Litman Gregory Masters Equity Fund Second Quarter 2018 Attribution

During the second quarter of 2018, the Litman Gregory Masters Equity Fund gained 1.45%, underperforming the Russell 3000 Index benchmark return of 3.89% and the Morningstar Large Blend Category gain of 2.67%. Year to date, the fund has underperformed the Russell 3000 by 50 basis points (bps), while outperforming the Morningstar category by 105 bps. Since its December 1996 inception, the fund’s 8.36% annualized return is in line with the Russell 3000 Index’s gain of 8.41% and ahead of the Morningstar category’s 6.87% 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 market continues to move toward a higher risk profile. The dominance of high-multiple growth and technology shares such as FAANG (Facebook, Apple, Amazon, Netflix, and Google/Alphabet), the extraordinary level of mergers and acquisitions activity, and the use of borrowed money to buy back expensive shares are all indicative of past historical excesses. Money-losing companies are outperforming money-making companies. Firms have moved to reporting “adjusted” earnings, which are increasingly disconnected to economic reality. The deal frenzy, as evidenced by AT&T/Time Warner and Comcast/Disney/Fox/Sky, has put corporate balance sheets at their riskiest level in over 50 years. In response to the bidding war with Disney, we liquidated our position in Comcast. Interestingly, at the same time the market-cap-weighted benchmarks are almost all near their highs, a sizeable number of stocks have weakened significantly in recent months. We are encouraged by this sign of a turn. Investors have a big dilemma today: buy cyclical value-oriented stocks and trust that an economic downturn is not at hand or if it is, hope that it is short-lived and shallow; or conversely, chase the relatively small number of growth-oriented tech, biotech, and social media stocks and hope the momentum does not stop. We are being extra cautious, with higher than normal cash levels, as we view the latter move as financially reckless and the former as a touch premature.

Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices continued to be volatile last quarter as lingering concerns about a trade war and mixed economic data led to growing concerns about potentially slowing global growth. These fears weighed on US equity markets by the end of the quarter after a stronger April and May. Despite a seemingly higher level of caution among investors, we believe the outlook for underlying company fundamentals remains favorable and should lead to positive equity returns over the medium to long term.

We had two new holdings in our US equity portfolios last quarter: American Airlines and Charter Communications. We trimmed some positions on price strength, and tax traded certain positions where we believed it was appropriate to capture tax losses. We sold our positions in Bank of America and Oshkosh.

Scott Moore, Nuance Investments
While the portfolio was stable during the quarter, there were modest changes as our team continues to center on optimizing the best risk-reward situations we can find within the sea of investment opportunities that exist. Our overweight position in the health-care sector continued to grow during the quarter. We initiated positions in Dentsply, a leading manufacturer of dental equipment and consumables, and Johnson & Johnson, a leader in consumer products, medical equipment and supplies, and pharmaceuticals. We believe both companies have significantly better risk-rewards than other market opportunities. We remain overweight to the consumer staples sector, but we have lowered our weight during the first six months of the year. We continue to see opportunities within names like Diageo, and we initiated a position in Sanderson Farms, a leading poultry producer. We have lowered our weight in the sector as we exited our positions in Kimberly-Clark and Colgate-Palmolive and moved into what we view as more certain competitive positions. While we remain in line with the benchmark, our weight in the financial sector is our largest sector weight. During the quarter, we initiated positions in Reinsurance Group of America, where we believe the company is underearning its long-term potential due to both low-duration interest rates and a large excess capital position, and Unum, where we believe the market has over-reacted to a potential capital charge in their long-term care business. Our underweight position in the energy sector remains unchanged as we believe that crude oil–related companies are likely facing a multiyear period of competitive transition. We continue to be underweight to the utility, information technology, real estate, and consumer discretionary sectors due to valuation concerns.

Chris Davis and Danton Goei, Davis Advisors
In the year-to-date period the US stock market returned 2.65%, continuing its long advance in an environment of heightened volatility in the capital markets. The portfolio also delivered positive results, outperforming its benchmark during the period. Our investments in Amazon.com and Alphabet were particularly accretive to performance in the year-to-date period. Similarly, in the second quarter, Amazon, Alphabet, and Encana were contributors to performance, while Berkshire Hathaway was a detractor.

