Funds Report: The Mercator International Opportunity Fund Q2, 2022

Hervé van Caloen, CIO

Mercator International Opportunity Fund

Q2, 2022

The Mercator International Opportunity Fund

(Class I Shares: MOPPX & Class A Shares: MOOPX)

2nd Quarter 2022 Report

Performance Report
Fund / Index	Q2 2022	YTD	1 Year	3 Year Annualized	Since Inception Annualized
MOPPX (CL I) Inception Date: April 2, 2018	-29.07%	-44.98%	-47.66%	3.11%	1.51%
MOOPX (CL A) Inception Date: August 30, 2019	-29.10%	-44.99%	-47.71%	N/A	2.79%
MSCI EAFE INDEX	-14.51%	-19.57%	-17.77%	1.07%	-1.70%

Expense Ratio
Fund	Annual Fund Expense Ratio (net)	Annual Fund Expense Ratio (gross)
MOPPX (CL I) Inception Date: April 2, 2018	1.41%	2.17%
MOOPX (CL A) Inception Date: August 30, 2019	1.55%	2.52%

Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. The Fund’s current performance may be lower or higher than the performance data quoted. For up-to-date performance data please contact the Fund’s transfer agent at 1-800-869-1679.

The Fund’s adviser has contractually agreed to reduce its fees and to reimburse expenses, at least through April 30, 2023, to ensure that total annual Fund operating expenses after fee waiver and reimbursement (exclusive of any front-end or contingent deferred loads, 12b-1 fees, taxes, leverage interest, borrowing interest, brokerage commissions, expenses incurred in connection with any merger or reorganization, dividend expense on securities sold short, acquired (underlying) fund fees and expenses or extraordinary expenses such as litigation) will not exceed 1.40% and 1.55% of the average daily net assets attributable to the Institutional Class and Class A shares, respectively.

The Great Multiple Contraction

Belgian 3D printing software company Materialise (MTLS; 2.09%) was a darling stock of the “transformative technology” bubble. Its stock price shot up from the low teens to near $80. It then crashed in sympathy with the COVID-19 tech selloff. Yet this volatility notwithstanding, nothing in the company’s business model or business expectations ever changed. If anything, the 3D printing industry has been gaining momentum. More and more applications in the aerospace, automotive and medical industries are driving a slow revolution in the additive manufacturing industry.

The Mercator Fund bought Materialise several years ago because of its GARP (Growth At a Reasonable Price) characteristics. It was indeed trading at a reasonable multiple of revenues before it shot up during the tech craze. We expected a steady yearly return in line with the company’s mid-teen growth rate. Instead, we saw our investment multiply in a very short period of time. That did not make sense and we exited the position near its all-time high.

The subsequent correction in MTLS was even more dramatic than its rally. The stock fell more than 70% in the blink of an eye. Just like that, the company was again valued reasonably. We started getting back in at around $20. By the end of last quarter, MTLS was trading back at $13 and at only 3 times revenues, down from 17 times. We added to the position as the stock got even cheaper.

This is just one of many examples of the volatility investors have had to navigate. MTLS was among the stocks that clearly reached excessive valuations. A correction from such a level is understandable. However, we did not expect every growth stock to be washed away in sympathy with technology stocks, fundamentals and valuations be damned. A great many GARP stocks with low PEG (Price Earnings to Growth) ratios similarly became victims of the sudden loss of appetite for anything associated with growth.

The Most Anticipated Recession In Recent Times

In early June, we traveled to Stockholm and met with a number of Scandinavian companies. The message we got from most of them was that business conditions are still quite favorable. They told us that demand is still strong and profit margins remain healthy. Yes, cost inflation is a reality, but, ironically, so much talk in the media about inflation makes customers more accepting of price increases. And, so far, higher prices have not yet depressed final demand. This is why many CEOs and CFOs are puzzled by the market moves. As in the case of Materialise, companies’ valuations melted like snow in the sunshine even as operations remain robust. In this Scandinavian companies are not unique.

Take for example British digital media company Future Plc (OTCPK:FRNWF) (FUTR:LN; 3.07%), one of the fund’s largest holdings. FUTR’s stock price is down more than 50% this year despite better-than-expected earnings growth of 51% in the second quarter and firm full year guidance of 40%. This successful growth company now trades at less than 10 times earnings, in line with an Italian utility company. It seems fear has crushed valuations to irrational lows as heedlessly as hubris inflated many tech stocks’ multiples to crazy highs only a year ago. At these levels, one should not be surprised to see some private equity firms sniffing around.

Another example of this buyers’ strike is Taiwan Semiconductor Manufacturing Company (TSM; 1.81%), down 40% from its high and trading at less than 15 times forward earnings. When TSM announced better-than-expected earnings growth of 67% in the second quarter with no slowdown in sight, the stock barely gained a few percentage points. No matter how good the news, buyers are not showing up. Yet.

The Great Disconnect: Macro Forces vs Company Fundamentals

Markets have been selling off for the last nine months in anticipation of a 1970’s style stagflation, if not outright depression à la 1930’s. The news is full of negative headlines, about the war in Ukraine, a mortgage crisis in China, rising energy prices, central banks raising interest rates amidst runaway sovereign debt, and more. There is an undeniable global malaise.

Never in my 35 years on Wall Street have I seen such disconnect between the top-down view of the world and the bottom-up information we gather talking to companies’ executives. Today’s macro forces and geopolitical tensions do not inspire confidence. Caution is understandable. But business is telling us a completely different story, one of, well, business as usual. Which is right?

