OBERWEIS INTERNATIONAL OPPORTUNITIES INSTITUTIONAL FUND (OBIIX)
OBERWEIS FOCUSED INTERNATIONAL GROWTH FUND (OFIGX)
January 24, 2023
Dear Fellow Shareholder:
THE YEAR IN REVIEW
In 2022 global equity markets continued to be materially influenced by inflation developments in the US and the Federal Reserve’s response to them. Where the Fed has led, other central banks in the developed world have followed. With the exception of China, the key central banks across the world have pursued a synchronous tightening of monetary policy over the last twelve months. Consequently, the multiple compression we saw in 2021 for many of our investment holdings became even more pronounced in 2022, to such a degree that it outweighed generally strong underlying fundamentals and earnings growth within the portfolios. The Oberweis International Opportunities Institutional Fund returned -37.45% vs. -27.02% for the MSCI World Ex-USA Small Cap Growth Index. On a cumulative 3-year basis, the fund outperformed its benchmark by almost 700bps, with a positive return of +4.51% vs. a negative return of -2.38% for the benchmark. For the nine months from inception at the beginning of April to year-end, the Oberweis Focused International Growth Fund returned -22.75% vs -9.07% for the MSCI EAFE Index.
As we have written previously, we view quarterly and yearly results as “merely short-term data points along the road.” An evaluation of stock-picking skill is only statistically relevant over a long-term horizon. We seek to generate favorable absolute and relative returns over an entire market cycle rather than just quarterly or annual periods. As we have previously noted, even with effective application of our process, we do not expect to outperform in every period. Instead, we invest with an eye on long-term high alpha generation and try to avoid giving undue attention to short-term results, whether favorable or unfavorable. The strategies are not benchmark-hugging strategies and thus may, unsurprisingly, deviate from their benchmarks over the short-term, such as a couple of quarters or years. Only strategies that do not hug their benchmarks have the potential to deliver excellent long-term results that meaningfully beat their benchmarks over time. Short-term fluctuations are expected, and, in fact, our experience has shown that times of short-term underperformance tend to be the best times to add to strategies with high long-term alpha.
Towards the end of the year, inflation data started to respond to tighter monetary policy, looking less threatening with goods inflation coming down as supply chain constraints have eased. Furthermore, the shelter component of US CPI, which constitutes more than 40% of the core measure, should soon start to reflect the loosening of the rental market for residential real estate, thus exerting further downward pressure. The Core PCE index (the Fed’s favored inflation indicator) rose 3.6% in November on an annualized basis over the previous three months, the smallest rise in 3-month core PCE inflation since February 2021. On a year-over-year basis it rose +4.7% and month-on-month by +0.2%. If, hypothetically, it rose by a similar month-on-month amount in the next six months, core PCE inflation would be approximately +3.4% year-on-year in May.
However, the trip back to the Fed’s stated 2% target looks to be a difficult one, due in large part to services. They constitute almost a third of core CPI and this broad category was up by +7.25% on a year-over-year basis in November, driven by strong wage growth. With the job fill rate in these industries low, and almost a year of tighter monetary policy unable to meaningfully impact the labor market, the implication is that the quest to lower inflation to 2% is not going to be easy. The great majority of yield curve spreads have remained inverted, often considered to be a leading indicator of an economic slowdown, while the latest Philadelphia Federal Reserve survey of professional forecasters shows the probability of recession in the next year to be the highest in the 50+ years the survey has been conducted.
Also of importance, towards the end of the quarter, China formally relaxed many of the severe Covid-related restrictions it had placed upon its population, and is now enacting a policy that looks increasingly like the out-and-out pursuit of herd immunity. Such a dramatic U-turn is likely to have considerable implications. The lockdowns meant that retail sales in China were about US$400bn below trend this year, representing significant pent-up demand, so a reopening has the potential to be a stimulative event of material proportions as well as an inflationary tailwind.
OUTLOOK
After a year when global bonds and equities have seen their biggest ever loss in market value, and with more forecasters expecting a recession than at any point in recent history, pessimism is not hard to find amongst developed market investors. Evidently the Federal Reserve has a challenging task in front of it. The diminished rate sensitivity of the consumer has affected its ability to push the underlying inflation rate down to 2%. Without the tools to micromanage the economy, investors fear a policy misstep is growing in likelihood.
