IVA Funds: Letter from the Portfolio Managers

IVA Funds: Letter from the Portfolio Managers
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IVA Funds’ letter from the portfolio managers from the annual report.

Dear Shareholder,

Over the period under review, October 1, 2013 to September 30, 2014, your IVA Funds continued to deliver good absolute returns (8.00% for the IVA Worldwide Fund Class A, at net asset value, and 7.05% for the IVA International Fund Class A, at net asset value, respectively), well in excess of inflation and nominal GDP growth. Even though many markets rose and, hence, valuation became even steeper during that period, we were able to find a few new opportunities, especially in Hong Kong, therefore our equity exposure actually rose in the International Fund to 60% at period end while it remained almost unchanged in the Worldwide Fund, 52% as of September 30, 2014.

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IVA Funds: Low equity exposures

Still, those remain pretty low equity exposures. Why is that? 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), our 10 analysts are finding mostly fully priced securities and quite a few overpriced ones as well. We are struggling to find genuine bargains, i.e. stocks offering at least a 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 has no appeal to us. That idea, frankly, strikes us as being a trap, the same way so many value investors thought it was acceptable in 2006 and 2007 to buy securities that seemed cheap, yet were not safe with their excessively leveraged balance sheets. Instead of fantasizing that low rates should justify higher valuations (as in the “Fed Model”), investors should ask themselves: Why are rates so low today? Why do so many Central Banks globally need “Quantitative Easing” and “Financial Repression”? Perhaps they should read the recent report “Deleveraging? What Deleveraging?” (Buttiglione, Lane, Reichlin and Rheinhart, Geneva Reports on the World Economy, September 16, 2014) where the writers argue that “Contrary to widely held beliefs, the world has not yet begun to delever and the global debt to GDP is still growing, breaking new highs,” as the debt build up led by the developed economies until 2008 has been substituted by a debt build up in the emerging economies, in particular China but also to some extent in the “Fragile Eight” group comprised of India, Turkey, Brazil, Chile, Argentina, Indonesia, Russia and South Africa. This report came out just a few months after the Bank for International Settlements 2013/2014 Annual Report expressed grave concerns about the “limited room for maneuver in macroeconomic policy,” with “fiscal policy generally under strain…and monetary policy testing its outer limit.” So if the world remains such an imbalanced and indebted place, you could actually argue that these ultra-low interest rates should be encouraging investors to ask for a much higher equity risk premium, using moderate multiples and insisting on healthy margins of safety instead of a lower equity risk premium i.e., using higher multiples and narrower discounts.

IVA Funds: Credit bubbles in the Western economies

It is interesting to remember in 2006 and 2007 how many commentators were talking about “decoupling” i.e., trying to convince us that many western economies would probably witness a bursting of their credit bubbles while many emerging economies would keep growing nicely and “decouple,” including China. That made no sense to us as China was then (and still is today) a vast export oriented economy. It is ironic today for us to fear the opposite, i.e., the distinct possibility that “Global Markets Catch the Chinese Flu” (The Wall Street Journal article by Ruchir Sharma, October 17, 2014). We certainly do not intend to be “long term owners of cash” (Dylan Grice) but we are happy to wait patiently for genuine bargains to surface. We do not have a bunker mentality, we are always trying to identify cheap stocks and we do get excited when markets experience corrections (late January and early February 2014, late July and early August 2014, and during September 2014, the last month of the Funds’ fiscal year). These periods gave us a chance to do some “nibbling,” either finding a few new securities or adding to some existing positions. Our cash levels remain elevated in both Funds (36% in Worldwide and 25% in International). While we understand the drag on performance resulting from that cash, we are also mindful that cash has some “defensive” value as it can act as a buffer when markets correct while it also has “offensive” value as it is the ammunition that will allow us to hopefully pounce when financial assets get cheaper.

Someone was recently explaining the significant optionality value of cash, by arguing that “cash is a perpetual call option on every asset class with no strike price and no expiration.” We would reason that in the case of the IVA Funds it is even more; i.e. cash is a perpetual call option on every security in the world, small or large, stock or bond, that would qualify as being, at the appropriate price, a good investment.

IVA Funds Performance

In the Management’s Discussion of IVA Funds Performance (pages 7 to 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 ending September 30, 2014. As was the case last year, the significant outperformance illustrates vividly that individual stock picking is “alive and well,” even in today’s world of globalization and increased correlations. One thing that is striking and unusual today, and considering how pedestrian global economic growth is at this moment, is how high corporate profit margins are in so many industries and in so many countries around the world. To a large extent, stock picking is about trying to identify those companies that may maintain their high margins going forward and those that may not. This is not only due to the fact that wages may finally be able to grow in some parts of the world (in Japan, for instance) and impact margins but also due to the enormous changes that are altering the competitive landscape in so many industries. Think about the changes in retail (with e-commerce in particular), energy (with shale oil), technology (with cloud computing), consumer products (local brands challenging some of the global brands), etc. Over the past two years, one example that we have been giving of a company that was at risk to see its margins come down was Tesco, the UK based retailer. It was interesting to read Warren Buffett admit recently that owning Tesco was a “big mistake” for Berkshire Hathaway. The one country today where stock picking going forward may be about identifying companies with low margins where there is scope for margin improvement is Japan where many sectors (food, healthcare, etc…) remain too fragmented and offer scope for major consolidation. Japan, until now, has not been known for its vibrant mergers and acquisitions activity and takeovers (even friendly ones!) remain very taboo. We have been impressed, though, to see over the past few years how many Japanese companies have finally shown a willingness to increase dividend payout ratios and even conduct stock buybacks, instead of letting cash levels reach “extreme highs.” Stock picking does work quite well in Japan as certain performance numbers show in the Management’s Discussion of Fund Performance (pages 7 to 9). We still have decent size exposure to Japan in both Funds, but remain well hedged on our yen exposure.

