Portfolio Objective
The Fund seeks long-term capital growth by investing primarily in common stocks of companies that have a market capitalization that are less than the largest company in the Russell 2000 Index and which Schneider Capital Management believes are undervalued.
Arnold C. Schneider III is primarily responsible for the day-to-day management of the Fund’s portfolio.
All investments contain risks and investors should consider the risks associated with investing in these types of Funds. Investments made in small capitalization companies are subject to a higher degree of market risk because they tend to be more volatile and less liquid when compared to larger more established companies.
Performance Review and Portfolio Strategy (cont.)
Performance was far short of the indexes in the quarter and year as our oil and typical economically sensitive over weighted positions were punished severely as macro factors greatly outweighed fundamentals in a risk off market environment. Stock selection in energy was not a major factor. Aside from the price of oil, we believe fundamentals in our portfolio are solid. Oil prices were down in the year, but oil equities were down far more as the market placed trough multiples on our view of trough cash flow. Equity market deep value factors severely underperformed in both periods creating a style headwind as valuations failed to matter. We believe the quarterly upside potential in our portfolio is the second highest since 2009.
Outlook
A minor oversupply of 1 percent for most commodities impacts the price in a disproportionate way. The cessation of the OPEC deal with Russia in the summer in anticipation of the imposition of Iranian sanctions in November brought on much more production than the ultimate reduction in Iranian exports. OPEC far overestimated the reductions given tricky U.S. negotiations with numerous parties and an administration desire for low oil prices. Additionally, Saudi and Russia surged their production in the fall to game the December negotiations from a higher production level. Thus, overall OPEC production went up moderately in the second half of 2018 instead of the intended flat outcome. Combined with typical seasonal demand reductions in the winter, we went from a slight deficit to a slight surplus. During the third quarter, the Rapidan Group estimated global spare capacity to be the second lowest in 60 years. While the restart of 1.2 million barrels of voluntary production cuts temporarily expands the spare capacity, it could quickly return to 3q levels both seasonally in the summer and from the low level of 2018 dislocations.
For instance, at low oil prices, Venezuela’s humanitarian disaster could lead to further defaults and seizures of its oil facilities or force majeure on exports, reducing its production potential. Over $9 billion/ year of principal payments are due in 2019 and 2020. Complete collapse of the regime and/or the current 1.2m barrels of production (800k exports) is possible. Mild initial Iranian sanctions could tighten upon renewal in May.
On the demand side, we see no slowdown from available data despite the strong dollar. 2018 demand of roughly 1.4% is equal to the long-term average. Starting in a few months, the new IMO sulfur rules for shipping will tighten global crude supply/demand by estimates ranging from .5 to 1 million barrels/ day. Given that U.S. shale production growth in recent years has been required to provide 100% of global demand, oil prices should not sustainably go under West Texas Intermediate (WTI) $50 per barrel. At those prices, yearly shale growth would crater from recent levels of well over 1 million barrels/day.
Outlook (continued)
U.S. Exploration & Production based operators are committed to spending within cash flow, and prices much below $50 are insufficient to grow their production. With the withdrawal of most of U.S. supply growth, global supply growth could not keep up with demand growth. 2019 futures prices at December end would lead to much slower U.S. production growth and further tighten global supply demand.
A correction in the equity market was not surprising, but the composition of the decline was. While it is difficult to mind read the market’s new economic concerns in the fourth quarter, discussions about the impact of rising short and long-term rates on the U.S. economy seemed to increase. While China and other international economies continue to slow, we see little evidence the overall U.S. economy is slowing yet. The U.S. consumer is in good shape, with a personal savings rate above average at 6%, rising wages and employment. Household debt service ratios are at a near record low 10%, well below the long term 12% average. Mortgages are virtually all fixed rate. While housing affordability has gone from excellent to merely good, it is not poor. Short term rates are still not yet restrictive at less than a 1% real rate. Core Personal Consumption Expenditures (PCE) inflation is not a current problem at below the 2 percent target, with few signs of overheating. Financial conditions have at least temporarily tightened with the stock and credit market declines, but the stock market is only roughly 10 percent of the Leading Economic Index. Overall, U.S. economic fears about today’s level of rates and the stock market collapse seem overblown.
On trade, uncertainty is high so wild downside cases are easy to create. Currently, the “bad” cops (Navarro and Lighthizer) are staking out a strong position against a weaker and slowing China, a typical negotiating ploy. Ultimately, a NAFTA like compromise is the most likely outcome.
Tightening financial conditions should create modest pressure on economic growth which probably peaked at 3% year over year growth in the third quarter of 2018. Somehow, the market has fast forwarded a likely deceleration in economic growth into a recession. Moreover, the market’s reflexive move to play full court defense and rotate into perceived low risk stocks (high valuations make these higher risks in our judgment) moved relative forward p/e ratios on low volatility and defensive stocks to a 30 year high in the quarter. High beta stocks trade at a near record low compared to low beta. For example, Utilities sell at a 70% p/e premium to banks despite a similar yield and much lower earnings growth. A return of cyclical multiples to even the low end of their normal spread to defensive issues would yield significant appreciation. The test of hugely undervalued stocks is time, as ultimately stock prices follow earnings. Market turmoil has created massive bargains in our portfolio and a large idea list as a variety of cyclicals sell at mid -single digit multiples of earnings. The industrials segment of the S&P 500 is at the lowest weighting in the last 16 years. Our cyclical non- oil positions are primarily special situations as opposed to industry plays that require strong economic growth.
Value stocks may remain undervalued for extended periods of time and the market may not recognize the intrinsic value of these securities. There are no guarantees that any investment style will result in favorable performance over time. Investing in foreign securities poses additional market risks since political and economic events unique in a country or region will affect those markets and their issuers.
The Russell 2000 index is an index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States.
Portfolio Holdings are subject to Change. Discussions of Portfolio holdings should not be considered recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk.
This update is being provided for informational purposes only. It is not intended as a recommendation or solicitation to purchase any security. Investors should consult with their Investment Professional about their particular investment program.
