January 23, 2017
Dear Fellow Oberweis Funds Shareholder:
2016 IN REVIEW
We will remember 2016 simply as a strange year, and we’re not even talking about the Chicago Cubs winning the World Series. From the surprising Brexit vote in June to Donald Trump’s unlikely victory in November, 2016 was a year when the unexpected actually happened. Even more surprising was the reaction in the equity markets to each of these profound events — in both cases the expectation for extreme market volatility following the event proved surprisingly short-lived. In fact, the U.S. stock market’s action following the election has been nothing short of amazing given the potential uncertainty surrounding a Trump administration. Some of his proposals, such as reduced regulations and tax reform, could prove quite favorable, while others, such as protectionist trade policies that could curtail free trade, have negative implications. In any event, it’s safe to say change is coming. Equity markets, especially those trading at juicy valuations, do not typically react positively to uncertain change. But in this case, US investors have been downright giddy — at least so far.
For investors in non-US equities, however, making money in 2016 was considerably more challenging. Even prior to Trump’s election, the US economy was already on better footing than in most other countries. After Trump’s victory, marginal investor preference for US equities accelerated, while a simultaneous appreciation of the US dollar relative to other currencies reduced the value of foreign assets in US-dollar terms. That helps to explain the large difference in performance between US small-cap growth stocks and those abroad. For the year, the Russell 2000 Growth Index gained 11.32% while the foreign stock MSCI ACWI ex-US Small-Cap Growth Index returned -0.28%. While a difficult period internationally, it is worth noting that US large-cap stocks, in our view, have become quite expensive, implying that a lot of good news has already been discounted. Meanwhile, we believe stock valuations in countries outside of the US remain more reasonable.
With respect to the Oberweis Funds, our teams faced multiple style headwinds in 2016 that generally proved difficult to fully overcome via stock selection. Our process focuses on growth stocks over value stocks, but in 2016 growth stocks dramatically underperformed value stocks. In the US, the Russell 2000 Growth Index lagged the Russell 2000 Value Index by 2,042 basis points (or over 20 percentage points) for the year and 1,050 basis points during the fourth quarter alone. Our process also seeks to identify companies achieving positive earnings surprises and upward analyst revisions, but such companies did not fare well on a relative basis in 2016. These style factors tend to be cyclical but do affect shorter-term performance; over the long-term data suggest the opposite is the norm, and that higher estimate revisions are usually positive for portfolio performance. Our experience has shown that disciplined process application, even during out-of-favor periods, normally proves prudent over a full market cycle. Our Micro-Cap team did an outstanding job in 2016; the Micro-Cap Fund returned 24.60% versus 6.86% for the Russell Micro-Cap Index. I’m especially proud of these results in light of the style headwinds discussed above.
THE YEAR AHEAD
As a global investment firm, our most spirited team meeting typically occurs around the end of each year, when our investment team members from Chicago, New York, London, and Hong Kong all fly in to discuss and debate market opportunities all around the world. We don’t always agree, but it is highly useful to compare the insights of our team, who bring diverse perspectives from all over the world.
In the US, we believe investors are betting big that President Trump will pass a significant cut in US corporate tax rates, which would help to justify today’s above-average P/E’s for US large-cap equities. But we also worry that other Trump-driven missteps are likely and that the present investor infatuation with US equities could be short-lived as the “honeymoon” period subsides. The devil, as always, is in the details, and as perception morphs into reality in Washington after the inauguration, 2017 could well be a year that international diversification proves prudent.
In the Eurozone, overall economic conditions are not as good as in the US, but investor expectations are also far less ebullient. Remember that investor returns are strongly affected by the variation between reality and expectations. Europe is finally showing signs of modest inflation, with the highest Eurozone CPI reading in the last three years in December. PMI’s across the European region have remained above 50 (implying expansion) and have broadly come in better than expected. The U.K. has yet to see dramatic economic contraction despite the Brexit vote. At the micro level, European corporate aggregate earnings remain well below US corporate aggregate earnings despite high historical correlations. As a result, there is significant potential for an improvement in European earnings that is not reflected in stock prices, which are trading in-line with long term averages. However, upcoming French, Dutch and German elections could result in short-term volatility, particularly if Brexit- and Trump-inspired populism spreads.
In Japan, less dramatic monetary actions from the Bank of Japan, combined with higher US interest rates, should prevent the Yen from being as volatile as it was in 2016. Recent Japanese economic data also appear to be improving slightly, with the December PMI reaching the highest level in a year. Fiscal spending is likely to drive moderate growth in 2017. Valuations in Japan appear to be the most interesting among the major developed markets, trading at a slight P/E discount to long-term averages.
