OBERWEIS INTERNATIONAL OPPORTUNITIES INSTITUTIONAL FUND (OBIIX)
January 28, 2020
Thank you for your investment in the Oberweis International Opportunities Institutional Fund (OBIIX). This Fund is managed by a team led by Ralf Scherschmidt and 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
What a difference a year can make! In last year’s letter, following a significant decline in 4Q2018 for international small-cap growth stocks, we noted that valuations for our asset class were among the cheapest of the past decade. As it turns out, fear and great buying opportunities are often neighbors. 2019 delivered an excellent year for international small-cap growth equities. The MSCI World Ex USA Small-Cap Growth Index returned 28.04%.
Much of 2019’s gain stems from macro worries that turned out to be not as bad as expected. Top among them were trade wars, slowing economic growth and rising interest rates. On January 15th, 2020, the U.S. and China signed the much-anticipated “Phase One” trade treaty. To be sure, US-China trade negotiations have a long way to go, but this step marks a sharp directional change from the escalatory feuds that preceded it. On economic growth, recession prognosticators were either wrong or early. US growth has remained on track while tepid growth outside the U.S. has nonetheless exceeded expectations. In terms of monetary policy trends, the US Federal Reserve reversed course in 2019, cutting interest rates three times in 2019. The US yield curve has steepened since the inversion fears of early 2019. Instead of rising, interest rates declined in 2019, with the yield on the 10-year US Treasury bond falling 77 basis points in 2019 to 1.92%. And as these developments unfolded, investors turned bullish on equities, with equities in most geographies and asset classes posting exceptional gains. Globally, growth stocks beat value stocks, but large-caps beat small-caps.
The International Opportunities Institutional Fund returned 23.50% in 2019. In 2018 and 2019, our investment style faced significant headwinds, which we believe to be attributable to current investor preferences. In this period, investors preferred highly predictable near-term earnings over favorable long-term earnings opportunities. For example, in Japan, which was our highest detracting country to performance, Japanese companies within our universe, which performed the best, were companies with the highest Return on Equity (ROE) levels. Companies within that same universe, which experienced positive earnings revisions (i.e. the types of companies we will own within this fund), posted a negative return for the year. As a reminder, we seek to own companies that are attractively valued because their future earnings power is substantially underestimated and not companies which are well loved because of their known, strong margins, efficiency and returns. Over the long term, there is a tradeoff between near-term earnings visibility and long term earnings potential, but we believe the past two years have rendered the price for favorable long-term earnings growth much less than normal (at least in relation to companies with more certain near-term earnings). Similar to other periods of underperformance in the past, we believe that 2018-2019 is likely to set the stage for a mean reversion to a more normal balance. In our opinion, this shift in investor preference stems, in part, from uneasiness of ‘peak cycle’ earnings. That is, investors fear that present margins cannot be sustained, given the extended nature of the margin improvement and earnings recovery since the 2008/2009 global financial crisis. As a result, investors fearful of the ‘peak cycle’ in earnings have piled into companies with relatively known near-term earnings, even if companies with potentially higher-than-expected earnings in out-years offer more potential upside. The longer and stronger such preferences persist, the cheaper the longer-term but “less certain” growth opportunities become.
While we expect margins to fluctuate with the economic cycle, we also do not believe there is a structural change that would derail longer-term productivity increases and efficiency improvements. In the recent past, margins rose from the cost restructuring associated with the financial crisis, the robotization of the factory floor, and the benefits of outsourcing due to globalization. Today, many people are starting to become attuned to the productivity benefits of the cloud. Beyond that, we are confident that many other new technologies will drive growth and productivity in the coming decade and the remainder of the century. Similar to other out-of-favor moments in the past, we believe that seeking out companies with significant underestimated earnings is especially productive when they are unpopular with others. In our experience, out-of-favor periods for our style have very often been precursors for future periods of significant alpha, though obviously no one can predict the future.
Our strategy focuses exclusively on companies with the potential to earn significantly more than what the market expects over the coming years. While such a philosophy has been slightly out of favor in the recent past, we attribute the move to natural ebbs and flows rather than anything structural. In fact, in our opinion, the low investor sentiment explains the shortening of the duration of equities, which leads investor to overvalue current year earnings and undervalue life-time earnings of a company.