The central puzzle to solve remains the tight labor market in the US, which appears to be a structural biproduct of demographics and is also, to a greater or lesser degree, replicated across developed markets. Consensus estimates have consistently been too bearish on jobs with payrolls data in the US beating Bloomberg’s median estimate in 11 of the last 12 months. Some labor market indicators have weakened: layoffs are up from a low base, primarily at technology or mortgage-related companies, and the use of temporary workers appears to have peaked in September. However, job openings per unemployed person are still elevated at 1.7:1, and the most critical measure, initial unemployment claims, have not risen in a marked way. Until we see unmistakable signs of weakening, it seems unlikely that the Fed will drastically change course. Chairman Powell indicated as much in his December press conference, pointing to a restrictive policy stance “for some time”.
It seems clear that while the Fed (and by extension other global central banks) may slow the pace of its interest rate increases, it is unlikely to return to stimulative policies any time soon, barring a serious recession. Ten-year inflation expectations, as derived from capital markets and surveys, currently sit at around +2.2%, just below where they were in 2002-2008. The associated real ten-year yield is almost +1.5%, a bit below the average for this period. The retirement of the Baby Boomers and global budget deficits both argue for real rates to be similar to the pre-GFC period, which is to say higher than what we have seen over the past decade. In short, the idea that economies weaken, central banks pivot, and markets soar, to our mind is a less likely scenario when the disinflationary force of excess labor supply is no longer present.
While the above may read bearishly, this is not necessarily so. The drop in consumers’ rate sensitivity and the tight labor supply are arguably providing a roadmap to avoiding recession. The differential between wage gains and core inflation, which was -2% a year ago, over the last four months has been +4%. It seems likely that wage growth will continue to outstrip inflation in the coming months which, together with central banks slowing monetary tightening, would be a bullish combination for spending growth next year.
In a soft-landing scenario, current earnings forecasts for 2023 would likely be too low. And, perhaps most importantly, it does now appear that the outlook for inflation has improved with the easing of supply chain bottlenecks and residential rental market. Moreover, rarely has the consensus opinion been as negative on the economic outlook as it is today. Given the unprecedented path to the current point, we approach any confident macro forecasts with a great deal of humility and skepticism. The implications of this uncertainty for portfolio allocation are clear: remain diversified, tilt towards free cashflow generators, be careful of stretched balance sheets.
With respect to valuation, free cash flow yields for both small and large cap stocks in developed markets remain near historical highs, even after the strong fourth quarter. Further, expectations for forward returns are among the lowest they have ever been. Rarely ever has the consensus opinion been as pessimistic. Historically, attractive valuations and trough expectations have made an excellent set-up for forward-looking returns.
PORTFOLIO HIGHLIGHTS
At year end, the Oberweis International Opportunities Institutional Fund was invested in 62 stocks in 14 countries. Its top five country weightings (portfolio weighting versus the MSCI World Ex USA Small Cap Growth Index) at the end of the quarter were Canada (17.9% vs. 9.9%), Japan (15.9% vs. 28.6%), United Kingdom (15.5% vs. 13.4%), Australia (8.8% vs. 9.2%), and France (7.4% vs. 2.7%). On a sector basis, the fund was overweight industrials (38.4% vs. 23.6%) and underweight health care (1.0% vs. 11.2%).
Top contributors for the year include Hexatronic Group AB (HTRO SS), which returned 44.2% and contributed 99bps; D/S Norden A/S (DNORD DC), which returned 158.4% and contributed 72bps; and Aixtron SE (AIXA GY), which returned 43.3% and contributed 64bps. The largest detractors in 2022 include Future plc (FUTR LN), which returned -70.6% and contributed -228bps; Nordic Semiconductor ASA (NOD NO), which returned -50.7% and contributed -227bps; and Food & Life Companies Limited (3563 JP), which returned -57.3% and contributed -156bps.