In China, expectations by foreign investors regarding Chinese equity markets remain pitiful as the spectre of Trump looms large. However, Chinese investors, in our view, seem to be more sanguine. Macroeconomic data in China point to signs of stabilization. If growth in the US accelerates as many economists expect, it’s hard to imagine that the Chinese economy will not benefit in spades. Unless, of course, President Trump launches a trade war, and that’s the fear of many, but a risk that nearly everybody has thought of and perhaps has already been over-discounted in stock prices. Chinese equities have experienced a prolonged period of underperformance, despite favorable earnings growth at many of our portfolio companies. Within our China portfolio, we primarily own niche-oriented companies whose success or failure is more predicated on growth of the Chinese middle class, product quality and successful execution rather than overall GDP growth and exports, and these days we are finding cheaper-than-normal valuations because many investors remain fearful of a trade war. It would not surprise us to see Chinese equities perform relatively well in 2017 because investor expectations are already so low. Our experience is that some of our best investment opportunities in China have followed periods of investor apathy, and that seems to be the case today.
In terms of current valuations, the average forward P/E ratio at the end of 2016 was 19.5 times for the Micro-Cap Fund (versus 19.1 last year), 23.1 times for the Emerging Growth Fund (versus 29.6), 19.7 times for the Small-Cap Opportunities Fund (versus 19.6), 16.1 times for the International Opportunities Fund (versus 18.6), and 17.5 times for the China Opportunities Fund (versus 14.2). Remember, each of the Funds invests in companies with expected earnings growth rates substantially higher than that of the broader market and sector mix will affect each Fund’s average P/E. As of 12/31/16, the weighted-average market capitalization was $766 million for Micro-Cap, $3.75 billion for Emerging Growth, $2.12 billion for Small-Cap Opportunities, $3.75 billion for International Opportunities, and $14.30 billion for China Opportunities.
We appreciate your investment in The Oberweis Funds and are grateful for the trust you have shown us with your valuable investments. If you have any questions about your account, please contact shareholder services at (800) 245-7311. Thank you for investing with us in The Oberweis Funds.
MANAGEMENT DISCUSSION ON FUND PERFORMANCE
Global equities returned 7.51% in 2016, as measured by the MSCI World Index. U.S. equities, as measured by the 11.96% return on the S&P 500 Index, outperformed foreign equities in 2016. Within the United States, small-cap growth stocks outperformed large-cap growth stocks by 424 basis points in 2016, as measured by the respective returns of the Russell 1000 Growth (+7.08%) and Russell 2000 Growth (+11.32%) indices. Within domestic small-cap, value stocks significantly outperformed growth stocks, with the Russell 2000 Value Index (+31.74%) outperforming the Russell 2000 Growth Index by 2,042 basis points for the year.
DISCUSSION OF THE OBERWEIS FUNDS
The Oberweis Funds tend to have a style bias that leads to stronger performance in periods in which small-cap stocks beat large-cap stocks and when growth stocks beat value stocks. Small-cap stocks outperformed large-cap stocks, but the far more dominant factor was the exceptionally strong underperformance of growth stocks relative to value stocks in 2016, which hurt performance of the Funds in 2016.
The International Opportunities Fund returned -5.28% versus 0.86% for the MSCI World ex-US Small Cap Growth Index. The portfolio benefitted from stock selection in the United Kingdom, offset by adverse stock selection in Japan and Canada. On a sector level, the portfolio benefitted from stock selection in Financials, partially offset by adverse stock selection in Industrials, Materials, and Consumer Staples. At the stock level, Parex Resources (PXT CN), Sunny Optical Technology (2382 HK), and JD Sports Fashion (JD LN) were among the top contributors to performance; Swedish Orphan Biovitrum (SOBI SS), UNIZO (3258 JP), and Mitsui Chemicals (4183 JP) were among the top detractors. OBIOX Holdings
The Emerging Growth Fund returned -1.54% versus 11.59% for the MSCI AWCI Small-Cap Index. At the country level, stock selection was particularly favorable for the Fund’s holdings in the United Kingdom offset by adverse stock selection in the United States, Japan, and China. At the sector level, the Fund benefitted from strong stock selection in Healthcare offset by adverse stock selection in Industrials, Financials, and Information Technology. At the stock level, Momo (MOMO), Inphi (IPHI), and Gigamon (GIMO) were among the top contributors to performance; Infinera (INFN), Car (699 HK), and China Taiping Insurance (966 HK) were among the top detractors. OBEGX Holdings
The China Opportunities Fund returned -9.22% versus -12.78% for the MSCI Zhong Hua Small Cap Growth Index. The portfolio benefitted from favorable stock selection in Consumer Discretionary, Materials, and Information Technology, partially offset by adverse stock selection in Industrials and Healthcare. At the stock level, Momo (MOMO), Tal Education (TAL), and Tencent (700 HK) were among the top contributors; Sound Global (967 HK), 21Vianet (VNET), and China Biologic Products (CBPO) were among the top detractors. OBCHX Holdings
