Litman Gregory Masters Equity Fund Third Quarter 2017 Attribution

During the third quarter of 2017, the Litman Gregory Masters Equity Fund gained 6.21%, while its Russell 3000 Index benchmark returned 4.57%.i The Morningstar Large Blend Category was up 4.22% in the third quarter. The fund has now gained 14.57% since the beginning of the year, which compares to 13.91% and 13.19% returns for the Russell 3000 Index and Morningstar Large Blend Category, respectively. Since inception, the fund’s 8.25% annualized return is in line with the Russell 3000 Index’s gain of 8.24% and ahead of the Morningstar Category’s 6.72% 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 character and tone of most stock markets around the world remains bullish. While economic and corporate performance has improved in 2017, stocks have continued, as they have for quite some time, to vastly outpace fundamentals. The average stock, and certainly almost any benchmark, appears to be significantly overvalued. Investor sentiment remains high, and while this historically has been a good contrarian indicator, it hasn’t proven to be in recent years. A powerful move from active into passive investment strategies and perhaps an unjustified but enduring belief in the Federal Reserve may be preventing the normal ebb and flow of the market. As of this writing, it has been over 450 days since there has been even a 5% correction, the longest stretch in over 20 years. A few companies and sectors have come under pressure, such as those in the energy area or those competing against Amazon. Amazon’s ability to take on industry after industry without having to make money is an unusual and likely not sustainable development, but challenging this company has proven very hazardous to a lot of stocks. Biotech and technology stocks have been particularly strong. We took advantage of this strength to fully monetize the position in Arrow. With the merger risk with Cash America dissipating, we initiated a position in First Cash.  

Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices rose again last quarter on continued improvement in the global economy. 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 trimming some positions on price strength and repositioning these assets across certain industrial holdings. In our view, global equities have provided attractive returns so far this year. Despite higher equity prices, we continue to find attractive opportunities on a selective basis.

Scott Moore, Nuance Investments
We believe the opportunity set remains limited as we enter the latter part of 2017. Our Nuance universe (our internally researched and approved group of roughly 250 leading business franchises) remains largely overvalued, and the stock prices of most on our list do not reflect the potential risks inherent in their market valuations. While the opportunity set remains narrow in our view, we added to our weighting in the financials sector as just a small reset in future interest rate expectations during the quarter created an opportunity in select high-quality financial institutions like MetLife and Travelers Companies. We also continue to find arbitrage opportunities that 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, we believe they have risk-rewards that are significantly better than the opportunity set today. The current arbitrage opportunities in the portfolio, CR Bard and Rockwell Collins, result in slightly overweight positions in the health care and industrials sectors. We remain overweight to the consumer staples sector as we are seeing opportunities in select global leaders like Diageo, Proctor & Gamble, and Kimberly-Clark. We continue to be underweight to the utilities, 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 ending September 30, 2017, the U.S. stock market advanced, with the S&P 500 Index returning 14.24%. The portfolio also delivered positive results but trailed its benchmark in the period largely due to energy. Our investments in Alphabet and Amazon.com in particular were accretive to performance in the year-to-date period whereas Apache was a detractor. During the third quarter, Encana, Berkshire Hathaway, and Alphabet were accretive to performance while Apache remained a detractor, along with United Technologies.

Business conditions remain favorable with relatively full employment and moderate growth prospects in the United States coupled with low interest rates and inflation levels. In our view, now more than at any other point in the current business cycle investors must select companies individually using a true active management approach as businesses differ widely in their growth rates and valuations and, as a result, in their risk and return profiles.

In addition, current valuations and operating margins favor investing selectively. We continue to find value on a company-by-company basis both in businesses with wide competitive moats and room for margin expansion and earnings growth as well as in select out-of-favor businesses, particularly in the financial services and energy sectors. We have also made long-term investments in leading technology companies whose long-term growth prospects are 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.

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
Major U.S. indexes finished the quarter in positive territory while growth indexes outperformed value indexes, a continuation of the year-to-date trend. Multiple factors, including low unemployment, strong earnings growth, and minimal volatility continued to propel markets higher. Further, hopes of a business-friendly tax reform package being passed also boosted investor sentiment and overall returns.