At year end, the Oberweis Focused International Growth Fund was invested in 28 stocks in 10 countries. Its top five country weightings (portfolio weighting versus the MSCI EAFE Index) at the end of the year were United Kingdom (20.3% vs. 15.3%), Japan (18.5% vs. 21.9%), France (16.0% vs. 11.9%), Switzerland (13.6% vs. 10.1%), and Netherlands (10.2% vs. 4.3%). On a sector basis, the portfolio was overweight information technology (20.4% vs. 7.8%) and underweight communication services (0.0% vs. 4.5%).
Top contributors for the nine months from April 1 to December 31 include Novo Nordisk A/S (NOVOB DC), which returned 20.1% and contributed 72bps; BP P.L.C. (BP/ LN), which returned 18.9% and contributed 37bps; and Edenred (EDEN FP), which returned 6.2% and contributed 20bps. The largest detractors include Future plc (FUTR LN), which returned -53.8% and contributed -290bps; Datadog, Inc. (DDOG US), which returned -46.5% and contributed -236bps; and Adyen N.V. (ADYEN NA), which returned -30.6% and contributed -198bps.
We appreciate your investment in The Oberweis Funds and are grateful for the trust you have shown in us. 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.
Sincerely,
James W. Oberweis, CFA – President Ralf Scherschmidt – Portfolio Manager
MANAGEMENT DISCUSSION ON FUND PERFORMANCE
MARKET ENVIRONMENT
Developed markets ex-US equities returned -14.45% in 2022, as measured by the MSCI EAFE Index. Global small-caps ex-US, as measured by the MSCI World Ex-USA Small Cap Index, returned -20.59%, underperforming large-capitalization stocks. Value stocks in developed markets ex-US outperformed growth stocks in 2022. The MSCI EAFE Value Index returned -5.18%, outperforming the MSCI EAFE Growth Index by 1792 basis points for the year.
DISCUSSION OF THE OBERWEIS FUNDS
The Oberweis International Opportunities Institutional Fund underperformed its benchmark in 2022, returning -37.45% versus -27.02% for the MSCI World Ex-USA Small-Cap Growth Index. The portfolio benefited from stock selection in Germany and France while stock selection in Japan and United Kingdom detracted from performance. On a sector level, the portfolio benefited from stock selection in Industrials while performance was negatively impacted by stock selection in Consumer Discretionary. At the stock level, Hexatronic Group AB (HTRO SS), D/S Norden A/S (DNORD DC) and Aixtron SE (AIXA GY) were among the top contributors to performance. Future plc (FUTR LN), Nordic Semiconductor ASA (NOD NO) and Food & Life Companies Limited (3563 JP) were among the top detractors. OBIIX Holdings
The Oberweis Focused International Growth Fund underperformed its benchmark for the nine months from April 1 to December 31, returning -22.75% vs -9.07% for the MSCI EAFE Index. The portfolio benefited from stock selection in Denmark while stock selection in the United Kingdom and France detracted from performance. On a sector level, the portfolio benefited from stock selection in Energy while performance was negatively impacted by stock selection in Information Technology. At the stock level, Novo Nordisk A/S (NOVOB DC), BP P.L.C. (BP/ LN) and Edenred (EDEN FP) were among the top contributors to performance. Future plc (FUTR LN), Datadog, Inc. (DDOG US) and Adyen N.V. (ADYEN NA) were among the top detractors. OFIGX Holdings
For current performance information, please visit www.oberweisfunds.com.
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. Unusually high returns may not be sustainable. 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.
*Life of Fund returns are from commencement of operations on 03/10/14 for OBIIX and 04/01/22 for OFIGX
** December 31, 2022. Expense ratio is the total net annualized fund operating expense ratio. The expense ratio gross of expense offset arrangements and expense reimbursements were 1.14% for OBIIX and 1.97% for OFIGX. Oberweis Asset Management, Inc. (OAM), the Fund’s investment advisor is contractually obligated through April 30, 2023 to reduce its management fees or reimburse OBIIX and OFIGX to the extent that total ordinary operating expenses exceed in any one year 1.10% and 0.95% expressed as a percentage of each Fund’s average daily net assets, respectively.
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 EAFE Index is an equity index that captures large and mid-cap representation across 21 developed markets countries around the world, excluding the U.S. and Canada. The index is comprehensive, covering approximately 85% of the free-float-adjusted market capitalization in each country.