Maybe the constant talk of a coming recession will end up generating one. But, so what? Economic cycles are the norm, not the exception. They help clean the economy. The good companies get stronger and the weaker adjust or disappear. The prospect of a recession should not mean companies are worth half what they were worth before. A slowdown for a quarter or two does not necessarily mean that growth companies were overvalued relative to their long-term prospects. After all, most of the time recessions tend to be followed by recoveries.

The End of Money Printing…

Of all recent macro events, the one that caused the biggest shock in the markets was the beginning of monetary policy normalization. The change in direction was long overdue and widely anticipated, but it still managed to rattle investors. The era of cheap money is coming to an end. The transition to a more realistic cost of money has started but will take some time. For the real interest rate on ten-year treasuries to turn positive, up from today’s minus 6 percent, inflation has to come down a lot. Or else treasuries have to drop a lot more.

Greenspan’s Great Moderation and Bernanke’s Wealth Effect were meant to abolish economic downturns. Every bump on the road was magnified and then remedied by even lower interest rates and more quantitative easing. As a result, for the last four decades, downturns were infrequent as well as short and brutal. The dual mandate–keep both inflation and unemployment low–was interpreted to mean that every downturn needed a monetary response, at least as long as inflation remained contained.

The Fed has continued monetary stimulus for forty years, a very long time. Most investors have never before experienced a “normal” business cycle. Not that such experience necessarily makes one much wiser. But perhaps today’s market overreaction to the possibility of a recession, even if a mild one, can be understood in this context. It is normal, after all, to fear the unknown.

… Leads to Fiscal Responsibility

Low cost of capital in recent years gave politicians a new opportunity to spend, spend, spend. As public debt ballooned, Larry Summers and Jason Furman argued in a November 2020 paper * that it was time to “…reconsider traditional views about the dangers of debt and deficits.” They advised policy makers to take advantage of “the fact that both the present value of GDP has risen and debt service costs have fallen as interest rates have fallen” to increase public spending. Go on, spend more! That’s the kind of advice a politician does not need to hear twice.

Almost nobody, on the left or the right, is talking about public deficits anymore. But what will happen when this debt has to be refinanced at a much higher rate? Like Japan and Europe before us, the US will have no choice but to impose fiscal discipline for decades in order to return the cost of our public debt to a manageable level. The years of fiscal folly are over. A tighter monetary policy will force more responsible fiscal policies as well. This all means the end of asset inflation.

The End of Asset Inflation

A more normal monetary policy is likely to generate more normal economic cycles. Stock price volatility should abate. The investment environment may be quite different from that of the liquidity-driven boom/bust years when timing market sentiment seemed more important than long-term investments in the best companies.

If a rising tide lifts all boats, the reverse is true as well. The market sell-off has taken most growth stocks’ valuations down. Markets have momentarily stopped differentiating between good companies and less solid businesses. This will not last. The combination of earnings growth and multiple contraction is rapidly making the best growth stocks very attractive even for value investors. We are experiencing something reminiscent of the aftermath of the dot.com bubble when Amazon (AMZN) sold off in sympathy with pets.com. The latter went bankrupt while Amazon became a once-in-a-lifetime investment opportunity.

Currency Headwinds

The Mercator Fund’s NAV has been hurt by the strength of the dollar. The yen is down 30% over the last 18 months and both the euro and the pound sterling have lost 15% vs the dollar in the last 12 months. We don’t think such outperformance of the greenback is sustainable over the long term. A stabilization of the major currencies is likely now that most central banks are following the Federal Reserve Bank’s interest rate hikes. At the same time, we must note that currency movements are notoriously difficult to predict. We cannot forecast when or to what extent a reversion might be.

With that in mind, during last quarter we started to build positions in companies that benefit from weaker currencies. In Japan, we bought shares of Subaru (OTCPK:FUJHY) and Olympus (OTCPK:OCPNY), companies with costs mostly in yen and revenues largely in dollars. The market for Subaru cars is predominately in North America while Olympus’s endoscopy technology is sold all over the world. For both companies, a weak yen has the doubly beneficial effect of boosting revenues and expanding profit margins.

The Invasion of Ukraine

It is easy for investors to get carried away by headlines and macro events. International investors in particular spend a lot of time and energy worrying about geopolitical and macro-economic trends. This is often a distraction from businesses’ fundamentals. The global demand for endoscopy is not much affected by Christine Lagarde’s views on interest rates. That being said, a tectonic event like the first post-WWII military conflict in Europe does have repercussions an investor needs to pay attention to.

A global shortage has been created by the Western countries’ decision to boycott fertilizers from Russia and its puppet state Belarus. These two countries account for 40% of the global production of potash. The boycott, combined with China’s ban on potash exports has led to price increases that are here to stay.

Ukraine has been the bread basket of Europe for years. The invasion of Ukraine by Russia is creating food shortages that may have unthinkable consequences. Because there is no end in sight to the conflict, prices are likely to remain very high for both fertilizers and agricultural products. That’s why the Mercator Fund has invested in Nutrien (NTR; 2.60%), the Canadian fertilizer, and in Cresud Sociedad Anonima (CRESY; 1.88%), the large Argentinian agriculture conglomerate.

Conclusion

International growth investors have had to deal with strong headwinds over the last year. Growth stocks have been out of favor, sometimes even trashed. The best performing stocks in the index, defense companies and oil producers, are the kind of securities Mercator typically will not invest in because of their limited appeal in the long run. They had a nice bounce due to geopolitical factors, but timing market rotations from one sector to another based on macro-events is at best a guessing game which we do not participate in.

Finally, we don’t attempt to time the market. Instead, we seek investment returns from picking the best companies with secular growth which will outperform because of superior fundamentals. As Charlie Munger puts it: “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns, If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”