Looking ahead, we believe selective stock picking is the best way to navigate the current market environment. As a result, at Davis Advisors we focus on the durability, sustainable growth, competitive moats, and management of every company in the portfolio and continue to exercise discipline regarding the share price of each company we own.

Frank Sands, Jr. and Michael Sramek, Sands Capital
We believe the majority of businesses in the strategy benefit from one or more secular trends, including e-commerce, data-driven decision-making, the union of health care and technology, software-as-a-service, and cloud adoption. 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 expect the strategy to be overweight to key growth sectors, including consumer, life sciences, and technology, and underweight to highly cyclical sectors such as energy, materials, and financials.

Dick Weiss, Wells Capital Management
US stocks posted strong returns in the second quarter, as seen by the 7.8% rise in the Russell 2000 Index and 3.4% return of the S&P 500 Index leading to positive year-to-date performance of 7.7% and 2.7%, respectively. The broad market indexes moved higher on rising earnings expectations and continued strong economic data. Growth stocks continue to surge higher and have been leading the popular indexes. Mega-cap growth stocks Amazon and Netflix are up 45% and 55%, respectively, over the year-to-date period. These are large gains for big companies as performance leadership has been fairly narrow within popular indexes over the course of the year. We employ a bottom-up, fundamental approach and, as such, there are no particular themes represented in our positioning. However, we remain cognizant of increasing capital expenditure trends in several sectors and are seeing opportunities to deploy capital in names trading below our intrinsic value estimates.

* 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 recent relative performance contributions of both sector weights and stock selection to help shareholders understand drivers of 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

  • It was a mixed bag of results for the 11 sectors comprising the Russell 3000 Index, with seven sectors gaining and four declining over the quarter.
  • The fund’s underperformance in the quarter was driven primarily by stock selection, particularly within the information technology (IT) sector.
  • The fund’s IT stocks gained nearly 2.8% during the quarter in aggregate but underperformed the IT stocks in the benchmark by nearly 400 bps. Visa, owned by Sands Capital as well as McGregor, gained slightly more than 11% in the quarter and was among the top contributors to performance. This gain, however, was more than offset by declines in CommScope (down around 27%) and TE Connectivity (a non-benchmark name that was down just over 10%). Both detractors are owned by McGregor, who discusses them in detail below.
  • Another sector that saw relatively weak stock selection was consumer discretionary. Although the portfolio’s exposure to the sector was up nearly 5.7% in the quarter, as a group, they failed to keep up with the benchmark’s names, which were up 8%. The portfolio’s largest holding, Amazon.com, was a winner gaining more than 17% in the quarter. The stock is owned by both Sands and Davis Advisors, and their comments can be read below. Conversely, MGM Resorts declined over 18% and was one of the main detractors from the fund’s overall performance. Nygren has owned the name since 2016, and he discusses the stock below.
  • Consumer staples and industrials were the worst absolute performing sectors; both lost roughly 7% in the quarter. Scott Moore of Nuance owns all three of the consumer staples stocks, where a relatively new holding Sanderson Farms was a detractor. Within industrials, McGregor’s position in metals company Arconic fell 26% in the three-month period.
  • A sector where stock selection marginally benefited relative performance was energy. A small but noteworthy position is Chesapeake Energy. This name, owned by Nygren and discussed below, rose over 70% in the period. Encana was another winner in the quarter, gaining more than 19%.
  • The fund’s cash position increased slightly from last quarter, averaging around 9.8%. The allocation to cash had a small negative effect from a relative performance standpoint.

 

Top 10 Contributors as of the Quarter Ended June 30, 2018

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Amazon.com Inc. 4.11 2.30 17.56 0.71 Consumer Discretionary
Netflix Inc. 1.42 0.50 33.88 0.44 Consumer Discretionary
Visa Inc. Class A 3.14 0.84 11.15 0.35 Information Technology
Chesapeake Energy Corp. 0.50 0.01 71.52 0.31 Energy
Alphabet Inc. A 3.37 1.16 8.64 0.29 Information Technology
Facebook Inc. A 1.33 1.53 22.80 0.28 Information Technology
Salesforce.com Inc. 1.39 0.31 16.18 0.21 Information Technology
Encana Corp. 1.03 0.00 19.14 0.18 Energy
General Motors Co. 1.42 0.19 12.47 0.17 Consumer Discretionary
Alphabet Inc. C 2.00 1.18 7.99 0.16 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

Amazon.com (Chris Davis and Danton Goei, Davis Advisors)

Amazon, an e-commerce giant that has profoundly reshaped the retail industry over the years, is an example of a market leader in the portfolio. 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 digital cloud. During the quarter, Amazon.com was the leading contributor to portfolio results, returning 17% in the period. Similarly, in the year-to-date period, Amazon.com was the lead contributor to portfolio results, returning 45% in the period.

