Litman Gregory Masters Equity Fund Second Quarter 2017 Attribution

During the second quarter of 2017, the Litman Gregory Masters Equity Fund rose 3.09%, narrowly outperforming its Russell 3000 Index benchmark, which returned 3.02%, as well as the Morningstar Large Blend Category, which returned 2.89%. Since its 12/31/1996 inception through 6/30/2017, the fund’s 8.03% annualized return is roughly in line with the Russell 3000 Index and ahead of the Morningstar Category’s 6.59% return.i

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

Themes, Trends, and Observations from the Managers*

Pat English and Andy Ramer, FMI
The stock market remains very expensive on just about any conventional measure of value. Companies have resorted to extensive manipulation of earnings (“adjusted earnings”) to give the illusion that valuations are better than they actually are. Growth stocks and popular issues like the so-called FANG (Facebook, Amazon, Netflix, and Google) stocks continue to outperform value stocks and trade at very high valuations. Passive flows have exacerbated this trend. Energy and several other commodities have declined sharply, perhaps reflecting an expectation of slower demand. The portfolio remains steadfastly invested in quality issues with strong business franchises and attractive relative valuations. The industry groups that have been hit the worst in recent months, energy and retail, may give us an opportunity if high-quality (not commodity exploration and production stocks) energy stocks become cheap and/or retailers that do not face a head-on collision with Amazon become available at inexpensive valuations. 

Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices rose again last quarter on continued improvement in the global economic outlook. Though equity valuations aren’t as cheap as they once were, our fundamental outlook remains positive. Our confidence is based on the strength of our companies’ balance sheets, low interest rates, low inflationary pressures, still significant global monetary stimulation, and the potential for a more favorable business climate (lower taxes, less regulation) in the United States.

In the United States, we’ve been modestly re-positioning across existing holdings as well as finding certain new opportunities in the consumer discretionary and energy sectors. We continue to avoid many companies that the market views as “stable” (like those in the telecom, utility, and consumer staples sectors) due to business quality/valuation concerns. However, as always, we continue to view company opportunities on a case-by-case basis and believe any company can be attractive at the right price.

Scott Moore, Nuance Investments
During the second quarter, sector weights in the portfolio remained stable, but the opportunity set has narrowed. As of June 30, 2017, our Nuance stocks (our internally researched and approved group of 250 leading business franchises) as a group is now largely overvalued, and the stock prices of most of our list do not reflect the potential risks inherent in their market valuations. With the opportunity set narrowing, we have added arbitrage opportunities, which we believe have little downside risk (due to our belief that the odds of the deal getting done are very high) and modest upside potential, and as such, they have risk-rewards that are significantly better than the opportunity set today. We have added significant arbitrage positions in the consumer staples sector with Whole Foods Market as well as the health care sector with CR Bard. We remain overweight in the consumer staples sector as a slowdown in emerging-market economies and currency headwinds have impacted global leaders such as Diageo. We were also able to add to our position in Procter & Gamble within the consumer staples sector as we believe their top-tier balance sheet and competitive position give the company better downside than the market. Our health care sector weight, with the addition of CR Bard, is now in line with the benchmark and remains mostly unchanged as well. We continue to own leaders such as Abbott Laboratories and Smith & Nephew. Our underweight position in financials was unchanged as the possibility of lessened regulation has resulted in significant expectations of returns on capital and earnings expansion during the last several months. We continue to be underweight in the utilities, information technology, real estate, and consumer discretionary sectors due to valuation concerns.

Chris Davis and Danton Goei, Davis Advisors
In the first half of 2017, the U.S. stock market advanced with the S&P 500 Index returning 9.34%. The portfolio also delivered positive results but trailed the index in the period largely due to energy. Our investments in Amazon, in particular, along with Alphabet were accretive to performance in both the quarter and year-to-date periods.

The U.S. economy continues to expand with relatively full employment, prompting the Federal Reserve (the Fed) to raise short-term interest rates earlier this year. Still, both interest rates and inflation remain subdued. At the same time, many U.S. businesses have generated what we consider rather robust earnings growth in recent periods. Market valuations reflect this healthy backdrop on balance. Given this fact, we believe it is perhaps more critical than at any other point in the current business cycle for investors to select companies individually using true active management as businesses differ widely in their growth rates and valuations and, as a result, in their risk and return profiles. We continue to find value on a company-by-company basis and are focusing heavily on areas of the market where operating margins have room to improve and where meaningful inefficiencies persist such as financial services, energy, and industrial businesses. We have also made long-term investments in leading technology companies whose long-term growth is more durable than the market recognizes in our estimation.

