Dear Investors,
The Frigate Folio took flight on July 1st in inclement weather and as economic malaise and geopolitical tensions intimidated many international investors. I warily eyed the deceleration of growth in China and other emerging markets, Europe's halting climb out of a lengthy recession and the U.S. debt ceiling stand-off. Global markets undulated through the summer and in the fall Middle East tensions culminated in a chemical attack against Syrian citizens on August 21st that activists claimed killed 1,000 people. Eventually, Russia's assistance in brokering a deal to put Syria's chemical stockpiles under international control de-escalated the potential for a U.S. - Syrian showdown, and finally, in October, Congress passed a bill to temporarily finance the government and lift the debt ceiling. It was a wild ride, but international markets in aggregate ended higher at the end of the October than they started in July.
The Frigate Folio also managed to rise above the noise and between July 1st and October 31st rose 12.3% net of all fees. Frigate was a good diversifier for U.S. investors, as the S&P 500 rose 10.1% over the same time, but our portfolio did slightly lag the S&P ADR Index - a comparable international equity benchmark which rose 14.2% over the same period. I believe about half of that lag was due to launching Frigate at the high point of the U.S. market on July 1st, as well as our cash position, which was 2.4% of the portfolio at the end of the period. When putting money to work in Frigate, the impact of intraday fluctuations can be mitigated by investing more gradually in volatile markets. Cash will always be a drag in a strong market, but I strive to keep this low. We would also prefer to compare our returns in Frigate with a net return index, in which the impact of foreign withholding taxes on dividends are taken into consideration, but no such index is available for ADRs.
The Frigate Folio is built from the bottom-up but is well-diversified across sectors. Surprisingly, our holdings in more defensive sectors such as healthcare and consumer staples tended to underperform during this period. The exposure of questionable Chinese marketing policies and slower growth in emerging markets likely impacted investor sentiment and contributed to rotation out of these sectors. Teva Pharmaceutical, one of the world's largest generic drug manufacturers, was a particular laggard, suffering due to concerns over competition surrounding its proprietary multiple sclerosis drug Copaxone and the surprise resignation of president and CEO Jeremy Levin. Mr. Levin's tenure was less than 18 months, and management dynamics will be a development to monitor. Although it continues to fight against infringement on Copaxone's patents, Teva has invested its prodigious cashflow in other ventures to offset its decline, including the acquisition of global biopharma company Cephalon, and a joint venture with Johnson & Johnson. I expect these businesses will offset the potential erosion of Copaxone and that deployment of Teva's free cash flow into new businesses or acquisitions will put earnings once again on an attractive path of growth. In the meantime, Teva trades at a forward P/E of approximately 8x, significantly below the industry average.
Japanese stocks were a bit of a drag on the portfolio during the quarter, with Komatsu becoming an indirect victim of the slow-down in emerging markets. The company reported a profit warning at the end of October. Komatsu makes large construction, mining and utility equipment, like excavators, harvesters and crushers as well as parts, as well as industrial machinery such as sheet-metal machines, stamping presses and machine tools. The company also provides the well-respected DANTOTSU solutions and products. Weaker commodity prices have led to lower demand for mining equipment of late, especially in Indonesia. Komatsu's machine tools and industrial machinery focused on the automobile manufacturing industry enjoyed stronger sales volumes in the period, but this wasn't enough to offset the other divisions. Komatsu management wrote in its first half report that Chinese demand is picking up, however, and a meeting I had with the management team of another mining service company during the quarter confirmed expectations of a rise in mining capital expenditures in the second half of next year. Should that be the case, earnings expectations should rise for the next fiscal year which ends in March 2015. In the meantime, Komatsu continues to bring new technology and products to the market. In April, the company unveiled the world's first machine control dozer with fully automatic blade control and a machine control hydraulic excavator as well. I have positive long-term expectations for such new products and the company's ability to innovate.
This change in mining expectations during the quarter also gave Frigate an opportunity to purchase Rio Tinto and BHP Billiton, Anglo/Australian mining companies whose share prices decreased earlier in the year due to lower commodity prices. In response, both companies reduced costs and fine-tuned their capital expenditures, thus freeing up cash flow, while still expanding iron-ore production. This should make us investors happy, even as we recognize that earnings will remain under pressure for the balance of this year. Assuming the industry doesn't embark on a capital expenditure arms race, these companies should benefit further when material prices start to improve.
Among the emerging market companies whose stocks performed well in Frigate this quarter were Indian companies Wipro and Infosys, two of the top four IT outsourcing companies in the world. Revenue growth had previously decelerated for both companies, since the economic crisis impacted IT spending, and an investigation into improper visa procedures exacerbated the negative outlook for outsourcing companies, creating a good entry point for Frigate. Eventually Infosys did settle the visa allegations and a mid-year earnings report revealed that growth for the outsourcing industry was relatively robust. Subsequently the share prices for both Wipro and Infosys rebounded respectably.
Although markets have stabilized since this summer, Frigate may still face headwinds. Eurozone economic growth could be slow and uneven, U.S. tapering might choke funding for emerging markets, and further Washington in-fighting could create uncertainty for global companies doing business in the U.S. - and for investors in those companies as well.
Nonetheless, many international markets are trading at P/E's less than the U.S. market and offer higher dividend yields. In addition, uncertainty and mediocre economic growth is not new. Frigate companies have survived and thrived through challenging conditions in the past. Valuations of our companies based on future estimated earnings look attractive, although my continuous review of our holdings could lead to substituting even more attractive companies in Frigate.
While I am updating my viewpoint on our current holdings and researching new ideas, I want to take this opportunity to thank you for investing along with me in the Frigate Folio. I will try hard to do my best for all of us. In the meantime, don't be afraid to reach out with questions and ideas - and have a great holiday season.
- Lauretta 'Retz' Reeves, CFA
[email protected]
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Lauretta's Notes: 
