OBERWEIS INTERNATIONAL OPPORTUNITIES
INSTITUTIONAL FUND (OBIIX)
January 26, 2017
Thank you for your investment in the Oberweis International Opportunities Institutional Fund (OBIIX). This fund, which is managed by Ralf Scherschmidt and team, seeks to invest in small and mid-cap companies primarily outside of the United States which are experiencing positive fundamental changes not yet fully reflected in market prices.
THE YEAR IN REVIEW
Much of 2016 revolved around its ending. The surprising victory by Donald Trump in the US Presidential election set off an unexpected rally in global equity markets to end the year, led by the US. In the last two months of 2016, the S&P 500 Index returned 5.7% while the MSCI World Ex-US Index returned 1.7%. Furthermore, from the date of the election through year-end, the US dollar rose over 4% as Trump-led economic optimism fueled investor confidence that an environment conducive to pro-business policy and tax reform would stimulate growth and cause US interest rates to rise at a faster-than-anticipated pace. Non-US equity investors faced a double headwind. The marginal preference amid global investors for US equities increased, while – at the same time – appreciation of the US dollar relative to other currencies reduced the value of foreign assets in US-dollar terms. After the election, the British Pound, Euro and Canadian dollar all depreciated. The Japanese Yen, which had appreciated approximately 17% during the first ten months of 2016, reversed course after the election and proceeded to depreciate nearly 17%. While a difficult period for international funds, it is worth noting that the premium valuation afforded to US equities implies that a lot of good news appears to have already been discounted. From here, any misstep by Mr. Trump may well dampen global investors’ love affair with US equities.
For the year, the Oberweis International Opportunities Institutional Fund returned -5.43% versus 0.86% for the MSCI World ex-US Small Cap Growth Index in 2016. In the fourth quarter, the Fund returned -7.85% versus -5.34% for the benchmark. While we are not pleased with the short-term performance, we have seen such periods in the past and find it relatively straightforward to understand when one considers the style factors that have driven recent equity returns for our universe. Consistent with our philosophy and history, our process is focused on companies undergoing misunderstood positive fundamental changes, which are often evidenced by positive earnings surprises and earnings revisions. Most of the time, such characteristics are rewarded by the market. In 2016, however, the market preferred companies with characteristics such as low absolute price-to-book multiples much more than companies with positive earnings revisions.
In 2016, companies with positive earnings revisions, which are the main focus of our time-tested investment philosophy, underperformed as a group. According to Empirical Research Partners, companies in the bottom quintile of earnings revisions (across all market caps within the developed world ex-US spectrum) outperformed those in the top quintile of earnings revisions by approximately 700bps for the year. This trend was even more pronounced in the second half of 2016, with the bottom quintile of earnings revisions outperforming the top quintile of earnings revisions by about 900bps.
While one would intuitively expect companies who earn more than expected – and experience positive earnings revisions as a result – to outperform companies who merely meet or even fall short of expectations, this is not always the case in the short-term, because valuations, interest rates and economic cyclicality also play a role. This was the case in 2016, as many economically-sensitive companies which had underperformed in 2015 rebounded in 2016. Even without significant actual positive changes in their fundamentals, expectations changed and such companies rallied with optimism that better economic times are on their way.
While no one knows what the future will bring, style cycles often mean-revert over time. After periods in which our fund has faced style headwinds, we have often seen above-average opportunities, as relative valuations tend to be better following periods of underperformance. We believe this to be the case today as well. Many of our portfolio companies experienced positive earnings revisions in 2016 and 2017 estimates, but did not experience corresponding stock price appreciation. On the flipside, more value-oriented equities did experience multiple expansions and are thus relatively more expensive than a year ago. In absolute terms, our fund’s weighted-average P/E declined by over 25% year-on-year.
As we enter 2017, the outlook for international equities remains mixed but the macroeconomic situation appears better than last year. In the Eurozone, inflation has started to show signs of improvement, with the highest Eurozone CPI reading in the last three years during December. PMI’s across the European region have remained above 50 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 massive potential for an improvement in European earnings which does not seem currently priced into European shares which are trading in-line with long term averages. On the flip side, upcoming French, Dutch and German elections are likely to continue to add volatility especially if the rise of populism continues.
In Japan, we feel slightly better that less dramatic monetary actions from the Bank of Japan (BoJ), combined with higher US interest rates, should prevent the Yen from being as volatile as it was in 2016. Recent Japanese economic data also appears to be slightly improving, with the Japanese December PMI reaching the highest level in a year and fiscal spending appears likely to drive moderate growth in 2017. Valuations in Japan appear the most interesting among the major developed markets, trading at a slight P/E discount to long term averages.