Amazon.com (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 a higher-margin sales mix to drive above-average revenue and earnings growth over the next five years.

Visa (Clyde McGregor, Harris Associates)

  • We continue to believe that Visa is a well-managed company and has significant competitive advantages in the banking industry through its deep payments network.
  • We think that the accelerating trend of paper to electronic forms of payment on a global basis will promote Visa’s growth for some time to come.
  • Visa’s acquisition of Visa Europe will widen its global market exposure and, in our view, provides the company with a significant value-enhancing opportunity.

Visa issued its fiscal second quarter earnings release that included solid volume growth, in our opinion. Payment network volumes rose 15% and cross-border transactions grew 21% from the prior year, which led to a revenue increase of 13%. Earnings per share (EPS) advanced 30% to $1.11, which outperformed market expectations. Management raised full-year guidance for net revenue to a range of low double digits (from high single digits) and now expects adjusted EPS will increase in the high-20% range (from the high end of mid-20%). We have been consistently satisfied with Visa’s fundamental performance.

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

Visa operates the world’s largest retail electronic payment network, processing more than 50% of all credit and debit transactions globally. This network serves as the critical link connecting merchants, merchant acquirers, and card issuers. Visa generates revenue by charging licensing and transaction fees to card issuers and merchant acquirers based on the dollar volume and number of processed transactions. Importantly, Visa’s cost base is largely fixed, enabling high incremental margins. The primary driver of the company’s growth is the steady global shift from paper-based forms of payment (e.g., cash and checks) to electronic transactions. Although Visa competes with other card networks, the industry is essentially an oligopoly, with extremely high barriers to entry.

Chesapeake Energy (Bill Nygren, Harris Associates)

  • We are very impressed with how well Chesapeake’s management team and board of directors have navigated this challenging commodity price environment, and we remain positive about the long-term prospects for this company.
  • We appreciate Chesapeake Energy’s efforts to eliminate wasteful spending by limiting capital expenditures and operating costs.
  • The management team has also shifted the focus from acreage growth to returns and capital efficiency.
  • We think underlying company assets are high quality with significant private market value and appreciate management’s efforts to highlight that value.

Chesapeake Energy benefited from rising crude oil and natural gas prices during the second quarter. We also appreciate that the company generated positive free cash flow from operations, as exhibited in its first quarter earnings report. Furthermore, production was up 11% organically, while adjusted earnings increased from $525 million to $733 million.

Moreover, adjusted earnings grew at 2.5x times the rate of revenue due to the shift toward higher-margin oil production. In our view, Chesapeake’s improving fundamentals show that the company is on the right track. With the enterprise trading at a substantial discount to our estimate of fair value, we believe the company is an attractive holding. 

 

Top 10 Detractors as of the Quarter Ended June 30, 2018

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
CommScope Holding Co. Inc. 1.48 0.02 -27.65 -0.48 Information Technology
Arconic Inc. 1.27 0.03 -26.00 -0.35 Industrials
TE Connectivity Ltd. 2.65 0.00 -10.04 -0.28 Information Technology
MGM Resorts International 1.05 0.06 -18.65 -0.22 Consumer Discretionary
C.H. Robinson Worldwide Inc. 1.70 0.04 -10.39 -0.19 Industrials
Qurate Retail Inc. 0.72 0.04 -17.10 -0.16 Consumer Discretionary
Adecco Group AG 0.79 0.00 -15.12 -0.14 Industrials
Henkel AG & Co. KGaA 1.03 0.00 -11.90 -0.14 Consumer Staples
Berkshire Hathaway Inc. A 2.38 0.00 -4.74 -0.12 Financials
Starbucks Corp. 0.63 0.28 -15.71 -0.10 Consumer Discretionary

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

CommScope (Clyde McGregor, Harris Associates)

  • We believe CommScope’s capability to provide both wired and wireless infrastructure differentiates the company from its competitors and should drive low- to mid-single-digit organic growth.
  • Increasing requirements for capacity and speed across communications networks is working to further boost growth, and we find that CommScope’s bundles of solutions (as opposed to singular products) and efficient operations has led to strong margins.
  • Its acquisition in 2015 of Broadband Network Solutions extended the company’s leading market position, expanded its fiber connectivity offerings, and positioned CommScope as a strategic vendor to telecom and cable companies with its increased scale advantages.

