Litman Gregory Masters Equity Fund First Quarter 2018 Attribution

During the first quarter of 2018, the Litman Gregory Masters Equity Fund gained 1.26%, outperforming its Russell 3000 Index benchmark (which fell 0.64%) and the Morningstar Large Blend Category (down 0.98%).i Since its December 1996 inception, the fund’s 8.39% annualized return is in line with the Russell 3000 Index’s gain of 8.32% and ahead of the Morningstar category’s 6.82% return.

Performance 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. Current performance of the funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.mastersfunds.com.

Themes, Trends, and Observations from the Managers*

Pat English and Andy Ramer, FMI
The multiyear market tranquility was interrupted in the March quarter. While many popular stocks continued to outpace the market (Netflix and Amazon were up 54% and 24%, respectively), several came under significant pressure (Tesla and Facebook were off 15% and 9%, respectively). Investors may be in the beginning phase of a momentum shift away from the FAANGs, perceived high growth and concept stocks. Still, it is too early to make this call as the “buy-the-dip” mentality will likely not die easily. Valuations remain near record high levels and that frames our continued cautious stance. We have and will continue to avoid the high tech and social media spaces. We still haven’t seen enough value develop in other sectors to become more aggressive.

Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices became more volatile last quarter as concerns about a trade war, the possibility of higher than expected inflation, and rising interest rates made investors fearful. These fears in turn pushed global equity markets lower by the end of the quarter after a strongly positive January. Despite a higher level of fear among investors, we believe the outlook for underlying company fundamentals remains on a positive track and should lead to positive equity returns over the medium to long term.

It was a quiet period for activity in our portfolio. We trimmed some positions on price strength and tax-traded certain positions where we believed it was appropriate to capture tax losses. There were no new positions initiated in the quarter.

Scott Moore, Nuance Investments
In our opinion, the opportunity set remains narrow as we enter the second quarter of 2018. In today’s valuation environment, we believe the equal-weighted Nuance Master Group (a group of around 250 leading businesses tracked by the team) is overvalued by approximately 20% and has downside (think recessionary period) of approximately 60%. As we have been clear about since last summer, our internal market set of opportunities is not exactly attractive on an absolute basis. With this backdrop, we want to create a portfolio that we believe has risk-rewards that are significantly better than the Nuance Master Group. In the health care sector, we continue to own leaders such as Abbott Laboratories and Smith & Nephew, and we added Cerner, a leading provider of electronic medical records software to hospitals, to the portfolio during the quarter. While our exposure in the financial sector is slightly below the benchmark, we continue to see opportunities within the sector. An above-average catastrophe loss year created an opportunity in what we view as select high-quality financial institutions like Travelers Companies and Everest RE Group. We exited our positions in Hub Group, Rockwell Collins, and Praxair as those names approached our internal view of fair value, and we are now underweight to the industrial sector. We continue to see opportunities in select global leaders like Diageo, Proctor & Gamble, and Kimberly-Clark, and we believe these companies, with their top-tier balance sheets and competitive positions, have better downside support than the market. We have an underweight position in the energy sector as we believe that crude oil–related companies are likely facing a multiyear period of competitive transition. We continue to be underweight in the utility, information technology, real estate, and consumer discretionary sectors due to valuation concerns.

Chris Davis and Danton Goei, Davis Advisors
In the first quarter of 2018, the U.S. stock market declined 0.76%, concluding a volatile period. The portfolio trailed the index during the period. Our investments in Amazon.com and Markel were particularly accretive to performance in the first quarter, while Wells Fargo was a detractor.

We see reasons to be optimistic about many businesses today, but not all companies in the U.S. stock market represent equally good value given current valuation levels. We believe selective stock picking is the best way to navigate the current environment and is a perennial approach to investing over full market cycles.

Frank Sands, Jr. and Michael Sramek, Sands Capital
We view secular trends, innovation, and company-specific competitive advantages as key to driving growth through a variety of economic environments. We believe the majority of businesses in the Select Growth strategy benefit from one or more secular trends, including e-commerce, the union of health care and technology, software-as-a-service (SaaS) and cloud adoption, and data-driven decision-making.

Secular trends are distinct from short-term economic factors as they tend to persist through market cycles and can provide powerful structural tailwinds that enhance the sustainability of a business’s growth for many years. We believe our long-term investment horizon allows us to capture the benefit of these characteristics and realize the ultimate earnings power of a company, while weathering volatility over shorter periods. Furthermore, our approach—active, concentrated, and benchmark-agnostic—enables us to have outsized exposure to companies within this sphere that are the best fits with our six investment criteria. (As a reminder, these investment criteria are: sustainable above-average growth, leadership in a promising business space, significant competitive advantage, clear mission and value-added focus, financial strength, and rational valuation and terms.)

