Charles De Vaulx: We worry About Massive Misallocation of Capital In China

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Charles De Vaulx IVA Annual Report (letter to shareholders).

Dear Shareholder,

First and foremost, we are proud and honored that we celebrated the five year anniversary of your IVA Funds at the close of this past quarter. As we explained in a recent newsletter (“Five Years in Review” October 2013, available on our website), our ability to protect on the downside was a large contributor to both our absolute and relative outperformance over this five-year period. Overall good stock picking equally played a significant part in achieving our goals. We are also privileged to work with a great team, both our investment team where we are helped by ten analysts and four traders, as well as our colleagues who support our overall business in operations, compliance, accounting, sales and marketing, human resources and technology. As for our clients who have entrusted their capital with our stewardship, we thank you for your support and allowing us to do what we love to do, and doing it in our idiosyncratic way. Come to think of it, we, too, are clients as the forty three of us working for International Value Advisers, LLC (“IVA”) have well north of $100 million of our own money in the Funds and other products we manage.

Over the period under review, October 1, 2012 to September 30, 2013, central banks around the world continued to drown markets in liquidity and manipulate government debt prices. In Japan, in particular, political changes led to the Bank of Japan (BoJ) announcing very aggressive “quantitative easing” exercises, buying long term Japanese government bonds as well as other assets.

Central banks have indeed been successful in lifting asset prices. As a result of both corporate profits reaching new highs around the world and price/earnings multiple expansion, the MSCI All Country World Index returned 17.73% over this same period, in spite of a correction late May and June 2013.

Even though we argued over the past year that equities would probably be the best house in a bad neighborhood, we have not been fully invested in equities and, in fact, we have reduced our allocation to equities and simultaneously raised our cash levels as the year progressed. We have refused to “walk the walk” because the “best house” argument remains a relative argument and we, at IVA, try to deliver returns that are as absolute as possible. Today there is a school of thought that holds that ultra-low interest rates (often negative in real terms, i.e. adjusted for inflation) eliminates the need for a value investor to insist on a reasonable margin of safety, justifying holding on to stocks when they become fully priced or buying new ones without much of a discount. The seductive appeal of this argument does not sit well with us and we accept the challenge of that heightened tension that exists today between protecting capital on one hand and preserving purchasing power on the other. We recently penned a newsletter (“The Optionality of Cash” June 2013, on our website) where we argue that cash can help protect the portfolio on the downside but can also act as dry powder to “pounce” once we find compelling bargains again. We welcomed the brief correction that took place from May 22, 2013 through late June 2013 and were able to do a little buying. But the rally has resumed and we have again become net sellers. Let us be clear: we do not intend to be “long term owners of cash” (Dylan Grice) and hope to exploit some of the volatility which we believe will be with us for a while.

In the “Management’s Discussion of Fund Performance” (pages 7-9 in this Annual Report) we quantify for both the IVA Worldwide Fund and the IVA International Fund how their respective equity components performed during this past fiscal year ended September 30, 2013. The significant outperformance this year, in contrast to the underperformance the previous year, illustrates vividly that individual stock picking is “alive and well,” even in today’s world of globalization and increased correlations. We will simply reiterate what we wrote in last year’s Annual Report:

“…we believe that stock picking will make a big difference in this low return world for the foreseeable future, with a particular emphasis on trying to identify those companies that may maintain their high margins going forward and those that may not. That requires having a team of analysts whose work goes way beyond the number crunching and increasingly studies the finer qualitative aspects of a business. As Albert Einstein said, ‘not everything that can be counted counts, and not everything that counts can be counted.'”

We reckon that the economic prospects may be slowly improving for the U.S. economy, but note that the “patient” may no longer be on “life support” yet still needs “training wheels” (in the form of quantitative easing). Given the continued appreciation of U.S. stock indices, valuation is now quite steep among U.S. equities, especially if one allows for the fact that corporate profits are rather elevated.

In a recent speech to the Economic Club of New York, former Fed Chairman Paul Volcker recalled that he entered the system as a neophyte economist in 1949: “Most striking then, as now, the Federal Reserve was committed to maintaining a pattern of very low interest rates, ranging from close to zero at the short end to 2½ percent or less for Treasury bonds. If you feel a bit impatient about the situation now, quite understandably so, recall that the earlier episode lasted 15 years.” A propos today, Paul Volcker noted: “Beneficial effects of the actual and potential monetization of public and private debt, the essence of the quantitative easing program, appear limited and diminishing over time. The old “pushing on a string” analogy is relevant. The risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention.”

In a story on Bloomberg News November 1, 2013 (“Federal Reserve’s bubble alarm stuck on snooze”), Jonathan Weil quotes Larry Fink (CEO of BlackRock Inc.): “…it is imperative that the Fed begins to taper… we have seen real bubble-like markets again”; Bill Gross (Pimco): “All risk asset prices are artificially high”; Netflix’s CEO Reed Hastings comparing his company’s stock performance with the “momentum – investor – fueled euphoria”; and Tesla’s CEO Elon Musk saying that his company had “a higher valuation than we have any right to deserve.”