Although CommScope’s first quarter earnings results were in line with consensus expectations, the company was negatively impacted by management’s lowered outlook for the full-year period. Notably, the adjusted earnings forecast was lowered 6.8% to $895 million. In the coming months, CommScope will be implementing plant efficiencies and cost-cutting initiatives in an effort to offset pricing pressures. Additionally, after speaking with others in the industry, our view that the company is taking the right steps overall to endure the challenging operating environment was confirmed, though we continue to monitor the situation closely. In the meantime, we believe CommScope’s capability to provide both wired and wireless infrastructure differentiates the company from its competitors. As a whole, we continue to believe CommScope is undervalued relative to its normalized earnings power. 

TE Connectivity (Clyde McGregor, Harris Associates)

  • TE Connectivity is the dominant manufacturer of sensors and connectors used in cars, industrial products, and communication systems and, because it is about three times the size of its nearest competitor, the company possesses a significant scale advantage in a growing industry.
  • Since TE Connectivity was spun off from Tyco International in 2007, its management team has transformed the company into a collection of high-return, faster-growing businesses with an improved product mix, which resulted in a nearly doubling of EPS while still paying dividends to shareholders.
  • TE Connectivity committed to using the majority of the $2.9 billion received from the sale of its network gear business to CommScope in 2015 for stock repurchases, which we saw as indicative of management’s focus on boosting shareholder value.

TE Connectivity delivered positive first quarter earnings results in our estimation, but investors were displeased with the report. Revenues increased 16% (7% organically) to $3.7 billion, earnings were up 17% to $630 billion, and EPS finished 19% higher to reach $1.42. Sales in the auto segment also increased 7%, despite global production being flat, and were driven by content growth and share gains that look sustainable due to strong project wins and increasing content. Management raised its organic growth expectation for the year from 5% to 6% and increased their EPS expectation by $0.10. Later in the reporting period, TE Connectivity was negatively impacted by investors’ concerns that a trade war between the United States and China would hurt semiconductor businesses. However, we appreciate that the company is the dominant manufacturer of sensors and connectors used in cars, industrial products, and communication systems and, because it is about 3x the size of its nearest competitor, the company possesses a significant scale advantage.

MGM Resorts International (Bill Nygren, Harris Associates)

  • We believed there were a number of ways that investors could benefit from an investment in MGM: a Las Vegas recovery, cost cutting, the deployment of a multifaceted development pipeline, and strong and deployable free cash flow.
  • Las Vegas has a resoundingly positive backdrop over the long term, and MGM should remain one of the largest beneficiaries as the home market continues to evolve from just gaming to a global convention, entertainment, and sports destination.
  • The investment case is now transitioning toward robust free cash flow, which will be increasingly returned to shareholders as the last of the development pipeline is deployed.
  • With MGM's development pipeline winding down the company has already begun to generate free cash flow, which should accelerate going forward. Management is forecasting a cumulative adjusted free cash flow of $4.5–$5.0 billion over the 2018–2020 time period, which would represent approximately 25% of the current market cap. Furthermore, they have promised to return over half of this to shareholders via buybacks (35%–45%) and dividends (15%–20%).

The share price of MGM Resorts International dropped sharply in April after the company released first quarter results. First quarter revenue from MGM met market expectations, while earnings fell somewhat short. However, investors became concerned that management downgraded full-year guidance owing to lower-than-expected growth in Las Vegas. Management now expects revenue growth per available room from Las Vegas strip properties will be in the range of 1%–3% (down from previous projections) as well as lower margins. Management attributed the reductions to several temporary items: disruption issues regarding the Monte Carlo renovation, a slower recovery at the Mandalay Bay property, and the cancellation of a high-profile boxing rematch originally scheduled for May. MGM also announced it completed the current $1 billion share buyback program (initiated in September 2017) and introduced a new $2 billion share repurchase program. Even though the company may face some challenges in the immediate term, we believe investors have over-reacted and our long-term investment thesis for the company remains intact.