Fundamental Value (FV) had an exceptional 2016 (inception 6/6/16 through year-end), returning 16.85% before fees averaged across clients vs a 7.48% return in the S&P 500. The majority of FV’s return came in the fourth quarter, as it gained 10.1% vs a 3.9% return in the benchmark.

This was clearly a time period when our brand of bottom-up value investing clicked, as we were able to best a rising market and did not incur material losses on any of the 15 stocks we owned at various points throughout the year. Our investments also beat the largest “value” ETFs, such as the Vanguard S&P Value ETF (+10.37%) and the iShares Russell 3000 Value ETF (+11.48%), despite the fact that those funds themselves outperformed the broader market.

Though we hope and expect FV will continue to outperform the S&P 500, we suspect that returns of this magnitude (~30% annualized) are unlikely in the near-term as US equity valuations today are very high. The chart below, using data from Bloomberg, shows that current valuations are higher today than any time in the past, excepting the late stages of the tech bubble. This indicates that future returns for US stocks are likely to be lower than previous returns.

In a period of potentially lower US equity returns, risk mitigation becomes paramount. There are two primary ways Bireme mitigates risk for clients. The first is through outperformance. We have managed to outperform thus far by demanding a deep knowledge of the companies we invest in, by avoiding the most overpriced segments of the market, and by our willingness to take a contrarian view. Following this process, we believe we can achieve satisfactory long term returns in the Fundamental Value strategy even in the event of lower overall US stock market returns.

Bireme’s second risk mitigation tool is dynamic allocation. By moving client funds from asset classes that have done well in the past to those that are poised to do well in the future, dynamic allocation can greatly enhance client returns. Today, that means underweighting US equities, and overweighting more attractive asset classes like international equities and alternative assets. In the Account section below, you can see your current strategy allocations relative to your unique allocation bands.

In Fundamental Value, we made three significant trades in the fourth quarter: selling Qualcomm, selling Viacom, and purchasing Time Warner.

Qualcomm was a big winner in the third quarter, appreciating 30%. Besides the change in price, another factor significantly changed our estimate of the prospective returns to Qualcomm investors: the announcement of the massive acquisition of automotive semiconductor specialist NXP. In our last quarterly letter, we noted that we were “in the process of evaluating what effect such an acquisition would have on our investment in Qualcomm.” We decided that the deal would dilute returns to QCOM investors and that it was time to take our profits and move on.

Unfortunately, it was not a positive price move, but poor business results that drove our divestment of Viacom, a media conglomerate that owns Nickelodeon, MTV, and Paramount Pictures. Although Viacom’s cable revenues have been declining for a few quarters, we had expected an eventual stabilization. Instead, the decline accelerated noticeably in the second and third quarters of this year. This fact, combined with our skepticism about the likelihood of a rumored deal with CBS, caused us to throw in the towel. Luckily, a rising market and our cheap purchase price of <8x earnings allowed us to exit the stock without incurring significant losses.

These two disposals were replaced in part by a new long position in Time Warner (TWX), the target of a merger deal with telecom giant AT&T. We purchased shares of TWX at about $88, a significant discount to the $106 AT&T was willing to pay, implying a ~20% annualized return if the deal closes next year. In an interesting twist, then-candidate Trump came out in opposition to the deal when it was announced in late October, likely contributing to the size of the spread. Trump even called out CNN (owned by TWX) by name, saying that the deal would “concentrate too much power in the hands of too few,” implying his administration would attempt to block the deal on antitrust grounds. However, we are confident that a Department of Justice led by Jeff Sessions, who publicly opposed Microsoft’s antitrust prosecution, will act similarly to previous Republican-led DoJs, sparing all but the most egregious mergers from antitrust enforcement. We also doubt Trump would oppose the transfer of CNN from a NY Democrat (TWX CEO Jeff Bewkes) to an Oklahoma-born Republican (AT&T CEO Randall Stephenson). Finally, we think that Time Warner’s assets have significant standalone value, providing some downside protection in the event that the deal does not go through and creating an  attractive risk/reward ratio.

We would also like to highlight one of our most successful investments of 2016: Samsung Electronics Preferred Shares. Despite its large size, Samsung trades at a valuation that indicates it is badly misunderstood. As both the largest manufacturer of memory chips AND one of the largest manufacturers of cell phones, it has a unique place in the electronics industry. In mobile phones, it is the only company with the quality and brand recognition to consistently compete with Apple at the high end of the North American and European cell phone market. But more importantly, Samsung’s massive scale in semiconductor manufacturing (40-50% share in both NAND and DRAM chips) means that it can remain profitable even through downturns in the industry.  The last two years in particular have borne this out, as Samsung’s memory division has maintained operating margins above 20% while its competitors have seen their margins crash.

Samsung’s shares deserve an earnings multiple consistent with its dominant industry position. But even after meaningful appreciation in 2016, Samsung’s common shares trade at 13 times earnings, a sharp discount from the roughly 20x PE of our benchmark, the S&P 500 Index. The preferred shares are even cheaper than the common, trading at a 20% discount despite equal economic ownership. Samsung Electronics Preferred Shares continue to be one of Bireme’s largest investments. If you are interested in learning more about why an investment in Samsung Electronics is so compelling, we encourage you to read Elliott Management’s detailed presentation on the company.

On the dynamic allocation front, results have been mixed. Clients benefitted from an overallocation to QMN, which gained 10.86% during the fourth quarter. They also benefitted from a tilt away from QII, which continues to struggle during a period of extremely low volatility. However, we’ve been underallocated to US equities through FV, and overallocated to international equities through GRV. That didn’t work out this quarter as FV (+10.1%) significantly outperformed GRV (+.35%).

We viewed international equities as more attractive than US equities before the quarter started, and we have gained conviction in that view as the relative outperformance of the US market in the quarter forced US valuations to even loftier heights. We are confident in our prediction that non-US equities are poised to outperform US equities, but caution clients that this is only true in the long term. We believe the outperformance potential of dynamic allocation is significant, but randomness rules in any particular quarter. Investors and managers need patience and discipline to reap these long-term rewards. We intend to have clients for life, and this enables us to implement long-term wealth maximization techniques like dynamic allocation.

We are grateful for your business and your trust, and a special thank you to those that have referred friends and family. There is no greater compliment.

Below you'll see a chart of the performance of your investments (in red) compared to a relevant benchmark (in gray). Benchmarks are investable assets chosen because they are most comparable to a given strategy.

Many wealth managers don't like to discuss returns, especially in comparison to benchmarks. That's because they are salesmen, not investors. They don't want to disclose their track records because their track records would prove that. These quarterly performance updates are one way in which we're bringing radical transparency to wealth management. 

We're happy to provide more details and answer any questions. We sincerely thank you for your time and your trust.

- Bireme Capital