Litman Gregory Masters Equity Fund Fourth Quarter 2016 Attribution

During the fourth quarter of 2016, the Litman Gregory Masters Equity Fund rose 3.84%, performing in line with the Morningstar Large Blend Category but slightly underperforming the 4.21% return of the Russell 3000 Index. For the year, the fund was up 11.98%, narrowly trailing the Russell 3000’s 12.74% gain, but ahead of the peer group’s 10.07% gain. As of year-end, the fund was ahead of its Large Blend peers in every trailing period.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 www.mastersfunds.com.

Themes, Trends, and Observations from the Managers*

Pat English and Andy Ramer, FMI
The stock market extended its bull market run to 7¾ years, including a sharp upward move post the U.S. elections. For most of this run, fundamentals have lagged. GDP, sales, and earnings growth have all significantly trailed stock gains, resulting in near-record-high valuations. Hope for tax and regulatory reform and a more favorable environment for businesses has helped fuel speculative fervor. History shows that valuations at the beginning of a president’s administration are a far greater determinant of the ensuing long-term stock market performance than any specific actions that are taken. Thus, we are generally cautious. We have holdings in a wide variety of end markets, from professional services to manufacturing to insurance to retail as well as other important end markets. We feel a few areas lack good investment prospects, including pharmaceuticals/biotechnology, utilities, and energy. The portfolio trades at a significant discount to the market.

Bill Nygren and Clyde McGregor, Harris Associates
Equity prices moved higher last quarter as investors continued to gain confidence in the outlook for the global economy. Our three- to five-year outlook for global equities remains positive. We expect a combination of dividends and underlying value growth to be in the mid-high single digits over the next couple of years. Our confidence is based on the strength of our companies’ balance sheets, low interest rates, low inflation, unprecedented global monetary stimulation, and the potential for a more favorable business climate (lower taxes, less regulation) in the United States.

Despite the price appreciation we witnessed in the fourth quarter, we continue to favor companies within the financial, industrial, consumer discretionary, and technology sectors. We continue to avoid most companies that the market views as “stable” due to valuation (like those in the telecom, utility, and consumer staples sectors) as well as most of the commodity cyclical companies. However, like 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 2016, the Nuance investment team was able to capitalize on a few key investment opportunities for our clients. The first opportunity was within the financials sector. We were able to make attractive investments in high-quality financial institutions, such as BOK Financial, Commerce Bancshares, Northern Trust, MetLife, and Charles Schwab, that we believed were underearning their long-term potential due to cyclically compressed returns on assets and equity, which had resulted in attractive valuations. Over the course of 2016, interest rates moved up and the above-mentioned investments all experienced outperformance. The second opportunity was within the industrials sector, specifically within the agricultural & farm machinery sub-industry. In general, we believed that agricultural equipment manufacturers were underearning their long-term potential due to cyclically low farm capital expenditures. Our investments in Deere and Lindsay profited nicely over the course of the year as expectations for a capital spending rebound in 2017 and 2018 began to emerge. Lastly, and consistent with the Nuance investment process, the investment team was and is always on the lookout for one-off investment opportunities that are underearning their long-term potential for transitory reasons. We believe our investment in HB Fuller fits this mold. Fuller is the number-two global adhesive manufacturer and was experiencing transitory issues during 2015, including a difficult SAP implementation and acquisition integration issues that abated in 2016. As a result, the stock reset higher with improved earnings power.

During the fourth quarter of 2016, the opportunities in the Nuance portfolio centered around three key themes. First, the investment team believes the oil & gas equipment & services sub-industry is currently experiencing significant underearnings versus its long-term potential, and as a result, we continue to have sizable investments in two industry leaders, Frank’s International and Schlumberger. Second, because of the U.S. election results and the subsequent call for health care reform, many of the health care sector stocks we follow have experienced modest underperformance. We made smaller investments in industry leaders such as Smith & Nephew and Abbott Laboratories, as the risk/reward profiles screened attractive. Lastly, we believe a pocket of opportunity has emerged within multinational consumer staples, as emerging-market slowdowns and currency headwinds have caused modest underearnings across numerous global leaders such as Unilever.

