Bernard Horn's 3rd Quarter Polaris Global Value Fund Shareholder Letter

Commentary on holdings and market

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Oct 18, 2017
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October 5, 2017

Dear Fellow Shareholder,

The Polaris Global Value Fund returned 3.74% for the third quarter of 2017. While we are pleased with the absolute positive performance, results lagged the MSCI World Index which returned 4.84%. This marked the third consecutive quarter of global growth stocks surpassing value stocks, a trend that will inevitably reverse course in due time. Overall, global stock markets delivered healthy gains, spurred on by earnings growth, upswings in general economic data and diminished political uncertainty in Europe. Even the escalating tensions on the Korean peninsula and the rash of natural disasters in the U.S., Caribbean and Mexico did little to dampen global markets.

The Fund posted absolute positive returns in eight of 11 sectors for the quarter. As dictated by another growth-oriented quarter, cyclical sectors performed best, led by materials, financials and consumer discretionary. The Fund benefitted from its overweight position in these sectors, and beat the respective benchmarks (see Performance Analysis graph below). Defensive sectors detracted with losses in health care and consumer staples. On an individual stock basis, more than 75% of Fund holdings were in positive territory; approximately 25 companies had double-digit gains. Among the top individual performers were Norwegian banking institutions, Sparebank 1 SR and DNB ASA; energy companies Thai Oil and WorleyParsons; and IT companies, NEXON Co. and Xerox Corp. Detractors were largely limited to health care holdings, Teva Pharmaceutical, Quest Diagnostics and Allergan plc; select Korean companies, including two automakers and a mobile carrier; and U.S.-based Regal Entertainment and The J.M. Smucker Co.

For the nine months ended September 30, 2017, the Fund gained 14.32%, while the MSCI benchmark returned 16.01%. The Fund achieved benchmark-beating performance over all longer time periods as reflected below.

Materials companies, Methanex Corp. (MEOH, Financial), Yara International and BHP Billiton, had double-digit gains during the third quarter, easily recouping losses from the prior 3-month period. Global demand for iron ore was strong, backed by Chinese steel production; BHP Billiton benefitted from rising prices of both iron ore and copper. The company also responded to an activist investor, enacting numerous asset allocation, operational and management measures most of which were in process already. Finally, BHP released robust fiscal year 2018 guidance across iron ore, copper, and coal but remained cautious on the petroleum business outlook. They decided to sell U.S. onshore (shale) oil properties.

Over the past few quarters, Yara International (OSL:YAR, Financial) dealt with the oversupply of urea and nitrogen products by focusing on improving operations and investing in higher -margin specialty fertilizer and industrial applications. In mid-September, urea prices started rising, indicating favorable supply-demand dynamics on which Yara capitalized. The stock was up nearly 20%. Supply-demand constraints also contributed to Methanex Corp.’s performance for the quarter. Availability of Gulf Coast methanol was in question following Hurricane Harvey, causing prices to jump nearly 10%. About 75% of Methanex’s capacity is outside the U .S., and their Gulf Coast assets actually continued to operate normally. A large methanol-to-olefins (MTO) plant in China resumed production adding to methanol demand, which looks promising for the foreseeable future. According to a research report, one in five tons of global methanol production will be utilized for MTO production to satisfy expanding Chinese chemical demand by 2021.

Two Norwegian banks, DNB ASA (OSL:DNB, Financial) and Sparebank 1 SR, led financial sector performance. DNB beat estimates, delivering better than expected results with expanding net interest margins, loan growth and lower loan loss provisions. The bank had de-risked loans to shipping, energy and offshore/logistics divisions. DNB also conducted two stock buybacks during the quarter. Although there was no significant news flow on Sparebank 1 SR, a revival of Norwegian loan growth and an uptick on lending margins were positive trends. Russian institution, Sberbank, delivered excellent half-year results, with higher net interest margins, lower credit costs, carefully-crafted expense controls and a return-on-equity in excess of 20%, despite a Russian economy that remained fairly soft.

U.S. banks and thrifts advanced smartly in September, as economic metrics showed improvement and the Federal Reserve signaled its intention for another rate hike before year end. One industry standout was International Bancshares, which rose more than 15% during the quarter after second quarter earnings outlined lower loan loss provisions and lower effective tax rates. Conversely, Puerto Rican bank Popular Inc. declined in the wake of Hurricane Maria on concerns about the local economy and loans collateralized by hurricane-affected assets.

NEXON Co. (TSE:3659, Financial) was the top contributor to Fund returns, up more than 30% for the quarter. The Japanese gaming company reported good second quarter results, driven by the success of their flagship game in China, Dungeon & Fighter. The recent release of Lawbreakers for the Western market, as well as some of their other titles, should help diversify their product portfolio. The company also launched MMORPG AxE in September; it became an immediate best seller in the Korean Apple store. Elsewhere in the information technology sector, U.S. business service/printing company, Xerox Corp., reported decent sales, market share gains in managed printing services and competitive product developments. In addition to top-line growth, Xerox reduced operating expenses and projected $1.5 billion in cost cuts by 2020. The market rewarded Xerox for its proactivity, as the stock price ticked up more than 15% by quarter end.

U.K. homebuilders continued to contribute to performance despite BREXIT concerns. Persimmon, Bellway, Barratt Developments and Taylor Wimpey each posted robust quarterly results, with historically high sales rates, better operating metrics and upbeat guidance. The U.K. government’s help-to -buy scheme (HTB) includes interest free loans in exchange for a share of house appreciation upon sale. HTB is reported to support 30-75% of some builders’ sales. Among other consumer discretionary stocks, Magna International rose more than 15% after unveiling its autonomous driving platform, MAX4, at the Frankfurt Motor Show. Competitor Autoliv announced plans to split into two publicly-traded companies, sending shares of it and other auto parts suppliers, including Magna, higher.