The Oberweis Micro-Cap Fund returned 24.60% versus 6.86% for the Russell Micro-Cap Growth Index. The portfolio benefitted from favorable stock selection in Healthcare and Technology. At the stock level, Central Garden & Pet (CENT), SkyWest (SKYW), and Inphi (INPH) were among the top contributors to performance. iRadimed (IRMD), Autobytel (ABTL), and YRC Worldwide (YRCW) were among the top detractors. OBMCX Holdings
The Small-Cap Opportunities Fund returned 7.38% versus 11.32% for the Russell 2000 Growth Index. The fund benefitted from stock selection in Healthcare and Energy, while stock selection in Technology and Consumer Discretionary detracted from performance. SkyWest (SKYW), Gigamon (GIMO), and Inphi (IPHI) were among the top contributors to performance; SPS Commerce (SPSC), Imperva (IMPV), and Cvent (CVT) were among the top detractors. OBSOX Holdings
The portfolio turnover rates were 102% for the Micro-Cap Fund, 126% for the Emerging Growth Fund, 150% for the Small-Cap Opportunities Fund, 125% for the China Opportunities Fund, and 139% for the International Opportunities Fund. The net expense ratios of the Funds were 1.64% for Micro-Cap, 1.59% for Emerging Growth, 2.00% for Small-Cap Opportunities, 1.95% for China Opportunities, and 1.60% for International Opportunities.
For current performance information, please visit www.oberweisfunds.com.
*Life of Fund returns are from commencement of operations on 01/07/87 for the Emerging Growth Fund, 01/01/96 for the Micro-Cap Fund, 09/15/96 for the Small-Cap Opportunities Fund, 10/01/05 for the China Opportunities Fund and 02/01/07 for the International Opportunities Fund.
** Expense ratio is the total net annualized fund operating expense ratio as of 12/31/16. The expense ratio gross of any fee waivers or expense reimbursement was 1.59%, 1.65%, 2.40%, 1.99% and 1.82% for the Emerging Growth, Micro-Cap, Small-Cap Opportunities, China Opportunities and International Opportunities Fund’s, respectively. Oberweis Asset Management, Inc., the Fund’s investment advisor, has contractually agreed to reimburse Fund expenses through April 30, 2017 to the extent necessary that Total Annual Fund Operating Expenses for OBEGX, OBMCX, OBSOX, OBCHX and OBIOX exceed 2.00%, 2.00%, 2.00%, 2.49% and 1.60% of average net assets, respectively.
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate, so that you may have gain or loss when shares are sold. Current performance may be higher or lower than quoted. Visit us online at oberweisfunds.com for most recent month-end performance. The Oberweis Funds invest in rapidly growing smaller and medium sized companies which may offer greater return potential. However, these investments often involve greater risks and volatility. Foreign investments involve greater risks than U.S investments, including political and economic risks and the risk of currency fluctuations. There is no guarantee that the funds can achieve their objectives. Holdings in the Funds are subject to change. Before investing, consider the fund’s investment objectives, risks, charges, and expenses. To obtain a copy of the prospectus or summary prospectus containing this and other information please visit our website at oberweisfunds.com or call 800-323-6166. Read it carefully before investing. The Oberweis Funds are distributed by Oberweis Securities, Inc. Member: FINRA & SIPC.
The MSCI Zhong Hua Small Cap Growth Index (Net) is a free float-adjusted, market capitalization weighted index that is designed to measure the performance of small cap stocks in the developed markets and emerging markets of China and Hong Kong excluding A share classes, with minimum dividends reinvested net of withholding tax. The MSCI World ex-US Small Cap Growth Index (Net) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of small cap growth developed markets excluding the US, with minimum dividends reinvested net of withholding tax. The MSCI ACWI Small Cap Index (Net) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of small cap developed and emerging markets with dividends reinvested net of withholding tax. The MSCI World Index (Net) is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.
The Russell 2000 Index measures the performance of approximately 2,000 companies with small-market capitalizations. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted earnings growth rates. The Russell Microcap Growth Index measures the performance of those Russell Micro Cap companies with higher price-to-book ratios and higher forecasted growth values. The performance data includes reinvested dividends. The Russell Microcap Index is represented by the smallest 1,000 securities in the small cap Russell 2000 Index plus the next 1,000 securities. Each index is an unmanaged group of stocks, whose performance does not reflect the deduction of fees, expenses or taxes. The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. Russell 2000 Value Index is a market capitalization-weighted index designed to measure the performance of the small-cap value segment of the U.S. equity market. It includes those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth rates. The S&P 500® Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.