Value Investing

Moerus Worldwide Value Fund 1H17 Letter To Investors

Moerus Worldwide Value Fund letter to investors for the first half year ended May 31, 2017.

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Dear Fellow Investors:

It is our pleasure to update you on recent developments regarding the Moerus Worldwide Value Fund (the “Fund”). This, our second Semi-Annual Shareholder Letter, will refer to the first half of the Fund’s Fiscal Year, which covers the six months ended May 31, 2017.

In this Letter, we will touch on Fund performance, new investments made during the first half of the year, how and why such opportunities became available, and how our flexible, unconstrained investment approach has aided us in uncovering new ideas.

We were excited and honored to recently celebrate the Fund’s one-year anniversary. We thank you very much for your support, interest and continued curiosity over the past year and hopefully in the years ahead. As always, we welcome any questions or queries that you might have.

Moerus Worldwide Value Fund

With regard to the table above, we’d like to reiterate something that we noted in our first Shareholder Letter, and will likely continue to emphasize in future letters: the Fund’s performance data is noted simply for informational purposes for our fellow investors. The Fund invests with a long-term time horizon of roughly three-to-five years or more, and to be clear, it is not managed with any short-term performance objectives or benchmark considerations in mind. The investment objective of the Fund is long-term capital appreciation, and we manage the Fund with the goal of achieving attractive risk-adjusted performance over the long term.

Please keep in mind that while Fund performance has compared favorably to the benchmark to date, our investment approach can and will, at times, endure periods of relative underperformance. Short-term results will fluctuate, but again, our goal is to achieve attractive riskadjusted performance and outperform relevant benchmarks over the long term, and we hope that our investors similarly take a long-term view.

Investment Activity in the Fund: Excess and Ensuing Crisis Bring Opportunity

During the first half of the Fund’s Fiscal 2017 (six months ended May 31, 2017), we initiated three new positions in the Fund and added to many of our existing positions. These six months were active ones on the investment front, as we continued to find what we would characterize as unusually attractive opportunities to deploy the Fund’s capital (more on this later). As a result, the Fund’s cash position declined from roughly 21.3% at the end of November 2016 to around 12.9% by the end of May 2017. As of May 31, 2017, the Fund’s portfolio included 37 holdings consisting of what we believe are attractive individual investments in companies across various industries and geographies, including North America, Europe, Asia, and Latin America. We will discuss the three new positions in the Fund shortly, but first, it might be helpful to briefly touch on a topic that is related to how these and other ideas come to the forefront of our investment efforts.

In our ongoing efforts to scour the globe in search of attractive investment opportunities to potentially add to the Fund’s portfolio, one of the characteristics that we absolutely insist upon is a valuation that we view as unusually compelling. Passing only this first test (of many) is rarely, if ever, an easy task, particularly in today’s capital markets, where dollops of easy money served up by the Federal Reserve over the better part of the past decade have inflated the prices of many different asset classes, including stocks, bonds and real estate. Not surprisingly, assets and businesses, in general, do not become available at dirt cheap prices when skies are bright, the good times are rolling, and the current outlook is rosy. On the contrary, such bargain pricing is often made possible only because the assets or businesses in question are either suffering from a poor near-term outlook, or are overlooked or neglected by the market because of their complexity or some sort of stigma that acts as a repellent to analysts and investors. Examples include:

  • Companies operating in industries that are currently depressed (for example, the Energy sector at various points in recent years since crude oil prices began collapsing in mid-2014).
  • Companies associated with geographic markets which have fallen into turmoil; take, for example, the United Kingdom immediately after the Brexit vote, or more recently Brazil after its latest high profile corruption scandal ensnared President Michel Temer.
  • Company-specific events that result in a fall from grace in the market’s eyes. Perhaps management has, for example, missed analysts’ quarterly earnings estimates or slashed the company’s dividend payments – events which never curry favor with short-term investors.

Whatever the specific case may be, the cut-rate pricing that we require in order to invest in a business often brings near-term uncertainty, turmoil, or stigma along with it. And while it may seem counterintuitive to day traders, momentum investors and other shorter-term players in the markets, we at Moerus actually embrace such negativity surrounding a potential investment. It is quite fine by us if our investments fail to win any popularity contests – after all, the assets wouldn’t be on sale at such discounts if they were currently in fashion and in demand. In our view, having a very low “approval rating” on Wall Street – provided that it is temporary and does not call the fundamental survivability of the business into question – often contributes to the conditions for what ultimately become the most attractively priced long-term investment opportunities.

So in our experience, uncertainty, adversity and/or stigma have often accompanied some of our most attractive investment opportunities. Are there signals that sometimes point towards where such turmoil is present? As we noted earlier, pricing, for one, often provides us with a helpful guide to areas where there is currently turmoil or disruption, simply because if a company’s stock price is unusually depressed, there is typically a “reason” for it, particularly amid an otherwise buoyant broader market. But taking this a step further, are there certain phenomena that sometimes help point us toward areas of potential opportunity in the future, allowing us to research, learn and conduct our due diligence ahead of time, in search of what might be the next interesting bargain?