During the quarter, the portfolio saw positive gains in numerous sectors including health care, financials, and materials, while information technology holdings tended to lag the index. Additionally, a stabilizing and rising oil price helped to reverse negative trends in prior quarters within the energy sector, which is encouraging as the portfolio has been overweight relative to the benchmark within the sector. We have also been increasing new name turnover within the portfolio more recently as we continue to find opportunities to deploy capital in high-quality companies trading at attractive levels relative to our Private Market Value (PMV) process, which is encouraging to us as we have been seeing opportunities in numerous sectors and sub-sectors.

* 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.

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

  • Both sector allocation and stock selection contributed to relative performance during the third quarter, though stock-selection was the primary driver.
  • The sector that contributed the most was consumer discretionary. Fund holdings in this sector were up 9.2%, whereas benchmark holdings gained just 1.3%. Fiat Chrysler Automobiles was the leading contributor in this sector, gaining close to 70% over the three-month period. Fiat Chrysler was also the top contributor at the overall fund level.
  • The highest-returning sector in the benchmark during the third quarter was information technology (up 8.4%). The fund benefited from its overweight to this sector; however, fund holdings mildly trailed those in the benchmark, resulting in a negative selection effect in the quarter.
  • The fund benefited from both an allocation and a selection effect standpoint in the consumer staples sector. This sector was the only negative-returning sector during the quarter (down 1.2%). In spite of this, fund holdings were positive and the fund is underweight to this sector (both of which contributed to relative returns).
  • The fund averaged just under an 8% cash position throughout the third quarter. This was the largest detractor from relative performance during the quarter.

 

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

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Fiat Chrysler Automobiles NV 1.16 0.00 68.49 0.64 Consumer Discretionary
Visa Inc. Class A 3.18 0.73 12.40 0.38 Information Technology
Lear Corp. 1.76 0.04 22.24 0.37 Consumer Discretionary
Alibaba Group Holding 1.59 0.00 22.58 0.33 Information Technology
Encana Corp. 0.99 0.00 34.06 0.31 Energy
Baidu Inc. ADR 0.85 0.00 38.48 0.28 Information Technology
Oshkosh Corp. 1.29 0.02 20.17 0.26 Industrials
General Motors Co. 1.45 0.20 16.79 0.24 Consumer Discretionary
Alexion Pharmaceuticals Inc. 1.19 0.12 15.30 0.23 Health Care
Berkshire Hathaway Inc. A 2.67 0.00 7.87 0.21 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 Contributors

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 higher during the third quarter on speculation that the company is going to be sold. Headlines abounded during the reporting period regarding Fiat as an acquisition target for a Chinese original equipment manufacturer and on rumors that Great Wall Motors was interested in buying Jeep. However, Fiat has received no formal offer thus far and remains committed to its 2018 plan. In our view, CEO Sergio Marchionne is focused on maximizing per share value for the benefit of shareholders. Furthermore, we believe Fiat Chrysler has one of the best management teams in the business with a strong track record of allocating capital efficiently. 

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

Visa operates the world’s largest retail electronic payment network, processing greater than 50 percent 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, its 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. We believe Visa can deliver attractive annual earnings growth over the next five years.

Visa’s share price steadily climbed through the third quarter after it held its investor day conference in late June and it reported straight-forward, strong results for the second quarter that were ahead of investors’ expectations. The primary driver of the company’s growth is the steady global shift from paper-based forms of payment to electronic transactions. Although Visa competes with other card networks, it is the market share leader with over 50 percent of credit card purchase volumes in the United States.

Lear (Clyde McGregor, Harris Associates)

We think that Lear’s management team, which was reorganized in the past few years, is a vast improvement since we last held a position in this company. In our assessment, Lear maintains a strong balance sheet and has a history of returning excess cash to shareholders through share repurchases. We believe Lear is well positioned to benefit from increasing automobile demand following the recession.

