Dear Fellow Shareholder, January 9, 2020
Global equity markets ended the year on a bullish note, with the MSCI World Index up 8.56% in the fourth quarter of 2019. The Polaris Global Value Fund gained 9.09%. U.K. market gains led to outperformance. This was a welcome reversal from the past few years, when overweight positions in the U.K. and other European countries paled in comparison to robust returns in the United States, where the Fund is underweight. In October, the U.K. and European Union reached an agreement on the conditions of the U.K.’s departure from the EU (BREXIT). Then in December, U.K. Prime Minister Boris Johnson won the general election in a resounding victory; years of BREXIT uncertainty gave way to inevitability. A revaluation of British stocks followed, as investors renewed interest in fundamentally strong companies. Stock prices of U.K.-based Bellway PLC (LSE:BWY, Financial), Taylor Wimpey PLC (LSE:TW., Financial), Babcock International Group (LSE:BAB, Financial), Next PLC (LSE:NXT, Financial) and Mondi PLC (LSE:MNDI, Financial) rose in excess of 20% for the quarter. Holdings in Sweden, Ireland, Colombia, Finland and Belgium also had double-digit gains. The Fund’s sole holding in India, Infosys Ltd. (INFY, Financial), declined on whistleblower claims.
Cyclical sectors drove performance: financials, consumer discretionary, industrials, materials and health care added measurably. Detractors were relegated to information technology and communication services where sector returns were positive but lagged the benchmark. Strength in most foreign currencies relative to the United States Dollar helped during the quarter.
Financials contributed most to Fund performance due to a substantial overweight relative to the benchmark. JPMorgan Chase & Co. (JPM, Financial) announced outsized quarterly earnings, with third-quarter profits up 8% and record revenue on the strength of its consumer lending and corporate investment banking divisions. German reinsurer, Munich Re, posted good results despite some catastrophe losses. At Hannover Re’s capital markets day, the reinsurer emphasized its cost leadership and explained investment portfolio risk mitigation in a low interest rate environment. Bancolombia SA (CIB) moved higher on steady net interest income, good cost control, low credit costs and expanding non-interest income. Conversely, Franklin Resources, Inc. declined on net asset outflows and lackluster performance due to Argentinian bond market exposure. Yet, Franklin achieved decent earnings, reporting higher income on lower expenses and taxes. Chubb Ltd.’s net income decreased due to realized losses in its variable annuity portfolio and a flat combined ratio; otherwise the Swiss property and casualty insurer’s net premiums and underwriting income increased.
U.K. stocks dominated the consumer discretionary sector. At a granular level, retailer Next reported strong online sales and growth in overseas business, guiding up for January 2020 ended sales. Homebuilder Taylor Wimpey released a solid trading update after reporting slightly higher volumes in home sales albeit slightly lower operating margins. In the U.S., Carter’s Inc. advanced after third quarter earnings. Although the children’s apparel manufacturer wrote down its investment in Skip Hop, which lost key customer Toys “R” Us, the underlying sales, earnings, and margins all increased.
In industrials, Babcock International had a tangential bump after the U.K. elections, but rose markedly on earnings news. Babcock confirmed full year guidance, pointing to a strong order book that included a new $1.6 billion ship building contract with the U.K. Ministry of Defense. SKF AB’s third quarter results were lackluster, but the market lauded the company’s resilience when compared to other bearings/seal manufacturing competitors. U.S.-based WESCO International gained more than 20%, after bidding to acquire rival wholesale distributor Anixter. While there is no guarantee that WESCO will prevail over other bidders, the deal looks promising. Anixter could be a complementary acquisition for WESCO, with opportunity for geographic and customer base expansion. However, the bidding war has caused Anixter’s share price to become a bit elevated considering the debt that WESCO would need to absorb.
UK-based pulp and paper company, Mondi PLC, rose more than 20%, leading materials sector gains. The company cited softer demand in key paper grade markets, but growth in its corrugated and consumer packaging. Mondi’s industrial packaging order book grew in the second half of the quarter, likely a function of constructive U.S.-China trade talks. Overall, the stock was flat for nearly the entire quarter, but saw a price spike after the U.K. elections. Yara International announced satisfactory earnings, but investors expressed concerns about 2020 risks including fertilizer demand and energy costs, sending the stock lower. On a positive note, urea (nitrogen fertilizer) prices appeared to bottom out (due to curtailment of Chinese supply), leading to price increase projections for 2020.
Rallies from two managed care organizations boosted the health care sector. UnitedHealth Group (UNH) was the single best contributor in the Fund, up 35% for the quarter, after releasing conservative but robust 2020 guidance. In December, UNH’s OptumRx announced a $304 million cash acquisition of Diplomat, a specialty pharmacy/home infusion service. Despite a higher medical loss ratio, Anthem Inc.’s Medicaid business improved, medical enrollment increased and SG&A expenses declined.
