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.
Our energy exposure was the cause of our underperformance versus our index in the quarter. Oil prices fell modestly during the period as U.S. crude inventories grew during an abnormally high refinery turnaround season which temporarily depressed product demand. Rising inventories exacerbated worries about slowing global economic growth. Oil indexes underperformed the commodity continuing a long pattern. Further, our stock selection in energy was poor. Many Exploration and Production stocks are currently trading below 2018 proved reserve values, a rare event given that much of their acreage value and resource upside is not included in this calculation. Currently, the valuations of the stocks in the sector reflect a long term price of only roughly $50/barrel. Additionally, energy companies now have similar free cash flow yields to the broad market. Recognizing this, numerous oil companies initiated share buybacks in the quarter.
Outside of Energy we had a solid quarter despite further rotation away from deep value. We did well with our stock selection in the Consumer Discretionary and Producer Durables sectors. In our view, inside equity markets there exists a huge dispersion of valuation. While this trend has been in place for a while, it has resulted in a record P/E premium for slow growing defensive groups compared to value stocks. Safety and predictability are in fashion, while companies with variable or uncertain earnings are not, we believe, despite the fact that the present value of a variable stream is no different than a similar steady stream. Valuation factors have been one of the worst performing segments year to date and a huge headwind over the past year. Cheap stocks have continued to get cheaper, creating wide valuation gaps. Treasury bonds rallied sharply which lowered the discount rate applied to future earnings. This further pushed up valuations of longer duration growth companies.
Outlook
With OPEC production down sequentially in May, global inventories should decline in the second half bringing them close to the 5 year average. The bond flotation of Saudi Aramco1 showed that its largest field, Ghawar, peaked a decade ago. Most of their other production is also in old fields, suggesting consensus views of 12 million barrel capacity are incorrect. The most production Saudi ever realized, even in the 3 year period of $100 plus oil in 2012 to 2014, was 11 million.
The various direct Iranian attacks were an obvious geopolitical escalation that potentially could disrupt oil supplies. There were additional less noticeable developments in the quarter. Houthi rebels accelerated attacks on Saudi Arabia itself, rather than its Yemeni opponents. They also added new targets with their Iranian supplied missiles and drones, aiming at oil infrastructure, rather than purely civilian and military targets in the past. Incredibly, Libyan oil production is intact despite a new civil war and some international oil companies withdrawing employees. Tripoli controls the country’s finances, while General Haftar controls most of the oil production. It is unusual that Tripoli banking authorities continue to send money to their poorer enemies in the East. If they stop this funding, it could impact oil production. Finally, Iraq has seen internal missile strikes aimed at oil facilities from Iranian backed militia groups. Only 2% of global supply is voluntarily shut in currently. Any disruption in these, or any of the other geopolitically challenged oil producing countries, would likely send prices soaring.
The global oil underinvestment period of 2015-2018 initiated a yearly average of about 1 million barrels/day of incremental long cycle conventional capacity, less than half the 2009-2014 average. Given the long tailed delivery of these projects, this slowdown has not shown up yet. This small annual amount, in combination with short cycle U.S. shale growth, will be hard pressed to meet International field decline rates of roughly 2 million barrels/day, much less over 1 million barrels/day of incremental demand. Additionally, falling 2019 shale capital spending is leading to sharply decelerating U.S. production growth. Finally, the new IMO shipping rules begin next year with estimates that it will divert up to half a million barrels/day of residual fuel into the power market thus tightening the oil market.
Worries about trade and economic growth grew. However, currently tariffed products are only about 1% of U.S. GDP, so the economic impact is a fraction of that. Counterintuitively, small business optimism rebounded in the quarter at a high level in the midst of negative headlines. Leading economic indicators are not predicting a recession. Since fed funds at 2.5% are exactly at the Federal Reserve’s estimate of the long run neutral rate, we believe any future cuts will be expansionary and likely to extend the recovery. There are no obvious excesses in the economy that need to be corrected. Internationally, the central banks are collectively in an easing cycle which supports overseas growth.
Our largest new positions in the quarter came from a variety of industrial companies. We believe our growing overweight in this area has enormous upside potential. These equities are internal improvement opportunities, rather than requiring strong economic growth to achieve earnings rebounds.
- As of 6/30/2019, the Fund is not invested in Saudi Aramco.
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.