Lear participated in the global auto market rally and finished higher for the quarter as a result. Notably, French and German new passenger car registrations increased 9.4% and 3.5% year-over-year in August. In addition, we found Lear’s second quarter earnings results to be positive, led by the topline, which was 10% higher in constant currency, while margins expanded another 20 basis points. Our investment thesis for this company is intact, as we believe Lear’s management team is working to enhance shareholder value.

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 and gas exploration and production company with properties in both Canada and the United States. Encana has divested itself of low-value, low-return assets in recent years and focused on a slimmed down portfolio of high-value, high-return opportunities, including purchasing prime properties in the Eagle Ford shale formation. Encana produces mostly natural gas, although production of natural gas liquids is likely to become more significant over time.

Despite volatility in energy prices in 2017 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. Despite being flat for the year-to-date period, Encana was a top performer during the third quarter of 2017 returning 34% for the three-month period.

 

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

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Diebold Nixdorf Inc. 0.38 0.01 -27.30 -0.25 Information Technology
CommScope Holding Co. Inc. 1.29 0.03 -12.67 -0.16 Information Technology
Regeneron Pharmaceuticals Inc. 1.16 0.15 -8.96 -0.11 Health Care
Chesapeake Energy Corp. 0.64 0.02 -13.48 -0.10 Energy
Oracle Corp. 2.43 0.56 -3.21 -0.08 Information Technology
General Electric Co. 0.81 0.87 -9.58 -0.08 Industrials
Noble Energy Inc. 0.30 0.05 -16.50 -0.08 Energy
Twenty-First Century Fox Inc. Class A 0.88 0.11 -6.27 -0.06 Consumer Disrectionary
United Technologies Corp. 1.24 0.35 -4.37 -0.06 Industrials
Starbucks Corp. 0.69 0.31 -7.47 -0.06 Consumer Disrectionary

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

Diebold Nixdorf (Dick Weiss, Wells Capital Management)

Diebold Nixdorf, a self-service security and services company, underperformed during the quarter. The company, among other things, sells, manufactures, installs, and services self-serving transaction systems (such as ATMs) to banks and financial institutions. Longer term, the company should save their customers money by limiting the labor requirements for banks (such as bank tellers). During the quarter, the company lowered guidance (revenue $4.7 billion–$4.8 billion versus prior $5.0 billion). Diebold is seeing a slower sales conversion cycle citing larger and more complex projects with higher software content. However, the company also increased its synergy net savings target from the recent Nixdorf deal by $40 million to $240 million, which should further help margins longer term. Our PMV estimate for the company is in the high-$30 range.

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 (BNS) 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. We like that free cash flow growth from the BNS acquisition is proceeding ahead of plan, which management is using to rapidly pay down debt.

Although CommScope indicated its second quarter would be weak, the magnitude was greater than investors anticipated. The slowdown in spending by service providers is now expected to extend for the next few quarters. Management cited industry consolidation, competitive dynamics, and the timing of certain large projects as reasons for expected weakness in revenues. That being said, we find that management is doing a good job of controlling costs tightly, while also being careful not to cut too deep. In addition, after speaking with others in the industry, our view that CommScope is taking the right steps overall to endure the challenging operating environment was confirmed. As a whole, we continue to believe CommScope is undervalued relative to its normalized earnings power.

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 the underlying company assets are high quality with significant private market value and appreciate management’s efforts to highlight that value.

Chesapeake Energy was negatively impacted by Hurricane Harvey, which forced the company to shut down some production. In our view, this was a relative non-event to its underlying business value. We think the company’s second quarter earnings report showed that Chesapeake is executing according to its plan, as production is on track to grow 10% from year-end 2016 to year-end 2017, including a 20% growth in oil production, and capital expenditures are coming in slightly below the midpoint of the budget. The outsized oil growth is leading to improved margins and earnings results. Importantly, Chesapeake expects to breakeven in 2017 with oil at $50 while still growing production, which we find to be a substantial improvement from previous years. We continue to believe that Chesapeake is significantly undervalued relative to its normalized earnings power.