Dear Fellow Shareholder:
We are pleased to report that the Private Capital (Trades, Portfolio) Management Value Fund (“the Fund”) achieved strong results over the past six months with a return of 10.63% for Class I shares. In all candor, it has been a rather strange period for U.S. equities. Large capitalization stocks achieved record highs with the S&P 500® Index recording an 8.22% gain over the past six months, while smaller capitalization issues have struggled since the early part of the year with the Russell 2000® Index gaining 4.83% during the past six months only due to its 6.59% return in October. The divergence was clearly seen from April through September when the large-cap S&P 500® Index returned 6.42% compared to the -5.46% return of the small-cap Russell 2000® Index, a differential of almost 12%.
We characterize the period as “strange” because the factors that provoked investor discomfiture with secondary stocks − a witch’s brew of negative news ranging from geopolitical threats such as Russia’s actions in Ukraine and the ascendance of the Islamic State, to economic stagnation in Europe, recession in Japan, and below par growth in China − pose the greatest fundamental threat to some of the large multinational corporations whose stocks have outperformed thus far in 2014.
Rather than spilling additional ink discussing what happened, we think it is more useful to put recent events in context. We have, for some time now, been clear in our view that the U.S. economy is amidst awell-established recovery. Recent statistics affirmthis perspective, withGDPgrowing 3.5% and reported unemployment dropping below6%(its lowest level in more than six years). Nonetheless, all is not “butterflies and puppy dogs” − labor force participation remains low, which masks true unemployment levels and household income growth is tepid, which dampens consumer spending. More positively, the recent sharp decline in the price of gasoline (under $3.00/gallon for the first time since 2010) is tantamount to a meaningful tax cut for most households. Taken together, it is clear that the key trends are moving in the right direction and the U.S. economy can be viewed like a giant locomotive, slowly but steadily building up speed and momentum.
If one accepts our metaphor for the state of the economy, then far from the apocalyptic event described by some market pundits, it is actually a significant positive that the Federal Reserve (the “Fed”) is winding down its quantitative easing (QE3) activities. We have previously written about our concern that the Fed might not curtail its stimulus programs quickly enough, resulting in a significant escalation in inflationary pressures that would in turn require a rapid increase in short-term interest rates. In contrast, the track we are currently on feels quite orderly. By slowly turning off the spigot of excess liquidity flowing from QE3 and intimating the onset of a modest tightening cycle (read as a small increase in short-terminterest rates), the Fed thus far has constrained inflation expectations and precipitated a powerful rally in the U.S. dollar, which through the dollar’s enhanced purchasing power promotes a virtuous cycle that should dampen inflationary realities.
We continue to believe that these factors are fostering an atmosphere conducive to further growth for the U.S. economy. Recovery from the Great Recession has been slow and painful, particularly for the bottom economic quartile of our population. The upside is an economy with significant slack, minimal speculative excess, and significant headroom for growth. Contrary to the skeptics who argue that the economy has been artificially supported by the Fed’s monetary stimulus, we believe that the baton is in the process of being passed back to the “real economy” and self-sustaining economic growth.
To be clear, our view is that the improving economy will result in higher interest rates, probably sometime next year. While we acknowledge that the specter of rate hikes may continue to drive volatility for equity markets as it did last June when the Fed initially suggested that it might taper its bond-buying program, we see near-termtrading disruptions as more likely to create opportunities than true threats for long-term investors. Given current inflationary expectations, interest rate increases will likely be measured, and will still leave borrowing rates at very attractive levels by historical standards. The benefits to corporate earnings and equity returns from a growing economy far outweigh the cost of higher interest rates.
