Bernard Horn’s Polaris Global Value Fund 2014 Letter
Dear Fellow Shareholder, January 12, 2015
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.
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 (LSE:GNC), an Ireland-based producer of convenience foods; U.S. utility Allete (ALE); two U.S. banks; two U.K. homebuilders; Duni AB (OSTO:DUNI), a Swedish tabletop paper products supplier; U.S. based UnitedHealth Group (UNH); MEIJI Holdings (TSE:2269), a Japanese dairy products company; and Symrise AG (XTER:SY1), 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 (SSL), Maurel et Prom (XPAR:MAU) and Tullow Oil PLC (LSE:TLW), as well as Canadian methanol producer Methanex Corp (MEOH).
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 (OSTO: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 (XPAR:ML) 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 (LSE:GNC) 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. (TSE:2269) 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 (BNCN), Ameris Bancorp (ABCB) and Independent Bank Corp (INDB) capitalized on recent acquisitions or realized synergies from integrations. U.S. reinsurer The Chubb Corp. (CB) 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 (UVSP) was sold as it reached its valuation limit.
Norwegian banks, Sparebank 1 SR (OSL:SRBANK) and DNB Bank ASA (OSL:DNB), 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. (HPQ) 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. (XRX) struck a deal to sell its information technology outsourcing business to France’s Atos for $1.05 billion. At Samsung Electronics (XKRX:005930), 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 (ALE)’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. (HKSE:00270) 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 (OHEL:YTY1V) and Trevi Finanziaria. Finnish elevator/escalator manufacturer Kone OYJ (OHEL:KNEBV) 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 (MIL:TFI) 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 (XTER:FNTN) reaffirmed its outlook for 2015, and noted increased subscribers. Deutsche Telekom (XTER:DTE)’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 (XTER:SY1) was the only standout. The company achieved good results across all divisions and geographies, including emerging markets. By contrast, Methanex (MEOH) 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 (XTER:LIN) 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 (ASX:NST) 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 (MPC). 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.
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.
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.
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.
In the U.S., lower gasoline prices may lead to more discretionary spending power, and indirectly boost consumer confidence. U.S. companies may see profit margins rise, as costs drop for logistics, utilities, running factories, and business and consumer travel. While areas like North Dakota may experience contraction from their torrid growth where unemployment is extremely low, most other regions in the U.S. will likely see long awaited improvement.
Lower commodity prices will also help China mitigate the decrease in its GDP growth rate for the near term, spurred on by new rail projects and building infrastructure. According to China Daily, China will target construction of 7 million affordable housing units, the same as 2014, although only 4.8 million units were built in the year. Commodity price declines will also mitigate the spending decline wrought from Japan’s consumption tax hikes.
However, lower oil prices may not have a dramatic impact in regions like Europe where taxes are a large percentage of the retail pump price. Instead, we believe Europe will benefit from deflation in 2015, a view contrary to some policy makers and pundits. Inflation is a highly regressive tax for low and middle income earners, especially since real wages have not increased in more than 30 years. The only way these consumers have to advance their economic condition is through lower prices. If real wages are constant but the real cost of goods declines, consumers have more real disposable income and can choose to save, pay down debts, invest or consume the added income.
Deflation also proves to be the stimulus for disruptive technologies. The likes of Uber and AirBNB would not have a business if not for the ability to muster the resources of underemployed labor and assets, who are more than willing to introduce deflation into these industries and arbitrage the excess costs. Disruptive technologies are enabling surprisingly successful new business models like Uber, etc., which target entrenched monopolies protected by government regulations and overburdened cost structures that generate “excess” revenues for the governments. In our view, governments will eventually have to adapt to this new disruptive economic reality and learn to downsize as their revenue base is challenged.
The research effort at Polaris continues to look at the deflationary forces at work in the global economy, and the disruptive technologies that create deflation. In recent quarters, we have identified good value investment opportunities. The continuing challenge will be to select those values that prove sustainably good investments over the long-term.
Bernard R. Horn, Jr., Shareholder and Portfolio Manager