Chris Davis, Davis Advisors
In 2016, Davis Advisors’ portion of the Equity Fund outperformed the S&P 500 Index by a wide margin. Our energy holdings, including Encana and Apache, were particularly accretive to results, along with banks and financial holdings, in general, namely Berkshire Hathaway, Wells Fargo, and JPMorgan Chase. Despite recent short-term volatility in the fourth quarter, Amazon.com was also a meaningful tailwind to performance for the calendar year 2016.

Looking ahead, we believe the durability and growth potential of the individually selected companies that make up the portfolio position us strongly for the years and even decades to come. When evaluating the investment landscape, we do not make investment decisions based on short-term forecasts, which history has shown can be unreliable. Instead, we focus on the important and knowable while maintaining a long-term perspective. Building wealth in the coming decade will require equity investors to look beyond the market index and be selective, adaptable, and flexible. Given the quality and valuations of the companies in the portfolio, we believe we are well positioned to grow shareholder wealth and exceed the performance of the broader market over the long term.

Frank Sands, Jr. and Michael Sramek, Sands Capital
The election of Donald Trump as U.S. president on November 8 sparked a “Trump rally,” which benefited those industries poised to gain from a reduction in regulation and increased fiscal stimulus, particularly in the form of infrastructure spending. Financials were the largest beneficiary, followed by energy, materials, and industrials. Our investment criteria has led to an underweight to these sectors, so their outperformance was a significant headwind to our relative investment results. Ultimately, we want to own dominant companies that are selling into growing markets or creating markets of their own. In our view, these businesses will become larger and more valuable, their earnings should increase, and over our time horizon that growth should be reflected in their share prices. We believe the companies we own today fit this approach well. We are excited to own them, and we remain confident that our investment philosophy and process will continue to add value for our clients over our long-term horizon.

Dick Weiss, Wells Capital Management
As the fourth quarter of 2016 came to a close, it also brought the close of an eventful year. As markets started the year with a sharp downward move, markets eventually rallied and finished the year on a positive note. Much of the influence in the quarter revolved around the U.S. presidential election, and to some, its surprising outcome. However, markets quickly raced higher post the election outcome as President-elect Donald Trump awaits to take office. We finished the year on a strong absolute upswing, outperforming most major U.S. indexes, although the sharp ascent of the small-cap space was a relative headwind to performance more recently. At the portfolio level, we have stayed true to using our Private Market Valuations (PMV) as our guide when buying and selling stocks. Inclusive of this, we have also been looking for companies that have been reinvesting back into their business, as we feel many companies may have gone too far in paying out their excess cash in the form of dividends and share buybacks.

* 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

  • The majority of Russell 3000 sectors ended the quarter in positive territory. While sector allocation had a positive contribution to the portfolio’s relative returns, stock selection overall was a detractor.
  • Financials were the biggest gainer in the benchmark, returning 20.65% for the fourth quarter. While stock selection here was a detractor, it was more than made up for by the portfolio’s nearly seven-percentage-point overweighting to financials (21.5% versus 14.6%). Financial names comprise the portfolio’s top four contributors for the quarter: JPMorgan Chase (up 30.52%, discussed below), Wells Fargo (up 25.50%), Bank of America (up 41.72%, discussed below), and BNY Mellon (up 19.33%).
  • Stock selection within industrials was a positive, with Oshkosh, owned by McGregor and discussed below, gaining 15.74%.
  • The fund’s underweight to both the health care and real estate sectors (by over eight and four percentage points on average, respectively) was a positive for relative performance in the quarter. These sectors were the two worst performers in the quarter and saw losses of 4.23% and 2.95%, respectively.
  • The information technology sector underperformed the broad index by three percentage points. An overweighting combined with poor stock selection resulted in this sector being the chief detractor to relative performance for the quarter. Two portfolio positions, Workday (owned by Sands Capital) and Zendesk (owned by Dick Weiss), were down 27.92% and 30.97%, respectively. Both names are discussed below.
  • Amazon.com, which falls under the consumer discretionary sector, was the top detractor. The stock, owned by Davis and Sands and discussed below, fell 10.44% for the quarter.
  • The portfolio carried an average cash position of around 6% in the quarter. This detracted marginally from relative performance since the benchmark moved higher.