Dick Weiss, Wells Capital Management
The first quarter of the year started on a strong note in January with a continuation of many trends equity markets witnessed throughout 2017, including robust economic data, low unemployment, and strong sentiment. As the quarter progressed, several technical and geopolitical factors led to an increase in volatility over the final two months of the quarter. First, several large funds had to unwind long equity positions that were paired with short volatility positions. Second, the U.S./China trade talk and follow-through (albeit on a small scale as of now) left investors wondering if synchronized global growth may stall and what ripple effects this may have on the markets. Nonetheless, we did not change our bottom-up fundamental process over this period of geopolitical and macro concerns as the portfolio performed very well in the first quarter. Of particular note, strong fundamentals at the company level came to the fore as several companies reported strong quarterly results during the quarter while negative performance contributors were limited in both number and scale. Additionally, the avoidance of exposure in the “bond-proxy” sectors (real estate, utilities, telecom, and consumer staples) proved to be prudent as these areas tended to underperform the broader market as interest rates crept higher. 

* The opinions herein are those of the sub-advisors at the time the comments are made and are subject to change.

Discussion of Performance Drivers

It is important to understand that the portfolio is built stock by stock with sector and cash weightings being residuals of the bottom-up, fundamental stock-picking process employed by each of the seven sub-advisors. That said, we do report on the relative performance contributions of both sector weights and stock selection to help shareholders understand drivers of recent performance.

Our sub-advisors invest with a time horizon much longer than three months. It is also important to remember that the performance of a stock over a single quarter tells us nothing about whether it will be a successful position for the fund; that is only known at the point when the stock is sold.

Litman Gregory Masters Equity Fund Sector Attribution

Equity Fund Attribution Chart

  • Of the 11 sectors comprising the Russell 3000 Index, just two—consumer discretionary and information technology—saw positive returns during the first quarter.
  • The fund’s outperformance in the quarter was driven primarily by sector allocation, as the portfolio’s underweight allocation to most of the declining sectors proved beneficial.
  • The fund’s meaningful average overweight (18.1% vs. 12.8%) to the consumer discretionary sector benefited relative performance in the period and was bolstered by strong stock selection within this sector. Amazon.com (up 23.76% and owned by the teams at Sands and Davis), Netflix (up 53.86% and owned by the Sands team), and Fiat Chrysler Automobiles (up 15.02% and owned by Bill Nygren of Harris Associates) were three standout positions during the quarter. Netflix and Fiat Chrysler are discussed in greater detail below.
  • Another sector with strong stock selection was information technology. Zendesk, owned by Dick Weiss, was up 41.46% in the quarter. Weiss discusses this position below. Allocation to this sector also contributed to relative performance, though modestly, as the fund had an average overweight (26.3% vs. 23.6%) to this sector.
  • Stock selection was weakest within the industrials, health care, and financials sectors, hampering relative performance. Within industrials, Arconic (owned by Clyde McGregor of Harris Associates) fell 15.28% in the quarter. Within health care, Cerner (owned by Scott Moore as well as the team at FMI) fell 13.93%. And within financials, Wells Fargo (owned by Davis) fell 13.10%. Each of these names is discussed in greater detail below.
  • The fund’s cash position declined relative to the previous quarter, averaging around 8.9%. The allocation to cash had negligible effect from a relative performance standpoint.

 

Top 10 Contributors as of the Quarter Ended March 31, 2018

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Amazon.com Inc. 3.82 2.02 23.76 0.82 Consumer Discretionary
Netflix Inc. 1.13 0.40 53.86 0.46 Consumer Discretionary
Zendesk Inc. 0.79 0.01 41.46 0.28 Information Technology
ServiceNow Inc. 1.01 0.09 26.89 0.24 Information Technology
CSRA Inc. 0.31 0.02 36.07 0.23 Information Technology
Fiat Chrysler Automobiles NV 1.10 0.00 15.02 0.22 Consumer Discretionary
Workday Inc. Class A 0.87 0.06 24.94 0.19 Information Technology
Mastercard Inc. A 1.12 0.57 15.91 0.16 Information Technology
Salesforce.com Inc. 1.25 0.28 13.76 0.16 Information Technology
Visa Inc Class A 3.09 0.79 5.09 0.15 Information Technology

Portfolio contribution for a holding represents the product of the average portfolio weight and the total return earned by the holding during the period. Past performance is no guarantee of future results. Fund holdings and/or sector allocations are subject to change at any time and are not recommendations to buy or sell any security.