Frank Sands, Jr. and Michael Sramek, Sands Capital
While we monitor trends and short-term market fluctuations, our focus continues to be on our businesses’ long-term opportunities. We maintain a five-year investment outlook, resulting in low portfolio turnover even when markets are volatile. We continuously look to strengthen our portfolio by investing in businesses generating above-average growth that we believe are powered by strong secular drivers and/or promising business spaces.

While we monitor macroeconomic events, we believe the uncertainty inherent in macro-driven factors reinforces the benefits of thoroughly understanding individual companies and the secular trends from which they may benefit. Regardless of the macro environment, the foundation of our investment process will always remain our bottom-up analysis of business fundamentals. Because the only certainty in financial markets might be the constant of change, we expect that selectively owning the right businesses will be the main driver of our ability to add value for clients with prudence over time.

Dick Weiss, Wells Capital Management
Overall, U.S. equity markets held their gains for the quarter despite the Federal Reserve raising interest rates during the final month of the quarter. The Fed announced a quarter-point rate hike (mostly expected by Wall Street) with the new range of 1.00% to 1.25%. Additionally, more detail was provided by the Fed on how it will unwind its $4.5 trillion balance sheet, while expectations for inflation over the next 12 months “is expected to remain somewhat below 2% in the near term” but stabilize. While many point to higher interest rates as a potential burden for economic growth as lending standards become more stringent and borrowing costs rise, the economy continues to show resiliency with improving home prices, higher consumption, and stable employment. At a macro level, these factors are important, but we continue to be cognizant of company fundamentals as the main driver for equity returns. To that tune, more and more companies we speak with have been ramping up capital spending as they see increasing growth opportunities. For the past several years, companies deployed capital back to shareholders in the form of dividend increases and/or share buybacks. Now, as we hear more companies discuss increasing capital expenditures, this could be an additional driver for economic growth and company growth, which would help companies to expand their incremental margins and flow returns to the bottom line or invest further in their underlying operations.

For the portfolio, we continue to use our Private Market Value process when sourcing new investment ideas. We are seeing pockets of opportunity in the materials sector and other sub-sectors of the market. We have been overweight to the energy sector, which has impacted relative performance from an allocation standpoint. However, we feel oil is bottoming out here, and should we see a rebound, we believe the portfolio is well positioned to outperform versus the index.

* 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 processes 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.

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

  • Stock selection was a positive contributor to relative performance during the quarter, while sector allocation slightly detracted.
  • The fund’s nearly 8% overweight to information technology resulted in a positive sector-allocation effect as the sector outperformed the broad market. In addition, the fund’s holdings in this sector gained 8.29%, easily outperforming the technology holdings in the benchmark. Out-of-benchmark name Alibaba Group Holding, owned by Sands, was up about 30% during the quarter and was the largest individual contributor to fund performance. Oracle, owned by Clyde McGregor and Bill Nygren, gained almost 13%. Both positions are among those discussed in greater detail below.
  • The consumer staples and telecommunications sectors were also mildly additive to relative performance in the quarter. Consumer staples benefited primarily from stock selection as Henkel (owned by FMI) and Unilever (owned by Scott Moore and sold during the quarter) returned 10.07% and 15.61% in the portfolio, respectively. The fund benefited from having no exposure to telecommunications, which fell 6.56% during the period.
  • Energy was the worst-performing benchmark sector for the quarter, falling 7.67%. Stock selection within energy was generally weak; energy holdings in the fund fell over 17%. Encana, owned by Davis, was the primary detractor to fund performance from an individual name standpoint. It fell over 24% in the period and is discussed below.
  • Stock selection within consumer discretionary was negligible overall, despite the strong return of While this stock, owned by Sands and Davis, gained over 9% in the period and was a leading individual contributor to the portfolio’s relative performance, other stocks in the sector performed poorly. Chico’s FAS (owned by Dick Weiss) and Twenty-First Century Fox (owned by FMI) fell 33.07% and 16.30%, respectively. Each of these positions is discussed below.
  • The portfolio carried an average cash position of 7% in the quarter. This was a slight drag on the fund’s performance since the benchmark rose during the quarter.


Top 10 Contributors as of the Quarter Ended June 30, 2017

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Alibaba Group Holding 1.33 0.00 30.67 0.36 Information Technology
Oracle Corp. 2.56 0.54 12.88 0.33 Information Technology
Alphabet Inc. A 3.50 1.10 9.66 0.31 Information Technology Inc. 3.26 1.49 9.19 0.28 Consumer Discretionary
Regeneron Pharmaceuticals Inc. 1.15 0.14 26.74 0.28 Health Care
Bank of New York Mellon Corp 2.45 0.20 8.46 0.21 Financials
Alphabet Inc. C 2.22 1.09 9.54 0.20 Information Technology
Visa Inc. Class A 3.52 0.71 5.71 0.20 Information Technology
QVC Group Class A 0.88 0.04 22.58 0.18 Consumer Discretionary
Itron Inc. 1.49 0.01 11.61 0.17 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