We are constructive on the long-term outlook of international equities, as they continue to be very attractive on both an earnings valuation as well as a free cash flow yield basis. Furthermore, investor sentiment still appears to us to be low, which we believe to leave room for upside surprise.
Despite strong gains in absolute terms, the team is excited about our current portfolio and, while no one can predict the future, believes the balance of opportunities to be above-average for the present portfolio:
1. During the fourth quarter the team found an above average number of new names which historically has acted as a precursor for future performance. It was quite simply one of the best earnings seasons for finding new ideas in some time. New ideas were diversified from both a country and sector perspective and that reflects the broad low investor expectations
2. Developed World ex-USA small cap valuations continue to be trading below their 30 year long term average
3. Developed World ex-USA equity flows were negative in 2019 (the herd was on average exiting international equities)
4. As measured by Empirical Research Partners, investor sentiment remains decidedly low. This is an excellent starting point for us as it relates to the recent headwinds stemming from the shortening of the duration of equities:
• As long as investor sentiment simply stays where it is, the headwind is removed
• If investor sentiment bounces from these low levels, and equity durations return to more normal levels, we would see a meaningful tailwind for our style
In regards to 2020, we will be watching how the recent tension in the Middle East manifests itself in the energy markets. We will watch if recent inflation data in places like Germany, which showed acceleration, is transitory or if inflation is finally creeping back into the equation. Of course, we will be watching the developments of the trade war and tariffs situation. As a reminder, we remain underweight so called bond proxies which have seen dramatic increase in valuations over the past five years as investors have searched for alternatives to ultra-low bond yields.
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 President Ralf Scherschmidt Portfolio Manager
MANAGEMENT DISCUSSION ON FUND PERFORMANCE
Global equities returned 27.67% in 2019, as measured by the MSCI World Index. Global small-caps, as measured by the MSCI World Small-Cap Index, returned 26.19%. U.S. small-caps outperformed International small-caps, as evidenced by the 25.41% return on the MSCI World ex-USA Small-Cap Index vs. 28.43% for the Russell 2000 index. Non-US small cap growth companies outperformed Non-US small-cap value companies by 522bps. The MSCI World ex-USA Small-Cap Growth Index return 28.04% versus 22.82% for the MSCI World ex-USA Small-Cap Value Index.
DISCUSSION OF THE INTERNATIONAL OPPORTUNITIES INSTITUTIONAL FUND
The International Opportunities Institutional Fund returned 23.50% versus 28.04% for the MSCI World ex-USA Small Cap Growth Index. The portfolio was negatively impacted from adverse stock selection in Japan, the U.K., Germany, and the Netherlands offset by positive stock selection in Australia, Sweden, Canada and China. On a sector level, the portfolio benefitted from positive stock selection in Consumer Discretionary, Consumer Staples and Industrials, while being negatively impacted by negative stock selection in Health Care, Financials and Materials. At the stock level, Afterpay Ltd. (APT AU), Evolution Gaming Group AB (EVO SS), and Intermediate Capital Group Plc. (ICP LN) were among the top contributors to performance; Burford Capital Ltd (7172 JP), GW Pharmaceuticals Plc. (GWPH US), and Nearmap Ltd. (NEA AU) were among the top detractors.
At year-end, the fund was invested in 83 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 (23.2% vs. 27.5%), the United Kingdom (22.6% vs. 15.7%), Canada (16.4% vs. 8.5%), Australia (11.5% vs. 6.6%), and Sweden (5.3% vs. 7.3%). On a sector basis, the fund is overweight financials (13.7% vs. 4.9%) and underweight health care (1.9% vs. 10.3%). 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
** December 31, 2019 unaudited data. Expense ratio is the total net annualized fund operating expense ratio. The expense ratio gross of expense offset arrangements and expense reimbursements were 1.12%. Oberweis Asset Management, Inc. (OAM), the Fund’s investment advisor is contractually obligated through April 30, 2020 to reduce its management fees or reimburse OBIIX to the extent that total ordinary operating expenses exceed in any one year 1.10% expressed as a percentage of each Fund’s average daily net assets.
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