Edited Commentary from the Respective Managers on Contributors

Netflix (Frank Sands, Jr. and Mike Sramek, Sands Capital)

Netflix is the leading online video streaming subscription service in the United States (based on subscribers) with a strong and growing international presence. We believe Netflix has a compelling value proposition, as it offers a wide variety of on-demand, ad-free programming at a low monthly cost. Our research indicates on-demand viewing is becoming a preferred way to access entertainment, and we believe Netflix is well positioned to benefit from this trend. Ultimately, we expect on-demand video streaming services will reach 90% penetration of broadband homes worldwide over the next five to 10 years, providing a powerful secular tailwind. While we expect Netflix to substantially increase its U.S. subscriber base, we believe its international expansion opportunity will be the primary driver of long-term growth. We estimate international subscribers will more than triple as Netflix enters new geographies and global broadband usage continues to grow. We believe the company’s scale creates buying power that gives it important leverage when negotiating with content providers. Scale should also enable Netflix to fund further development of proprietary television shows and movies, helping to distinguish it from the competition. We expect significant subscriber growth internationally combined with the increased profitability of the U.S. business will enable Netflix to achieve above-average earnings growth over the next five years.

Our Netflix investment thesis remained unchanged over the past three months. Given the strength of the business and expected above-average earnings growth, we believe Netflix’s valuation is fair.

Shares of Netflix advanced after the company reported strong fourth quarter results and guidance. Subscriber growth was significantly ahead of consensus expectations, despite the company increasing its prices, and average engagement grew 9%. Additionally, management expects 300 basis points of margin expansion, and first quarter streaming revenue growth of 43%, the fastest pace in five years. More importantly, we see the network effect continuing to strengthen, as content investments drive rapid subscriber growth globally, which then fuels the company’s ability to increase investments in content. We believe this virtuous cycle is set to continue over the long term. We estimate the company will cumulatively invest more than $50 billion in content over the next five years. Over the long term, we believe Netflix could become a must-have entertainment utility for many of the world’s broadband households.

Zendesk (Dick Weiss, Wells Capital Management)

Zendesk, a software-as-a-service (SaaS) company, rose over 40%. Zendesk reported fourth quarter results in January (a beat and raise) and trends throughout the first quarter 2018 showed positive developments in general, particularly in enterprise selling situations with larger installs, higher ASPs (average sales prices), and strong cross sells of additional product offerings. These results were critical issues over the last year when management replaced senior executive leadership in sales and began the process of growing its enterprise effort. All in, these trend changes provided support to the company’s 2020 goal of achieving $1 billion in sales and accelerated its breakthrough to profitability for the first time in the fourth quarter of 2017 and the expectation that 2018 will show a full-year profit for the first time.

Fiat Chrysler Automobiles (Bill Nygren, Harris Associates)

  • We believe Fiat Chrysler is well positioned to improve its profitability and narrow the margin gap with its peers.
  • We are impressed with the company’s management team, which is led by CEO Sergio Marchionne who has an impressive 20-year track record of creating wealth for shareholders.
  • Fiat Chrysler is aggressively shifting its mix from low-margin, mass market brands (Chrysler, Dodge, Fiat) to higher-margin specialty segments (Jeep, Alfa Romeo, Ram, Maserati), a strategy that has brought more focus to the brands and allowed the group to consistently gain market share.

Fiat Chrysler’s share price soared early in the quarter as December auto sales bested market expectations. We were pleased with the company’s fourth quarter earnings report, which showed that adjusted earnings, adjusted profit, and net industrial debt figures were slightly better than guidance for full-year 2017. Later in the first quarter, the U.S. Justice Department extended an offer to Fiat to recall 104,000 vehicles and pay a civil penalty to settle its emissions lawsuit. While Fiat Chrysler Automobiles’ current product portfolio skews toward larger, less fuel-efficient vehicles (in North America), the company is compliant and expects to remain so with increasingly stringent global emissions requirements. New product launches are expected to demonstrate significant fuel-efficiency improvements. Our investment thesis in Fiat remains intact. 