Alibaba Group Holding (Frank Sands, Jr. and Mike Sramek, Sands Capital)

Alibaba is the world’s largest e-commerce company. It operates primarily in China and accounts for over 80% of the country’s online market for physical goods. As the main driver of China’s economy shifts from infrastructure investment to consumption, we expect e-commerce will be one of the industries that benefits most. We believe Alibaba will retain its leadership position and be the primary beneficiary of this shift. The company has cultivated a broad ecosystem and has strong network effects. Global brands partner with Alibaba because of its large market share, third-party-only storefront model, and low fixed take rate. As a result, we believe the company can sustainably offer better prices and a broader selection of authentic merchandise than its competitors. Competition is further inhibited because Alibaba has trained customers to begin searches for products directly on its websites, as opposed to a search engine. We think Alibaba is positioned in front of a large and growing opportunity and believe it can generate above-average annualized revenue growth over the next five years.

During the quarter, Alibaba’s share price rose as it continued to execute well and exceed investors’ expectations. In the most recently reported quarter, total revenue growth accelerated to 60% year over year, with all major business lines (China e-commerce retail, international retail, cloud computing, digital entertainment, and maps) beating our top-line expectations. Advertising remains the critical driver of long-term growth and profitability, and thus far, gross merchandise volume (GMV) and ad targeting improvements have been the largest growth contributors. The company has additional tools at its disposal—including ad load, cost per click, and new ad formats—to spur further ad revenue growth if necessary. Beyond advertising, Alibaba’s e-commerce business remains healthy, delivering six consecutive quarters of year-over-year GMV growth in the low 20%-range. Longer term, we believe other areas, such as cloud and international retail, extend Alibaba’s growth runway. Cloud revenue grew over 100% year over year and the company now has nearly a million paying customers. Lazada and AliExpress contributed to international retail revenue growth in excess of 300%, and in those two assets, Alibaba now has the leading e-commerce business in Southeast Asia and one of the largest cross-border businesses in the world, respectively. We believe Alibaba still has large monetization potential in its core e-commerce business, and ad-based monetization will provide years of profitable growth. We expect annualized earnings growth in excess of 40% over our investment horizon.

Alibaba’s price-to-earnings multiple rose from 25 to 30 this year, but growth is accelerating, competitive and governance fears are fading, and the multiple only just recovered to the level it was two years ago.

Oracle (Clyde McGregor/Bill Nygren, Harris Associates)

  • Oracle’s management team has shifted its focus to developing the cloud-based computing business and has prioritized the engineering work and sales force realignments required to drive the transition as quickly as possible; the company took further action to grow cloud revenues with its acquisition of NetSuite in July of 2016.
  • As Oracle expands its cloud business, we believe the company can grow its share of wallet with existing customers and also target new addressable markets with smaller customers that had not been able to afford its solutions in the past.
  • We like that high switching costs reduce customer turnover for Oracle, and we think the transition of sales to the cloud-based model will pay off for long-term investors.
  • By our standards, Oracle’s management team has historically demonstrated operational skill, good strategic thinking, and value creation, which should help the company maintain a strong balance sheet with excellent cash flow generation.

Oracle delivered positive fiscal fourth quarter earnings results in June. The report was highlighted by (1) continued cloud software as a service/platform as a service (SaaS/PaaS) growth (up 69% in constant currency including NetSuite); (2) a significant moderation in the rate of decline in new software licenses; (3) steady growth in maintenance revenues (up 3%), indicating the stability of the installed base; and (4) non-GAAP operating margin improvement that was nearly 200 basis points ahead of consensus, reflecting increased cloud gross margins and well-controlled expenses. We also liked that Oracle announced a new financial reporting structure that provides greater insight into how the underlying businesses are performing. Furthermore, management issued guidance for its fiscal first quarter in excess of market expectations, adding to our confidence in this investment. (Frank Sands, Jr. and Mike Sramek, Sands Capital)

Amazon is one of the largest Internet-based retailers in the United States and a growing global leader in the computing infrastructure-as-a-service (IaaS) space. We believe each business is positioned to participate in a long-duration growth opportunity. As a retailer, Amazon is a customer-centric company where people can find nearly anything they want to buy online. We expect e-commerce growth to continue to outpace overall retail spending for the foreseeable future and believe Amazon should be a primary beneficiary of this global secular trend. The company’s IaaS offering, Amazon Web Services (AWS), provides organizations with on-demand access to computing, storage, and other services through its cloud platform. Over the coming decades, we expect AWS will be a key player in the paradigm shift toward shared infrastructure services. Amazon’s recently enhanced level of financial disclosures provides increased transparency that helps strengthen our conviction in the overall health and growth prospects of Amazon’s retail business and significantly raises our expectations for the long-term potential of AWS. As a result, we view Amazon’s two core franchises as attractive and rapidly growing businesses that each meet our investment criteria. We anticipate robust top-line growth, scale-based expense leverage, and higher-margin sales mix to drive above-average revenue and earnings growth over the next five years.