 

Top 10 Individual Contributors as of the Quarter Ended December 31, 2016

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
JPMorgan Chase & Co. 1.87 1.21 30.52 0.54 Financials
Wells Fargo & Co. 2.05 1.01 25.50 0.48 Financials
Bank of America Corporation 1.20 0.86 41.72 0.45 Financials
Bank of New York Mellon Corp. 2.49 0.21 19.33 0.43 Financials
Oshkosh Corp. 1.99 0.02 15.74 0.31 Industrials
Berkshire Hathaway Inc. A 2.47 0.00 12.90 0.31 Financials
TE Connectivity Ltd. 2.97 0.00 8.21 0.24 Technology
Citigroup Inc. 1.05 0.69 26.25 0.24 Financials
Itron Inc. 1.84 0.01 12.72 0.23 Technology
PacWest Bancorp 0.92 0.02 28.17 0.23 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 Selected Contributors

JPMorgan Chase (Chris Davis, Davis Advisors)

With $2.6 trillion in assets, JPMorgan Chase is a market leader in the portfolio. Its diversified operations include one of the top private banks in the country, one of the largest investment banks, the largest credit card company as measured by loans outstanding, and one of the top five asset managers in terms of assets under management. This well-diversified business mix provides some stability for the company’s cash flow through various economic cycles. JPMorgan faced strong headwinds following the financial crisis of 2007–2008, which resulted in large regulatory and legal settlements and the need to retain earnings to buttress its capital base. We believe these headwinds are nearing their end, and over the coming years these giant financial firms will be able to invest a substantial portion of their earnings to generate greater benefits for shareholders while returning more capital through share repurchases and higher dividends.

Bank of America (Bill Nygren, Harris Associates)

  • Bank of America operates as a strong deposit franchise in quality markets, in our assessment. We think an improving interest rate environment along with additional expense reductions and further share repurchases make Bank of America’s current stock price greatly discounted to the company’s true worth.
  • We believe Bank of America’s permanent reduction in physical branches and headcount should translate to lower costs that will boost the company’s earnings per share going forward to more normalized levels.
  • We like that Bank of America’s credit quality remains strong and that the company continues to reward shareholders via repurchases and dividends, actions that are aligned with our investment thesis.

Investors’ expectations that a Trump administration and a Republican majority in Congress would lead to increased spending on infrastructure projects and less regulation boosted the share prices of financial holdings during the quarter, including Bank of America. In addition, speculation that Trump’s proposed tax reform would enhance economic growth and subsequently allow for interest rates to return to more normalized levels benefited companies in the sector. In our estimation, Bank of America remains attractively priced, even without an increase to interest rates. Given the strong capital markets performance, healthy loan and deposit growth, and continued progress in reducing the expense base exhibited in the company’s third quarter earnings report, we remain confident that management has a solid plan for the future and believe the investment will continue to provide value for our shareholders.

Oshkosh (Clyde McGregor, Harris Associates)

  • We like that the majority of Oshkosh’s corporate profits are generated from its access equipment business (aerial work platforms, boom lifts, etc.), which benefits from increasing housing starts.
  • In our estimation, Oshkosh’s management team has a track record of cutting costs and improving profitability.
  • We appreciate that Oshkosh possesses what we find to be a strong free cash flow with a deleveraged balance sheet and a history of executing share repurchases.

Oshkosh was a beneficiary of the U.S. presidential election during the quarter. Investors anticipated that President-elect Trump’s rhetoric leading up to the election would hold true, which included a decrease in regulation and an increase in infrastructure spending. We were also pleased with the results of Oshkosh’s fiscal fourth quarter, as sales increased 11%, the operating margin improved from 5.7% to 7%, and earnings per share were up over 50% to $1.05. Management reiterated its guidance for fiscal year 2017. In our estimation, Oshkosh’s management team has a track record of cutting costs and improving profitability. We appreciate that Oshkosh possesses what we find to be a strong free cash flow with a deleveraged balance sheet.