 

Top 10 Detractors as of the Quarter Ended March 31, 2018

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Wells Fargo & Co. 1.87 0.94 -13.10 -0.26 Financials
Arconic Inc. 1.45 0.04 -15.28 -0.23 Industrials
Encana Corp. 0.97 0.00 -17.37 -0.20 Energy
Cerner Corp. 1.13 0.07 -13.93 -0.19 Health Care
Oshkosh Corp. 1.14 0.02 -14.75 -0.16 Industrials
General Motors Co. 1.45 0.19 -10.45 -0.16 Consumer Discretionary
Nutrien Ltd. 0.97 0.00 -12.93 -0.15 Materials
Chesapeake Energy Corp. 0.53 0.01 -23.74 -0.14 Energy
Facebook Inc. A 1.33 1.50 -9.45 -0.13 Information Technology
Capital One Financial Corp. 2.79 0.17 -3.36 -0.12 Financials

Portfolio contribution for a holding represents the product of the average portfolio weight and the total return earned by the holding during the period. Past performance is no guarantee of future results. Fund holdings and/or sector allocations are subject to change at any time and are not recommendations to buy or sell any security.

Edited Commentary from the Respective Managers on Detractors

Wells Fargo (Chris Davis and Danton Goei, Davis Advisors)

Among our current contrarian investments is Wells Fargo, which we consider attractively valued given its strong position across North America in banking, insurance, investments, mortgages, and consumer and commercial finance services. With a current valuation of roughly 12x earnings, we believe the company remains attractively priced even taking into account the negative impact of the recent controversy surrounding the bank’s temporary regulatory constraints on its growth. During the quarter, Wells Fargo was a detractor to portfolio results, declining 13% in the period.

Arconic (Clyde McGregor, Harris Associates)

  • Arconic’s three primary operating divisions (Engineered Products & Solutions, Global Rolled Products, and Transportation & Construction Solutions) possess unique strengths that we think work in the company’s favor for robust long-term revenue growth; we expect Arconic’s operating margins to expand materially, as reductions in corporate overhead, sourcing, and plant optimization are met with increases in capacity utilization.
  • Its Engineered Products & Solutions division operates in a highly technical market with strong barriers to entry given the stringent certification process, high switching costs, and product quality/engineering demands.
  • Arconic’s recently-developed Micromill technology is capable of producing aero and automotive parts that are twice as formable and at least 30% lighter than competing high-strength steel.
  • We believe the secular trend in both the commercial aerospace and automotive industries toward utilizing more lightweight components will benefit Arconic’s current business as well as provide considerable market share gains going forward.

Despite issuing very good fourth quarter results by our measure, Arconic’s share price declined following the release. The company’s revenue increased 10% (up 6% organic), adjusted earnings rose 24%, and earnings per share of $0.31 handily beat market forecasts by nearly 30%. For the full year, organic sales grew 5%, adjusted earnings rose 9%, and margins also expanded. Management’s full-year 2018 earnings-per-share guidance range of $1.45–$1.55 fell short of market forecasts of $1.61, which may have concerned investors. Even so, the company authorized a new $500 million share repurchase program and the early reduction of $500 million worth of debt, both of which we view quite positively. Later in the quarter, Arconic’s share price was pressured further by the potential of U.S.-imposed tariffs on aluminum, which could raise input costs. While there remains much uncertainty about this tariff, we believe management is focused on strengthening Arconic’s fundamentals for the benefit of shareholders.

Cerner (Scott Moore, Nuance Investments)

Cerner is a leading provider of electronic medical records software to hospitals. They have gained market share consistently over the last decade and, in our opinion, are positioned to continue doing so with 20%–30% of the market still operating on an outdated platform. They also have a solid balance sheet with a net cash position. Recently, a large pending deal with the Department of Veterans Affairs was called into question by the firing of VA Secretary Shulkin. We believe Cerner is still the vendor of choice as they are the software provider to the Department of Defense and interoperability between departments is critical to the VA project. The stock sold off on investor concerns over whether the deal would be completed and when it would launch. We believe this is a transitory event and an over-reaction to short-term news. We continue to hold Cerner.  

Cerner (Pat English and Andy Ramer, FMI)

Cerner is a leading provider of health care information technology. We view this as an attractive area for long-term investment due to the high degree of recurring revenue and strong margins.

Cerner declined approximately 14% in the first quarter of 2018, which underperformed the S&P 500’s approximate 1% decline. As 2017 came to a close, Cerner was thought to be the frontrunner to win the large Department of Veterans Affairs (VA) Health IT contract that’s set to be awarded later this year. This belief had propelled the stock during the final months of 2017. However, recent leadership changes at the VA have made this outcome less certain, and Cerner’s share price has responded accordingly. We believe it’s possible that Cerner ends up winning the VA Health IT contract, but the timing around when this deal is announced is now more uncertain. Regardless, we believe that Cerner will continue to grow at an attractive rate over the long term—with or without the VA contract—and that the stock trades at a reasonable valuation given the combination of these growth prospects and the high-quality nature of the business. The stock is still trading at a higher level than we paid and what we wish to pay at this time. We are comfortable with our position.