During the quarter, Amazon reported results that exceeded consensus expectations, with retail sales growth of 21% and Amazon Web Services growth of 43% over the same quarter in the prior year. However, we believe the steady rise in Amazon’s share price year to date is underpinned by substantial improvements in investors’ perception of the company’s growth prospects. The company is further solidifying its position as the leader of retail and maintains a deep competitive moat with AWS.

While Amazon’s valuation may appear steep on a forward price-to-earnings basis, we believe it is rational when we look out over five years, the lens through which we view all our investments. (Chris Davis and Danton Goei, Davis Advisors)

Amazon is an e-commerce giant that has profoundly reshaped the retail industry over the years. Borrowing a concept from Costco Wholesale, Amazon offers an optional membership-based business model through its Amazon Prime service. In addition to its retail business, Amazon has a state-of-the-art, rapidly growing web services business that enables companies and other organizations to outsource their computer systems to Amazon’s electronic cloud. More recently, Amazon has started to expand its video content offerings and footprint in the grocery business, among other areas, to gain and maintain advantages over the competition. With $136 billion in revenue, Amazon continues to grow at double-digit rates and remains an attractive long-term investment.

Bank of New York Mellon (Pat English and Andy Ramer, FMI)

The thesis for owning Bank of New York is that they are a financial processor, akin to a toll booth operator, in the custody and money management arena. They are unlike a traditional bank, as evidenced by the high operating margins and lower exposure to net interest margins. The thesis for owning the stock has not changed over the past three months. Currently, the stock is trading for 14.8x 2017 earnings estimates and 1.5x current book value. Bank of New York has performed better for two reasons. One, most financials have been outperforming the market. Two, Bank of New York has continued to control expenses and deliver reasonably good earnings growth. The relative move was insignificant and we have taken no action in the stock.


Top 10 Detractors as of the Quarter Ended June 30, 2017

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Encana Corp. 1.09 0.00 -24.73 -0.31 Energy
Chico's FAS Inc. 0.49 0.01 -33.07 -0.20 Consumer Disrectionary
Twenty-First Century Fox Inc. Class A 0.53 0.13 -16.30 -0.17 Consumer Disrectionary
Chesapeake Energy Corp. 0.83 0.01 -16.33 -0.15 Energy
Schlumberger Ltd. 0.71 0.40 -15.08 -0.14 Energy
Noble Energy Inc. 0.71 0.06 -17.32 -0.14 Energy
Arconic Inc. 1.00 0.05 -14.01 -0.13 Industrials
Frank's International NV 0.48 0.00 -20.45 -0.12 Energy
Newfield Exploration Co 0.42 0.03 -22.89 -0.11 Energy
PacWest Bancorp 0.72 0.02 -11.38 -0.09 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

Encana (Chris Davis and Danton Goei, Davis Advisors)

In the energy sector, we own a select group of focused exploration and production companies with strong capital allocation discipline; deep management experience; and low-cost, long-lived reserves. One such example is Encana, a Canadian-based oil & gas exploration & production company with properties in both Canada and the United States. Encana is a low-cost producer as well as a natural beneficiary of higher energy prices. Despite recent volatility in energy prices as well as share prices for the group as a whole, Encana remains undervalued in our view based on current and expected production growth per share.

Chico’s FAS (Dick Weiss, Wells Capital Management)

Chico’s FAS engages in the retail of private label women's apparel, accessories, and other non-clothing items. The firm's product portfolio consists of the following brands: Chico's, Soma, and White House Black Market. It also operates boutiques, retail stores, and websites to sell the products. The retail sector has been under pressure due to too much inventory and falling prices as a result. Chico’s has not been immune from these trends but is focused on cutting costs, which is part of our original thesis for owning the company.

Twenty-First Century Fox (Pat English and Andy Ramer, FMI)

The thesis for owning Fox is that they have a differentiated lineup of networks and studio assets that can thrive in the new world of TV/video consumption. This thesis has not changed over the past three months. The valuation of the stock remains attractive, trading at less than 9x EBITDA and 12x forward earnings-per-share estimates, respectively. Many media stocks underperformed the market in recent months and Fox was caught up in this industry dynamic. While there has been some softness in the ad market, Fox is far less exposed (just 25%) to this part of the revenue stream than most players. Paid subscriber trends were still positive in Fox’s fiscal third quarter.