symrise was the only standout. The company achieved good results across all divisions and geographies, including emerging markets. By contrast, Methanex has been hampered by natural gas supply constraints, causing reduced production at one Trinidad plant and restricted activity in Chile and Egypt. Lower commodity prices have also been at issue, both with methanol at Methanex and iron ore and oil at Australia’s BHP Billiton.
During the year, we conducted extensive research on numerous stocks, including those in the materials sector. With the recent decline in foreign markets, two stocks became attractive, The Linde Group and Northern Star Resources, which we opportunistically purchased at better valuations than expected. Linde is a German multi-national industrial gases and engineering company. The company appears attractive, as it is a dominant player in a consolidated industry, with low downside risk, many long-term contracts and strong visible cash flows. Northern Star is a gold producer in Australia. We expect this small-cap stock to be a Fund diversifier.
As would be expected by global oil price declines, the energy industry was severely impacted. The Fund’s holdings were no exception, with Thai Oil, Marathon Oil, Tullow Oil, Maurel et Prom and Sasol down. One bright spot was Marathon Petroleum. The company differentiates itself from competitors with a business model that focuses on domestic refining and gas station franchises. Refining margins are up and refiners, like Marathon Petroleum, are increasing throughput ahead of expected additions to production in 2015. In the past year, Marathon Petroleum’s division Speedway acquired Hess, expanding its retail station presence from nine to 23 states throughout the East Coast and Southeast. Recent lower gas prices may spur on more travel and subsequently more stops at gas stations.
Polaris Global Value Fund: Year End 2014 Performance Analysis
The Fund returned 3.68%, slightly lagging the MSCI World Index benchmark for the year. Strong outperformance among U.S. stocks drove performance in the Index. The U.S. market now represents 58% of the World Index; the Fund’s underweight position in U.S. holdings detracted from returns. However, the Fund remained in absolute positive territory, boosted by performance in seven out of 10 sectors. Healthcare, consumer staples, consumer discretionary and information technology were the top contributors. Healthcare also dominated the top 10 individual stocks, with Actavis, Anthem (renamed from WellPoint after merger), UnitedHealth Group and Teva Pharmaceuticals adding to gains. Other strong performers included Greencore Group and MEIJI Holdings, as well as U.S.-based General Dynamics. General Dynamic’s defense business has been an effective hedge and positive performer in a world marked by geopolitical turmoil. Detractors were relegated mainly to the energy and materials sector, with declines at Tullow Oil and Maurel et Prom. Trevi and Methanex also dropped in reaction to commodity price trends. During the year, we sold at a profit both Valassis Communications, a U.S. direct mail/geography targeted advertising company, and banking institution Univest of Pennsylvania to make room for new portfolio companies.
Polaris Global Value Fund: Investment Environment and Strategy
Crude oil prices dropped more than 40% over the last three months, as demand growth slowed while supplies and production continued to increase. The International Energy Agency reduced its demand forecast several times recently. The Organization for Economic Cooperation and Development stated that oil demand is expected to be lower on continued energy efficiency gains, while slower growth in demand from emerging markets reduced expected demand in 2014 and 2015. Simultaneously, supply continues to increase. Once investment in oil fields is committed, projects are not cancelled and continue to add to supply. On November 27, Saudi Arabia, a low-cost oil producer, announced it would not cut back production to prop up prices.
Our outlook has shifted as a result of these commodity price declines. We refer readers to the Polaris Third Quarter 2005 Quarterly Report (www.polarisfunds.com/fund-reports) where we argued rising oil prices would have a detrimental impact on global consumption when oil prices rose from $25 per barrel to $65. Conversely, the current drop in oil prices could boost or strengthen consumption, disposable income, consumer balance sheets, savings, and investments.
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Polaris Global Value Fund Performance Commentary
Eight of the Fund’s 10 sectors had absolute positive performance in the fourth quarter. In consumer discretionary, Duni was up on encouraging sales and profit numbers attributable to organic growth, recent product launches and the completion of a recent acquisition. Four U.K. homebuilders announced healthy results, on increased demand due to improved mortgage availability.
Consumer staples holding Greencore reversed course from last quarter’s decline, adding double-digit gains after reporting results that reflected its participation in the fast growing food-to-go business. In Japan, Meiji Holdings Co Ltd. reported healthier margins and rising profitability. The integration of the 2009 merger of its dairy and pharmaceutical divisions is finally achieving better results.