In short, yes. While potential ideas come from many, various sources, throughout our history areas of excess have frequently provided us with quite a bit of food for thought, often resulting in some of our most interesting investment opportunities. For this reason, excesses often attract our attention, both as areas to avoid when they are in progress, and as potential sources of future opportunity in their aftermath, when we can assess the damage and sift through the rubble for possible gems.

All three new investments made in the Fund during the first half of its year – Franklin Resources, NN Group NV and UniCredit SpA – were opportunities borne out of a backdrop that has been influenced by what we see as areas of considerable excess, most notably:

  • The avalanche of investor assets into passive investment vehicles (including index funds and ETFs) and out of actively managed funds (for example, hedge funds or mutual funds).
  • The phenomenon of low, zero, and even negative interest rates, as implemented primarily by the Fed in the U.S., the ECB in Europe and the Bank of Japan.

Let’s get a bit more into these excesses that we are currently seeing in the investment world, and how they have allowed us to take advantage of what we believe are exciting longer-term opportunities for the Fund.

The Death of Active Management?

Hyperbole and eye-catching headlines in the financial press tend to get our attention because they occasionally provide a window into areas where excesses may be building, sowing the seeds for potential opportunities in the future. Some headlines from time to time point us to areas where bubbles may be forming – for example, the proverbial “This Time is Different” argument that has surfaced in some form near the peak of many past investor manias. At the opposite end of the spectrum, excessively negative headlines often lambaste the losers of the day in Wall Street’s never-ending popularity contest. To that latter point, one of the most frequent targets of extremely dire coverage in the financial press in recent years has been the field of active investment management.

As you probably know, active management, or the practice of picking specific stocks, bonds, and other assets with the goal of outperforming a general market index, has been under siege of late. In 2016 in the United States alone, passively managed funds – whose investments are not chosen by a portfolio manager but instead are systematically selected to match an index or specified part of the market – attracted almost $505 billion of assets. The inflows to passive products came mostly at the expense of actively managed funds, which suffered $340 billion in outflows during 20161. In a nutshell, the problem for active management centers on many actively managed funds having failed to outperform benchmark indexes in recent years. This has prompted a shift of investor assets into passive funds that are designed, at a lower cost, to virtually match their respective indexes.

Headlines such as “Is Active Management Dead?” and “Who Killed the Active Fund Manager?” – yes, those were actual titles – typify the extent of the extremely negative sentiment towards active management in recent years. The gloom and pessimism surrounding the field, in addition to the headlong stampede into passive investing that has taken place in recent years, have provided us with an interesting opportunity to invest in Franklin Resources, a high-quality company operating in what we believe is still a very, very good business, recent challenges notwithstanding. But before we dig deeper into Franklin Resources, let’s discuss active management in general.

Given our decision to launch Moerus Capital in late 2015 and then this Fund in mid-2016, it perhaps goes without saying that we strongly believe in the merits of active investing. There have been many thoughtful, well-articulated comments made and pieces written by some of the most successful, well-known investors in defense of active investing and on the limitations of passive investing. While we don’t want to reinvent the wheel by making our own case here, there are a few points that we’d like to make.

First, although it is true that many active funds have struggled to beat their benchmarks in recent years, history is replete with the cases of active managers who have compiled track records of impressive, market-beating risk-adjusted returns over the long-term. For those who maintain a long-term focus, choose their funds and managers wisely, and don’t trade in and out of the market frequently, we believe there is a real opportunity to generate risk-adjusted returns that beat the market. Remember that passive investing inherently guarantees mediocrity – returns slightly below those of the relevant index being tracked (after fees). We believe that investors can do better than that if they have a long-term approach, stick with it, and invest with high-quality managers who have demonstrated expertise in their respective métier.

On a related note, in offering their opinions on the active versus passive debate, many in the financial media have focused their attention mostly on returns, noting that many active funds have failed to beat market indices in recent years. Unfortunately, far less often have we seen an adequate discussion of risk, specifically the risks assumed by blindly investing in every company in an index – this is what investors in passive funds are essentially doing – regardless of valuations and margins of safety (or lack thereof). In our view, “passive” investing is a bit of a misnomer, in that anybody who invests in an S&P 500 index fund, for example, is actively making a decision to invest in every company in the S&P 500, and assuming whatever risks that entails. While it is true that investing in such a fund assures an investor that he or she will not materially underperform the S&P 500, it also ensures that the investor will be fully exposed to any significant declines in the index. This may be tempting for the average investor to overlook after over eight years of a generally rising stock market (as we have seen in the U.S., at least).

But here are some historical facts that may give pause:

  • If you were invested in the S&P 500 at its September 1929 peak, before the stock market crash and the Great Depression that followed, you would not have seen the index return to those levels again until the middle of 1954, nearly 25 years later.
  • Investors in the NASDAQ index in March 2000, at the peak of the tech bubble before it burst, did not see the index return to those levels until mid-2015, some 15 years later.
  • Japan’s TOPIX index still, to this day, hasn’t even come close to revisiting its peak reached in December 1989, when the Japanese market was the darling of the investment world.

Source: Bloomberg

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