With the US and China also showing broadly better than expected economic data over the last few months of 2016, the Citigroup Global Economic Surprise Index reached its highest level over the last four years. Given a slightly more positive economic global backdrop, the Bank of America/Merrill Lynch global earnings revision ratio reached the highest level in six years, led by Europe and Japan. The better global backdrop both on a macro and micro level should position our “relative to expectations” strategy favorably as we head into 2017.
Lastly, the core downside risk in 2017 revolves around the evolution of free trade, or lack thereof, given the recent election of protectionist leaders in both the US and Europe. We have already seen the Chinese Yuan and Mexican Peso depreciate dramatically, somewhat compensating for tighter future trading situations with the US. It remains yet to be seen what direction trade takes in the U.K. given trade deals will change post Brexit officially being evoked. On the positive side, it appears that future upside to growth could be created by fiscal stimulus plans around the world.
At quarter-end, the portfolio was invested in 92 stocks in 17 countries. Our top five country weightings (portfolio weighting versus the MSCI World ex-US Small Cap Growth Index) at the end of the quarter were Japan (28.5% vs. 28.2%), the United Kingdom (15.3% vs. 15.2%), Canada (10.5% vs. 9.6%), France (8.5% vs. 4.2%), and Australia (7.2% vs. 6.0%). On a sector basis, the portfolio is overweight information technology (19.2% vs. 14.8%) and underweight real estate (2.2% vs. 5.4%).
Some of the top performers for the quarter included: Takeuchi Manufacturing Co. Ltd. (6432 JP), which returned +34.3% and contributed 33 basis points to the portfolio’s return; STMicroelectronics (STM FP), which returned +31.1% and contributed 28 bps; and JD Sports Fashion Plc. (JD/ LN), which returned +2.5% and contributed 23 bps. Some of the leading detractors for the quarter included: Kyudenko Corp. (SOBI SS), which returned -26.3% and detracted 41 bps; Megmilk Snow Brand Co. Ltd. (2270 JP), which returned -24.1% and detracted 40 bps; and IG Group Holdings Plc. (IGG LN), which returned -45.5% and detracted 30 bps.
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.
James W. Oberweis, CFA Ralf Scherschmidt
President Portfolio Manager
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.
Amid international growth equities, returns for small-cap and large-cap stocks were comparable. Small-cap edged out large-cap by 24 bps in 2016, as measured by the respective returns of the MSCI World Ex US Small Cap Growth (+0.86%) and the MSCI World Ex US Large Cap Growth (+0.62%) indices. Within international small-cap, value stocks significantly outperformed growth stocks, with the MSCI World Ex US Small Cap Value Index (+7.87%) outperforming the MSCI World Ex US Small Cap Growth Index by 701 basis points for the year.
DISCUSSION OF THE INTERNATIONAL OPPORTUNITIES INSTITUTIONAL FUND
The International Opportunities Institutional Fund tends to have a style bias that leads to stronger performance in periods during which small-cap stocks beat large-cap stocks and when growth stocks beat value stocks. The Fund was adversely impacted by value stocks outperforming growth stocks. Additionally, companies experiencing positive analyst earnings revisions underperformed.
The International Opportunities Institutional Fund returned -5.43% versus 0.86% for the MSCI World Ex US Small Cap Growth Index. The portfolio benefitted from stock selection in the U.K. and Italy, offset by adverse stock selection in Japan and Canada. On a sector level, the portfolio benefitted from stock selection in Financials and Information Technology, offset by adverse stock selection in Industrials and Materials. At the stock level, Parex Resources Inc. (PXT CN), Sunny Optical Technology Group Co. Ltd. (2382 HK), and JD Sports Fashion Plc. (JD/ LN) were among the top contributors to performance; Swedish Orphan Biovitrum AB (SOBI SS), Unizo Holdings Co. Ltd (3258 JP), and Mitsui Chemicals Inc. (4183 JP) were among the top contractors. OBIIX Holdings
For current performance information, please visit www.oberweisfunds.com.
*Life of Fund returns are from commencement of operations on 03/10/14 for the 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 1.18% the Fund. 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 OBIIX exceed 1.10% 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 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. MSCI World Index (Net) is a free float-adjusted market capitalization index that is designed to measure developed-market equity performance throughout the world. The MSCI World ex USA Small Cap Value Index is based on a traditional market cap weighted parent index, the MSCI World ex USA Small Cap Index, which includes small cap stocks across 22 Developed Markets (DM) countries (excluding the US). The MSCI World ex USA Large Cap Growth Index captures large-cap securities exhibiting overall growth style characteristics across 22 Developed Markets (DM) countries and 23 Emerging Markets (EM) countries. The MSCI World ex USA Small Cap Value Index reweights each security of the parent index to emphasize stocks with lower valuations. Index weights are determined using fundamental accounting data—sales, book value, earnings and cash earnings—rather than market prices. 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.