We commented on Japan earlier (particularly a newsletter in March, “The Real Game Changer for Japanese Equities”). We are agnostic as to whether “Abenomics” will be successful but are very intrigued by the big changes we have seen in corporate Japan in terms of capital allocation: more and more dividends being raised; more and more stock buybacks and hopefully more corporate activity and willingness by management to pay a little more attention to shareholders than they have in the past. We trimmed our exposure there as the rally unfolded, and remain well hedged on our yen exposure.

Europe remains difficult for us. The eurozone economics are witnessing some degree of stability but many weaknesses remain (worsening public debt, costly credit, vulnerable banks…). While many crisis-hit economies have been able to go from big current account deficit situations to current account surplus, it remains unclear how sustainable these are. Additionally, in a Union where each Member carries veto powers, political changes play a large role that we find difficult, if not impossible, to handicap. We believe that the risk of an anti-euro government taking over in one member country continues to grow. Also, while job cuts have been significant, unit labor costs remain higher in Spain and Italy compared to those in Germany. Even Mario Draghi, the head of the European Central Bank (ECB), recently confessed to remaining “very, very cautious about the recovery. I cannot share the enthusiasm.” He added that the recovery was “weak, fragile and uneven and from low levels.” From a valuation level, what we find is a tale of two markets: banks, utilities and telecom companies have suffered tremendous and very fundamental setbacks since 2007 and are therefore down substantially, dragging indices down; while high quality, global companies headquartered in Europe tend to trade at all-time highs and be very pricey. In the middle you’ll find a number of cyclical companies with debt, usually not that cheap, and where balance sheets are far from pristine. We continue to look for opportunities in the Old Continent but without much success over the period.

Emerging markets have performed poorly over the period, which did not come as a surprise to us. We have had almost no direct investments in the BRIC countries (Brazil, Russia, India and China) in recent time. However, we made our first investment in Brazil over the period; we also added a few names listed in Hong Kong doing business exclusively in China. But these markets are not cheap enough for us to make large commitments. In China, in particular, we worry about massive misallocation of capital and a potentially moribund banking sector. Despite the recent correction, we are finding no opportunities in high yield debt either. In fact, we are witnessing the mirror image of 2008-2009. At that time high yield bonds were offering very attractive opportunities, many with returns better than equities and with less risk. Our remaining high yield exposure is of short duration (overall less than 3 years) and is comprised mostly of remnants of investments made in previous years.

Gold has acted poorly since September 2011 – it topped around $1900/oz. Gold may be flagging more disinflation in the next few months, especially if China’s economic growth keeps decelerating. Gold is also reacting to the possibility that real interest rates may rise in the future in various currencies. We trimmed our gold exposure earlier in 2013 as our equity exposure kept going down while our cash levels were increasing. We are keeping our options open as to what to do next there, if anything. We are pleased to have avoided gold mining stocks as we grew increasingly alarmed by rising production costs in the industry.

In conclusion, we are encouraged by the performance of your Funds over the period despite being underinvested in equities. Stock picking has been good and our big picture views (being wary of China and emerging markets, for instance) were vindicated. Our focus remains on preservation of capital during these uncertain times, believing that one of the most effective ways to compound wealth over time is to minimize losses and drawdowns. Like Ulysses during his odyssey, we are determined to ignore the sirens. We will keep insisting on appropriate discounts when we buy and hold securities. While we realize that “the purgatory of low returns” (James Montier) is not fun, we think that the challenges associated with that environment are much harder for our end clients and for the advisers that help those clients than they are for us. On our end, we are simply trying to remain disciplined and opportunistic but certainly will not change our ways on the basis that “this time is different.” On the contrary, we think that following time tested rules and principles will help us navigate the environment we are in.

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

Global equity markets delivered double-digit gains over this one year period, propelled by artificially low interest rates resulting from quantitative easing, and record high corporate profit margins. Equity markets temporarily corrected from May 22, 2013 to late June 2013 when the Federal Reserve indicated it might scale back its bond buying program later this year if the U.S. economy continues to improve and the unemployment rate falls below 7%. This boosted the yield on the 10-year U.S. Treasury note from 1.63% in early-May 2013 to 2.62% on September 30, 2013.

As global equity markets appreciated over this period and some of our holdings got closer to or even reached our intrinsic value estimate, we trimmed or sold out of those positions. This brought our total equity exposure down to 52.8% on September 30, 2013 from 63.0% on September 30, 2012 in the IVA Worldwide Fund, and to 54.3% from 57.1%, respectively, in the IVA International Fund. As a result, our total cash exposure rose in both Funds, to 30.6% in the IVA Worldwide Fund and to 27.5% in the IVA International Fund at period end. Even though both Funds were, on average,

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