IVA Funds: Issues in Europe

Europe remains difficult for us as levels of indebtedness remain high, banks are somewhat undercapitalized and there are still major differences in labor cost competitiveness among many countries, with Germany still far ahead of all of its neighbors, and France and Italy having barely started to reform some of their structural issues. Stock picking remains difficult as “quality” stocks (often small and mid-cap) are not particularly cheap. We remain wary of the euro and are partially hedged as a result.

Junk bonds do not even offer high yields these days, so we have not been active. We shall patiently wait.

Our allocation to gold remains modest as ongoing disinflationary pressures and a rising U.S. dollar act as a headwind while there is still uncertainty as to which way real interest rates will go. Negative real interest rates remain a major positive for gold, but that would change if there was a perception that real rates may not stay negative in the future.

IVA Funds: Stock picking

The fact that stock picking has been “alive and well” for the IVA Funds is interesting as an increasing number of advisors and clients go more and more passive, using index funds and exchange-traded funds (ETFs). We cannot blame them: why pay a high fee to “index huggers” and “closet indexers,” not to mention that too many funds seem to be more interested in “asset gathering” than genuine money management and investing. Even Warren Buffett instructed the trustee for his wife’s estate to put 10% in short-term government bonds and 90% in a very low cost S&P 500 Index Fund! (See our June 2014 newsletter on our website titled, “Active, Value, and Absolute versus Indexing). In many ways, the more so called “active managers” fail to beat their benchmark, the more room there is for a few of us to produce solid returns because of good stock picking over time. Please view our interview by Value Investor Insight on our website titled, “Winning by Not Losing” (January, 2014) to gain a flavor of certain lesser known stocks from around the world that are in your IVA Funds’ portfolios. We should also highlight that passive investing may have its share of risks as well. A recent article in The Economist, “Emerging Trouble in the Future?” (October 25, 2014) discusses how regulators are getting worried that ETFs, which have grown from $416 billion in 2005 to $2.5 trillion today, might struggle to cope with an environment where some of that money decides to move out.

In conclusion, we are pleased with the performance of your IVA Funds. We believe that financial assets will deliver modest returns for many years to come, based on their elevated valuation levels today and a difficult global economic outlook for the foreseeable future. “The purgatory of low returns” (James Montier) is challenging for everybody, but we believe that a pickup in volatility with continued solid stock picking should enable us to keep posting decent performance numbers as long as we keep following time tested rules. Warren Buffett says that “One gets the partners one deserves.” At IVA, we are fortunate to have as partners, very sophisticated advisers and clients who embrace our holistic approach and focus on value as well as our quest for returns that are as absolute as possible. We will strive to keep deserving our partners!

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

Important Information Concerning the Attached November 3, 2014

Letter from the IVA Funds Portfolio Managers

The views expressed in this document reflect those of the portfolio manager(s) only through the end of the period as stated and do not necessarily represent the views of IVA or any other person in the IVA organization. Any such views are subject to change at any time based upon market or other conditions and IVA disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for an IVA Funds are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any IVA fund. The securities mentioned are not necessarily holdings invested in by the portfolio manager(s) or IVA. References to specific company securities should not be construed as recommendations or investment advice. Past performance does not guarantee future results. The performance data quoted represents past performance and current returns may be lower or higher. Returns are shown net of fees and expenses and assume reinvestment of dividends and other income. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed may be worth more or less than the original cost. To obtain performance information current to the most recent month-end, please call 1-866-941-4482. As of the most recent prospectus, the expense ratio for the fund is as follows: IVA Worldwide Fund: 1.27% (A shares), IVA International Fund: 1.26%. Maximum sales charge for the A shares is 5.00%. As of September 30, 2014, the IVA Worldwide Fund’s top 10 holdings were: Astellas Pharma, Inc. (3.9%); Wendel 4.375%, 4.875%, 6.75% (3.5%); SIGB (Singapore Government) 2.375%, 2.875%, 3.75% (3.3%); Berkshire Hathaway, Inc. Class A, Class B (3.2%); Nestle SA (3.1%); Gold bullion (2.8%); News Corporation Class A, Class B (2.3%); Genting Malaysia Berhad (1.8%); Oracle Corp. (1.6%); DeVry Education Group, Inc. (1.6%). As of September 30, 2014, the IVA International Fund’s top 10 holdings were: SIGB (Singapore Government) 2.375%, 2.875%, 3.75% (4.7%); Astellas Pharma, Inc. (4.0%); Nestle SA (3.9%); Gold bullion (3.3%); Wendel 4.375%, 4.875%, 6.75% (3.1%); News Corporation Class A, Class B (2.9%); Genting Malaysia Berhad (2.6%); Hongkong & Shanghai Hotels Ltd. (1.8%); Toho Co., Ltd. (1.7%); Alten SA (1.6%).

Mutual fund investing involves risks including possible loss of principal. There are risks associated with investing in funds that invest in securities of foreign countries, such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates. Value-based investments are subject to the risk that the broad market may not recognize their intrinsic value.

An investor should read and consider IVA Funds’ investment objectives, risks, charges and expenses carefully before investing. This and other important information are detailed in our prospectus and summary prospectus, which can be obtained by calling 1-866-941-4482 or visiting www.ivafunds.com. Please read the prospectus and summary prospectus carefully before you invest.

The IVA Funds are offered by IVA Funds Distributors, LLC.

Effective February 22, 2011, the IVA Worldwide Fund and IVA International Fund are closed to new investors.

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