Charles de Vaulx’s IVA Funds letter from the portfolio managers for the month of October 2015.
Over the period under review October 1, 2014 to September 30, 2015, your Funds delivered slightly negative absolute returns (-4.21% for the IVA Worldwide Class A and -2.37% for the IVA International Class A), albeit ahead of their respective benchmarks (-6.66% for the MSCI All Country World Index and -12.16% for the MSCI All Country World [ex-US] Index).
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Even though many markets and individual equities have come down some over that period, we have not been able to find many opportunities. That is because many non-U.S. stocks have not come down much if any, in local currency terms; instead it is the U.S. dollar that has appreciated against their local currency. It is also because the stocks of better quality companies (companies with good businesses and solid balance sheets) have been a lot more resilient than the stocks of lesser quality companies.
Why do both Funds have pretty low equity exposures (51.5% in Worldwide and 51.8% in International) and fairly high cash levels (35.2% in Worldwide and 33.2% in International)? For the exact same reasons we articulated in last year’s Annual Report:
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), we are struggling to find genuine bargains, i.e., stocks offering at least 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 than otherwise, has no appeal to us. That idea, frankly, strikes us as being a trap.
IVA Funds – Lower interest rates have not prevented equity markets from coming down
The fact that over the past year low rates have not prevented equity markets from coming down should expose the fallacy of the “Fed Model,” whereby high market multiples observed over the past few years are justified by low interest rates. Anyone involved with Japanese equities from 1990 until 2012 could attest to the fact that low interest rates not only do not justify high valuations but also can be accompanied by a brutal and long lasting bear market. Instead of fantasizing that low rates could justify high multiples, investors should ask themselves: Why are rates so low today? Why do so many Central Banks around the world practice “Quantitative Easing” and “Financial Repression?” The Bank for International Settlements’ most recent Annual Report says it best:
The key sign may be the buildup of financial imbalances. This also means that rates are low today, at least in part because they were too low in the past. Low rates beget still low rates. In this sense, low rates are self-validating given the sign of financial imbalances in several parts of the world. There is a troubling element of deja vu in all of this.
It has been interesting to even see interest rate sensitive sectors, so called “yield plays,” like Master Limited Partnerships (MLPs) or Real Estate Investment Trusts (REITs), actually fall sharply over the past year without interest rates rising at all. We have also seen the price of many commodities (oil, natural gas, copper, iron ore, etc.) collapse over the past year; low rates have made it possible for energy and mining companies to borrow huge amounts of money to expand their capacity thus resulting in additional supply that exceeded the demand for said commodities. The Bank for International Settlements very recently came out with a statistic whereby total public and private debt relative to GDP for the entire world economy now stands at 265%, up from 219% at the peak of the prior credit cycle (2007), and all this while the rate of economic growth is decelerating. In other words, ever larger incremental amounts of debt are needed to produce less and less economic growth. That is not a healthy omen.
Besides worrisome macro-economic imbalances, another risk lies with the fact that corporate profit margins have remained high in many industries around the world, although that is rapidly changing for companies in China (State-Owned Enterprises in particular) as well as energy and mining companies. We believe margins are still at risk of reverting to more “normal” (by historical standards) levels, especially with all the disruptive changes that are altering the competitive landscape in so many industries. Not only in energy (with fracking), but also retail with e-commerce (Wal-Mart is feeling the squeeze), media with streaming and cord cutting (Viacom is losing share), technology (the cloud may be hurting software companies), banking (with greater regulation and higher capital requirements).… So even if one felt justified in using a lower than normal risk free rate (based on low interest rates globally), we believe a higher than normal equity risk premium is required today to value many businesses in the midst of all these changes.
IVA Funds – Global Markets Catch the Chinese Flu
We discussed last year the distinct possibility that ‘‘Global Markets Catch the Chinese Flu’’ (The Wall Street Journal article by Ruchir Sharma, October 17, 2014). It is disturbing today hearing commentators argue that the U.S economy is a relatively “closed” economy (amounts of imports and exports relative to GDP) yet not acknowledge that should the U.S. dollar continue to rise as it did under President Reagan, big chunks of the U.S. economy would suffer (steel, capital goods, paper, automobile, etc.) while earnings generated by American companies overseas would suffer as well (translation impact from a higher U.S. dollar) as 43 percent of the revenues from S&P 500 companies are generated beyond U.S. borders. What happens outside the U.S. and to the U.S. dollar matters enormously for U.S. stocks.
To repeat what we wrote last year, “We do not intend to be ‘long term owners of cash’ (Dylan Grice) but we are happy to wait patiently for genuine bargains to surface…. Cash is a perpetual call option on every security in the world, small or large, stock or bond, which would qualify as being, at the appropriate price, a good investment.”
We have welcomed the recent bout of market volatility. Please read the “Management’s Discussion of Fund Performance” on the following pages to get a flavor of where we have been buying or adding and where we have been trimming.
We still believe that over the next five years, financial assets will deliver modest returns based on their elevated valuation levels today and a challenging global economic outlook. We still believe that a continued pick up in volatility (“finally, markets are being markets again”) with good stock picking should enable us to post respectable performance numbers as we keep following time-tested rules.
More than ever, we will keep on following our holistic approach to investing, with a focus on value and a quest for returns that are as absolute as possible.
We appreciate your continued confidence and thank you for your support.
Charles de Vaulx, Chief Investment Officer and Portfolio Manager
Chuck de Lardemelle, Portfolio Manager