Within the consumer staples sector, Greencore Group gained ~25% while JM Smucker and Asahi Group lagged. Greencore hosted a capital markets day in September, where management boasted of new customer wins while managing its acquisition of salad/snacking manufacturer, Freshtime UK. The company hinted at further acquisitions in the highly-profitable fresh snacking space. Conversely, Asahi declined after reporting lower fiscal year sales and profits due to unfavorable foreign exchange and slowing domestic liquor and soft drinks business. Questions surrounded Asahi’s acquisition of Australia’s Carlton & United Breweries; regulators raised objections to the deal due to monopoly concerns in the Australian cider/beer market. U.S-based JM Smucker lowered guidance for the year, citing slowing growth in its traditional brands like Folgers Coffee and Jif Peanut Butter.
Double-digit returns from Microsoft Corp, Western Union, Samsung Electronics and SK Hynix offset modest losses from Infosys and Avnet Inc. Western Union continued to trade positively after the company announced cost-cutting measures. Samsung gained on expectations that the highly-cyclical semiconductor market will ramp up again in 2020, especially in DRAM and NAND memory. Samsung’s cell phone division focused on meeting 5G demand in an ever-competitive handset market. Indian-based Infosys declined as whistleblowers accused the CEO and other executives of unethical practices to boost revenue and profits in the short-term. Management denied these claims, welcoming an independent audit. The stock price of Avnet, Inc. dropped after Texas Instruments (TI) announced it will end its relationship with Avnet in December 2020; TI accounted for 10% of Avnet’s sales.
With the vast majority of Fund holdings in absolute positive territory, the negative outliers were few and far between. U.S. utility ALLETE; French advertising company, Publicis; German telecom, Deutsche Telekom; and South Korean tobacco manufacturer, KT&G, declined. Publicis reported weak organic growth and implied flat to negative organic growth for 2020. The advertising agency, which struggled with client attrition, acquired Epsilon in an attempt to improve its product offerings. Deutsche Telekom cut its dividend for 2019 to preempt uncertainty over the outcome of its stalled U.S. mega-merger (DT’s T-Mobile and Sprint) and to cover the heavy costs of building 5G networks. KT&G Corp.’s operating profits fell in the third quarter amid waning sales of e-cigarettes due to health hazard concerns. However, the company’s market share in Korea’s traditional combustible cigarette industry reached an all-time high. Brisk sales came as KT&G improved its competitiveness in the heated tobacco industry by launching new and limited-release products that captured customer demand.
2019: Year In Review
Global markets closed the decade on a bullish note, with fourth -quarter gains marking a year of unexpected strength given the considerable trade headwinds faced. Yet, the combination of low interest rates, continued resilience of the U.S. consumer, and strong election results in the U.K. fueled higher equity prices. The growth vs. value disparity loomed large, with the MSCI World Growth Index up 34.14% vs. 22.74% for the MSCI World Value Index in calendar year 2019. However, that trend may be at an end if the WeWork IPO was any indication. In September, the IPO was valued at close to $40 billion; by the time it was cancelled, the valuation dropped to $8 billion. Public markets were simply unwilling to support the heated venture-capitalist valuations. Since that time, growth momentum started to slow. Whether this was the turning point in an unusually long growth/value cycle has yet to be determined, but we welcomed more valuation-based investment behavior.
We achieved outperformance in the fourth quarter, but lagged the MSCI World benchmark in the prior three quarters. Much of this was attributable to the Fund’s underweight in the U.S. market, which continued to outpace most non-U.S. markets. We were overweight and outperformed in the vast majority of other countries, including European developed regions of the U.K., Germany, Sweden, Norway, Ireland, Finland and Australia. At the sector level, contributions came from financials, consumer discretionary, information technology and industrials, keeping trend with cyclicals that typically do well in a high-growth economy. Communications services and energy lagged; we were underweight these sectors.
The longest-running bull market in history celebrated its 10-year anniversary in 2019. Although such market dynamics do not typically favor disciplined value managers, we were gratified to outperform the MSCI World Index for the 10-year period. The Fund was up 10.81% vs. 9.47% for the Index over the period. Disciplined stock picking, focusing on attractively priced companies with good free cash flow, stands at the core of this long-term success.
Investment Environment and Strategy
Competing trends continue to muddle the direction of the global economy. Industrial production figures are slowing down, which indicates that industrials and similarly-positioned sectors (like materials and construction) could get weaker. Yet the service sectors, which comprise up to 75% of gross domestic product in many countries, show considerable strength. Corporate capital spending has slowed, as companies are wary of on-going U.S.-China trade frictions and weak bellwether industry metrics like industrial production and trade flow data. Yet retail spending has continued unabated, with consumers seemingly unfazed by the trade tensions. With no clear trajectory, markets may experience volatility in coming quarters, and we hope to capitalize on downturns to purchase watch list stocks.
As we enter a new decade, we are excited about the changes in technology, advances in healthcare, continued emerging market growth, and all the opportunities and disruptions that will ensue. We are also mindful of the headwinds we may face: excessive deficit spending, geopolitical upheaval, potential asset bubbles and liquidity crises to name a few. At Polaris, we remain committed to our value discipline and believe that buying good companies at attractive valuations continues to be a prudent strategy for the decades.
Sincerely,
Bernard R. Horn, Jr., Shareholder and Portfolio Manager
The views in this letter were those of the Fund manager as of December 31, 2019 and may not reflect the views of the manager after the publication date. These views are intended to assist shareholders of the Fund in understanding their investment and do not constitute investment advice.