Regal Entertainment (RGC, Financial), a U.S. theater operator, detracted from consumer discretionary sector results after missing consensus estimates. The lower-than-expected revenue was primarily due to softer box office attendance, although average ticket pricing trends increased. Markets were also wary about the shorter exclusivity period from theater to DVD/on-demand and a new “movie pass” subscription service. We believe the $10 per month unlimited pass will actually be a net positive for theaters, as more visitors equate to more money spent at concessions, a major profit source for theaters. Additionally, Regal made a $173 million acquisition of theaters in Houston, Kansas and Oklahoma that are expected to be immediately accretive to earnings and free cash flow.

South Korea’s Kia Motors (XKRX:000270, Financial) and Hyundai Motors battled sales slumps in China amid regional tensions; both also had weaker U.S. sales. A South Korean court ruled Kia owes workers back wages related to prior bonus calculations in a long-running legal case. The cumulative unpaid wages amounted to $400 million. Additional labor costs and wage adjustments arising from the ruling will more than double that amount; Kia provisioned another $400 million in estimated payments. As a result, the company is expected to post an operating loss in the next quarter.

In the energy sector, Thai Oil (BKK:TOP) gained more than 20% on the back of better pricing, decent volumes and higher refining margins related to tightening refined product supply after Hurricane Harvey’s impact on Houston. WorleyParsons, the Australian energy consulting firm, reported respectable annual results with improved cash collections and a 20% increase in backlog across nearly all divisions (hydrocarbons, mining and infrastructure). Despite low energy prices, WorleyParsons’ clients have adapted their cost structures to the new reality and are beginning to revive capital investment projects. Additionally, a Middle East-based consulting firm took at 19% stake in the company with a view toward a takeover.

Teva Pharmaceutical (TEVA), the Israeli drug company, dropped materially during the quarter. The company faced a perfect storm of industry pressures and self-inflicted missteps. Pricing pressure in the U.S. generics market was worse than normal. The resultant lower cash flow, and a high debt load from the Allergan acquisition, forced the company to cut its dividend and warn that debt covenants may be violated. Management planned asset sales to help alleviate cash requirements. Generic drug competition also impacted Allergan, as the stock declined nearly 15% on concerns of a 2018 generic alternative to Allergan’s flagship Alzheimer’s drug, Namenda. However, Allergan’s current drug portfolio remains resilient, led by advances in Botox and the introduction of Namzaric. Company management also signaled its intention to add new medicines and expand via acquisitions.

Another health care sector holding, Quest Diagnostics (DGX) reported solid quarterly revenues, attributable to their expanding book of business and healthy operating cash flow position. The company raised full-year guidance, confident in its business fundamentals and outlook. The stock price was stable until September 22, when the Centers for Medicare & Medicaid Services introduced proposed Medicare payment rates for clinical diagnostic laboratory tests. Draft rates called for a 10% rate cut in 2018 with heftier cuts from 2019-2021. Quest Diagnostics’ stock reacted negatively to this news and management intends to challenge the proposal.

Greencore Group (LSE:GNC) executed seamlessly in the U.K., as their food-to-go offerings retained strong growth. U.S. operations were similarly well positioned, backed by the timely integration of the Peacock Foods acquisition and new business wins. Yet the stock price fell when the firm announced it would change production at its Jacksonville facility from frozen sandwiches to fresh food. Investors were concerned this signaled difficulty with its Starbucks business. At only 2% of Greencore’s revenues, the Starbucks contract was far from substantial, but the market extrapolated that other legacy contracts may be at risk. J.M. Smucker Co. was weak following a disappointing quarter. Sales decreased 4%, with profits falling sharply. The primary culprit was pressure on their Folgers coffee brand after green coffee prices fell and Smucker’s lost ground in the subsequent jockeying for market share. Moreover, profits in Smucker’s pet food division were squeezed by lower prices and rising costs.

After a busy half year, in which we bought or sold more than a dozen companies, portfolio turnover slowed, as no new positions were added or exited in the quarter.

Investment Environment and Strategy

Global economic expansion may be sustainable in the coming quarters, as roughly three-quarters of countries are steadily improving. Eurozone countries are showing signs of recovery, with political risk diminished. China is seeing stronger investment and consumer-led growth. Strong commercial spending, domestic demand and a pickup in global trade bodes well for India. In Japan, private consumption, investment and exports support growth, the first upward inflection for this country in many years. In the U.S., consumer and corporate spending, manufacturing and employment metrics are promising. Inflation remains tepid, with one possible Federal Reserve interest rate hike left in 2018. Yet, liquidity problems in oil-based economies and continued capital flight from China are cause for concern. Brazil remains mired in corruption scandals.

Generally healthier macro-economic conditions are reflected in the companies we visit. Many report increased demand, positive momentum in cash flows and optimistic guidance. Corporate earnings are pushing stocks higher, leading to stretched valuations in certain sectors and countries. After a year of solid market appreciation, fewer attractively-valued companies are entering our screens. Those that appear are keeping our research team busy with fundamental analysis and on-the-ground visits. We are pleased portfolios have been de-risked to some degree after second quarter changes and we expect further activity in the fourth quarter. As always, we welcome your comments and questions.

Sincerely,

Bernard R. Horn, Jr., Shareholder and Portfolio Manager