All of the Fund’s U.S. financial holdings had positive returns in the quarter. Increasing loan balances and decreasing loan loss provisions buoyed net income at financial institutions over the past few quarters. Information technology stocks reported respectable earnings for the September 2014 quarter. Hewlett-Packard Co. was the sector’s top performer, after announcing plans to split into two publicly traded companies.
Utility sector holdings had double-digit returns for the quarter. Allete’s third quarter earnings were up, due to cost recovery revenue related to wind energy expansion and retrofit of an electric unit.
Mixed performance characterized the industrial sector, with positive performance in two thirds of the holdings offset by YIT OYJ and Trevi Finanziaria.
Commodity-driven sectors, namely materials and energy, were the main detractors. In materials, Methanex has been hampered by natural gas supply constraints, causing reduced production at one Trinidad plant and restricted activity in Chile and Egypt. As would be expected by global oil price declines, the energy industry was severely impacted. The Fund’s holdings were no exception, with Thai Oil, Marathon Oil, Tullow Oil, Maurel et Prom and Sasol down.
Our outlook has shifted as a result of these commodity price declines. We believe the net benefits to oil consuming economies outweigh the reduction in the growth of oil producing regions. Globally, only a small number of countries with small populations benefit from higher oil prices; most all others, including the U.S. and China, are net beneficiaries of lower prices.
The Polaris Global Value Fund is a diversified no-load mutual fund that attempts to provide above average return by investing in companies with potentially strong sustainable free cash flow or undervalued assets. The Fund is diversified across country and market capitalization, and typically holds 50 to 100 stocks that meet Polaris’ strict value criteria.
Polaris Capital Management, LLC (the “Adviser”) uses proprietary investment technology combined with Graham & Dodd style fundamental research to identify potential investments. Filters are applied as part of the investment approach, which attempts to identify a list of companies with the most undervalued streams of sustainable cash flow or assets worldwide. Polaris then conducts rigorous fundamental research on the companies identified in the screening process, selecting 50 to 100 companies in which the Fund invests.
The Investment Adviser
Polaris Capital Management, LLC is a global value equity manager that provides investment services for institutional and individual clients. Polaris management believes worldwide markets are generally efficient over time, but investor behavior creates volatility that leads to inefficiency somewhere in the world. An integrated global investment strategy could be utilized to help exploit this inefficiency. We believe investing in the most undervalued companies worldwide likely limits risk and has the potential for benchmark-beating returns.
Total return includes reinvestment of dividends and capital gains. During the period some of the Fund’s fees were waived or expenses reimbursed. In the absence of these waivers and reimbursements, performance figures would be lower. The Fund invests in securities of foreign issuers, including issuers located in countries with emerging capital markets. Investments in such securities entail certain risks not associated with investments in domestic securities, such as volatility of currency exchange rates, and in some cases, political and economic instability and relatively illiquid markets. Options trading involves risk and is not suitable for all investors. On June 1, 1998, a limited partnership managed by the Adviser reorganized into the Fund. The predecessor limited partnership maintained an investment objective and investment policies that were, in all material respects, equivalent to those of the Fund. The Fund’s performance for periods before June 1, 1998, is that of the limited partnership and includes the expenses of the limited partnership. If the limited partnership’s performance had been readjusted to reflect the first year expenses of the Fund, the Fund’s performance for the periods prior to June 1, 1998, may have been lower. The limited partnership was not registered under the Investment Company Act of 1940 (“1940 Act”) and was not subject to certain investment limitations, diversification requirements, and other restrictions imposed by the 1940 Act and the Internal Revenue Code, which, if applicable, may have adversely affected its performance.
The MSCI World Index, net dividends reinvested measures the performance of a diverse range of global stock markets in the United States, Canada, Europe, Australia, New Zealand and the Far East. The MSCI World Index is unmanaged and does include the reinvestment of dividends, net of withholding taxes. One cannot invest directly in an index or an average.
The Treynor Measure is a risk-adjusted measure of return that divides a portfolio’s return in excess of the riskless return by its beta. Beta is the measure of a fund’s relative volatility as compared to an index. A fund with a beta higher than 1 is expected to be more volatile than the applicable index. Alpha is the difference between a fund’s actual returns and its expected performance given its level of risk as measured by beta. The Sharpe Ratio is a measure of the risk-adjusted return of an investment.