In this context it is a worthwhile exercise to review and compare today’s valuations to 2007, the last time the S&P 500® Index traded at record highs. Back then, the predominant theme was that investors were benefitting from the “Goldilocks economy” – not too hot as to incite inflation, but not too cold as to risk recession. With the clarity of hindsight it is apparent that the economy back then was largely supported by massive speculative excess, propelled by reckless financial practices and sustained appreciation in the value of residential housing. Time is a great healer and seven years on, we find it is unsurprising that valuations have recovered and the broad indices have reached new highs. That said, in contrast to the euphoria typically concomitant with market peaks, we find market participants more inclined towards trepidation and consternation than approbation and complacency.
Today’s economy presents investors a series of counter-balancing, and in some cases, contradictory forces that are creating opportunities for stock-pickers willing to dig into the details, understand the risks, and take a thoughtful and contextual view of the factors that build lasting shareholder value. Among these counter-balancing forces:
• Unemployment is falling and jobs are taking longer to fill, which would ordinarily trigger higher wage growth. However, the long-term unemployed are still waiting in the wings, creating a labor reserve that is likely to temper wage growth that might otherwise engender inflation fears. The latest official payroll data showed that despite a drop in the unemployment rate to 5.8%, the number of long-term unemployed was unchanged. The data also showed that the average earnings of American workers has grown only 2% over the past year.
• While well off its lows, housing remains affordable benefiting from low interest rates and prices still well below the peak. Credit worthy buyers remain in relative short-supply. In fact, the Federal Housing Finance Agency has recently reduced lending standards to encourage more home purchase and mortgage origination activity.
• Consumer confidence is at its highest levels since 2007, however, spending is not robust across the board.For example, the GeneralRetailers subsector of theS&P500 Index has returned approximately half of the overall index gain over the past twelve months.
• Last, and probably most importantly, while theU.S. economy is improving, China’s growth has slowed, Brazil remains weak, Europe is stagnant and Japan has fallen back in recession.
These contradictions are representative of a global economy that is still recovering unevenly from financial crisis. In 2007, there were few worries about anything; now, the scars of 2008-2009 are still raw with investors and many are quick to see the next bogeyman in the form of a “reasonably valued” market. But even when “reasonably valued” describes the market as a whole, individual opportunities exist for the disciplined, bottom-up stock picker.
We are reminded of the statistician’s joke about the man who has his feet in the oven and his head in the freezer: on average, he’s comfortable. In other words, the market contains both overvalued and undervalued companies, which is a much more favorable environment for disciplined value investors like us than a market in which everything goes up in unison. Despite the stock market trading near all-time highs, we are seeing a steady flow of potential opportunities.
In summary, we continue to anticipate additional pockets of volatility as the prospect of higher interest rates is digested, a new Congress takes its place and sets its agenda, and spontaneous yet normal geopolitical events run their course. We continue to selectively take advantage of opportunities across a range of industries as we position the Fund’s portfolio to best capitalize on the environment we envision as we turn our eyes to 2015.
We are most grateful for your continued support.
Private Capital (Trades, Portfolio) Management
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Mutual Fund investing involves risk and it is possible to lose money by investing in a fund. The Fund is non-diversified and may invest a larger portion of its assets in the securities of a single issuer than a more diversified fund causing its value to fluctuate more widely. The Fund may engage in strategies that are considered risky or invest in stocks of companies that are undervalued which may cause greater volatility and less liquidity. Investors should consider the investment objectives, risks, charges, and expenses of the Fund carefully before investing. This report is not authorized for distribution unless preceded or accompanied by a current prospectus for the Private Capital Management Value Fund. The prospectus contains this and other important information about the Fund. Read it carefully before investing.
Shares of the Private Capital Management Value Fund are distributed by Foreside Funds Distributors LLC, not an adviser affiliate.
This letter is intended to assist shareholders in understanding howthe Fund performedduring the six months ended October 31, 2014 and reflects the views of the investment adviser at the time of this writing. Of course, these views may change and do not guarantee the future performance of the Fund or the markets.
Portfolio composition is subject to change. The current and future portfolio holdings of the Fund are subject to investment risks.
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