 

Top 10 Individual Detractors as of the Quarter Ended December 31, 2016

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Amazon.com Inc. 2.86 1.34 -10.44 -0.33 Consumer Discretionary
Workday Inc. Class A 0.79 0.04 -27.92 -0.26 Technology
Illumina Inc. 0.64 0.09 -29.52 -0.25 Health Care
Zendesk Inc. 0.60 0.01 -30.97 -0.22 Technology
Fairfax Financial Holdings Ltd. 1.06 0.00 -17.32 -0.22 Financials
Alibaba Group Holding SP 1.15 0.00 -17.00 -0.22 Technology
Visa Inc. Class A 3.30 0.67 -5.46 -0.19 Technology
Facebook Inc. A 1.55 1.21 -10.31 -0.17 Technology
Urban Outfitters Inc. 0.79 0.01 -17.50 -0.14 Consumer Discretionary
Henkel AG & Co. KGaA 1.17 0.00 -10.33 -0.14 Consumer Staples

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 Selected Detractors

Amazon.com (Frank Sands, Jr. and Mike Sramek, Sands Capital)

We continue to believe Amazon.com has built two increasingly dominant businesses in both its retail and web services operations. Amazon Web Services (AWS), the company’s infrastructure-as-a-service offering, provides organizations with on-demand access to computing, storage, and other services through its cloud platform. AWS continues to innovate and attract new enterprise customers and workloads, and the recurring nature of revenues should result in sequential growth. This year, the company announced a number of high-profile wins for this business. Salesforce designated AWS as its preferred public cloud architecture, and large enterprises such as GE Oil & Gas, Kellogg’s, and Lionsgate are using business-critical applications on the AWS platform. Additionally, Amazon’s retail business continues to execute well, delivering its highest level of profitability since 2011 and unexpected upside in its international business. Amazon’s two core franchises still feature a considerable growth runway, its valuation has come down over the past year, and niche offerings like Fresh and Prime Now should continue to diversify the company’s earnings growth potential.

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

Shares of Workday came under pressure following its earnings announcement, as investors were disappointed by management comments about deal slippage and conservative fiscal year 2018 guidance. Macro political uncertainty resulted in the deal slippage, particularly among some of Workday’s large European financial services customers. While this delays revenue recognition, we expect these deals will ultimately close. Management expects similar headwinds to impact fiscal year 2018, which led to lower billings guidance. In our view, the guidance is an attempt to manage investor expectations, rather than a fundamental change to the business or competitive environment. Results for the quarter were strong otherwise, with billings growth and gross profit exceeding our expectations. Our long-term view on the business remains intact, and we expect Workday to sustain revenue growth in the high-20% range over the next five years.

Zendesk (Dick Weiss, Wells Capital Management)

Zendesk was a relative detractor from performance for the quarter after generating strong returns for much of the year after being added to the portfolio. Zendesk offers a software-as-a-service customer service platform that enables companies to provide customer support. The company is in a strong position to grow the top-line in an expanding market. During the quarter, the company reported revenue growth of 45% year over year and booking growth of 35% year over year. However, the stock experienced some weakness as Zendesk underwent a sales reorganization process that resulted in some employee attrition and delayed deal conversion. We see these as temporary issues and currently have a PMV on the stock in the low to mid $30s.

Fairfax Financial Holdings (Pat English and Andy Ramer, FMI)

Our thesis was that Fairfax offered a diversified global property and casualty business that had performed admirably, generating costless float and underlying asset growth, and that the team behind this remained in place. Over the past several years the company’s balance sheet has been hedged against a global correction in asset prices that has proven to be overly conservative in this bull market. Increased optimism toward an improvement in the U.S. macroeconomic environment has led some investors to question the conservative composition of Fairfax’s invested assets and that hurt the stock last year. However, since the end of the September quarter, the company has pivoted toward a more balanced outlook. Astutely, the company sold its entire long-term U.S. Treasury holdings just prior to the U.S. election and reduced the hedged equity position by 50%. More recently, Fairfax announced the purchase of Allied World Assurance. This transaction should yield attractive returns on capital assuming Fairfax is successful in improving efficiencies. The stock is attractively valued at approximately 1x book value, and we are maintaining our stake.