Litman Gregory Masters International Fund Third Quarter 2017 Attribution

During the third quarter of 2017, the Litman Gregory Masters International Fund gained 4.83% and the MSCI ACWI ex USA Index was up 6.17%. The MSCI EAFE Index returned 5.40% in the quarter and the Morningstar Foreign Large Blend Category gained 5.36%.1 Year to date, the fund has generated strong absolute returns, up 20.38%, which compares to MSCI ACWI ex USA and MSCI EAFE returns of 21.13% and 19.96%, respectively. Since its inception in December 1997, the fund has compounded returns at an annual rate of 7.59% after fees, while MSCI ACWI ex USA, MSCI EAFE, and its foreign large blend peers have gained 5.57%, 5.12%, and 4.57%, respectively.

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*

David Herro, 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.

Outside of the United States, we’ve been largely repositioning the portfolio across existing holdings in the financial, industrial, and consumer discretionary sectors. Geographically, our portfolio exposure remains tilted toward developed markets; however, we are selectively exploring different opportunities across both developed and emerging markets.

Vinson Walden, Thornburg
Asset prices and global economic expansion continued to be aided by accommodative monetary policies, and a weakening U.S. dollar boosted developing markets. Many political and macroeconomic issues remain open; importantly, however, overall global consumer spending is growing and most macroeconomic indicators around the world have positively surprised year to date, with the United States a relative laggard.

Earnings expectations for various equity indexes for 2017 have improved following strong recent results in most markets, and global economic growth expectations have risen. These trends continue to support a rotation of investor preferences from more defensive debt and equity assets to those more economically sensitive. Under the current administration, political gridlock seems likely to persist in Washington, D.C. While the Federal Reserve has stepped up the pace of federal funds target rate hikes, most major central banks continue to pursue very easy monetary conditions.

We maintain our long-term investment perspective. Though we remain constructive about the long-term prospects for the portfolio, we expect periods of volatility.

Howard Appleby, Jean-François Ducrest and Jim LaTorre, Northern Cross
We are happy to see the fundamentals improve within our top holdings—casino operator Las Vegas Sands, Universal Music Group owner Vivendi, agricultural science and pharmaceutical company Bayer, and advanced semiconductor manufacturing equipment provider ASML. Collectively, these companies account for more than 40% of our portfolio. We see considerable runway for growth in each company and believe each sits with a dominant position in their respective industries, which should over time lead to revenue gains and margin expansion not fully reflected in the share prices today. Across the rest of our portfolio, we are optimistic that a gradual improvement in global growth will result in stronger earnings power, as companies such as SAP, Schlumberger, and Diageo take advantage of their market leadership.

Mark Little, Lazard Asset Management
Growth indicators remained broadly positive, especially in Europe, and commodities, including oil, were on a firmer footing. Meanwhile, bond yields remain at historically low levels. This combination saw money continuing to flow into equities, with a cyclical bent. In Europe, growth has finally picked up alongside credit growth, though political risk remains. The more benign commodity environment and some increased confidence is feeding into strong industrial demand, and Chinese consumers are spending again, now driven by rising personal credit. However, we need only look at U.S. car sales to see the impact slightly tighter monetary policy is having, reminding us of the overwhelming amount of debt that has continued to pile up on public and private sector balance sheets since the financial crisis.

Fabio Paolini and Benjamin Beneche, Pictet Asset Management
We continue to believe that most broad market aggregates are expensive. Historically, the sensible thing to do in such a market would be to invest in more defensive businesses with limited downside. However, the currently depressed interest rate environment globally has inflated the valuations for these businesses disproportionately. As always, we invest with a resolutely bottom-up mindset, which has drawn us to a broad range of businesses; some benefit from long-term secular trends such as Orpea or JD.com, others are conglomerates such as Softbank or CK Hutchison, which trade well below the sum of their parts. The most recent addition to the portfolio has been Hyundai Mobis, a Korean company we discussed last quarter but to which we have added as political concerns have clouded the perception of what we believe is an otherwise outstanding business. The common thread of all these investments remains the same; businesses which we believe trade extremely cheaply relative to their long-term cash-generating ability.

David Marcus, Evermore Global Advisors
Our investment emphasis continues to be on European special situations, as we believe value creation is underway at companies across the region. This was confirmed in the dozens of meetings we had with corporate management teams during our visits to Europe in the third quarter. We believe that the continued improvement in the European macro environment (e.g., unemployment in the eurozone recently fell to its lowest level since February 2009) coupled with continued restructuring and mergers and acquisitions activity has created an attractive opportunity set for new ideas.

* 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

Both sector allocation and stock selection contributed to the fund’s underperformance this quarter. It is important to understand that the portfolio is built stock by stock so the sector and country weightings are a residual of the bottom-up, fundamental stock-picking process employed by each sub-advisor.

Litman Gregory Masters International Fund Sector Attribution

International Fund Sector Attribution

  • Materials and energy sectors were up more than the overall market, so the fund’s underweighting to these sectors detracted from performance slightly.
  • The fund’s large overweighting to the consumer discretionary sector was a slight positive. It remains the fund’s largest sector overweight.
  • At the regional level, the fund’s largest overweight is to developed Europe. The fund’s stock selection within the eurozone was strong during the quarter and contributed positively to performance.
  • Stock selection was weak in the consumer discretionary sector and was the largest detractor to overall performance. However, stock selection was strong in technology and financials. Within technology ASML Holding and Baidu were up over 30% for the quarter. In financials, NN Group and Aurelius were among the top ten contributors as both were up over 20% during the period.
  • Stock selection within health care was a challenge for the fund’s sub-advisors. Teva Pharmaceutical Industries was down sharply during the quarter due to growth and pricing concerns related to its core generics franchise. This stock was sold during the quarter. Shire was down only 8% during the quarter but was among the top detractors due to its relatively large weighting in the fund. This stock remained in the portfolio as of the end of the third quarter.

 

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

Company Name

Fund Weight (%)

Benchmark Weight (%)

Three-month Return (%)

Contribution to Return (%)

Country

Economic Sector

ASML Holding NV ADR 2.38 0.29 32.42 0.70 Netherlands Information Technology
Vivendi SA 5.00 0.14 13.92 0.69 France Consumer Discretionary
Baidu Inc ADR 1.60 0.28 38.48 0.59 China Information Technology
NN Group NV 1.70 0.05 20.11 0.32 Netherlands Financials
Teekay Lng Partners LP 2.01 0.00 16.87 0.31 Bermuda Energy
Anheuser Busch Inbev SA/NV 3.21 0.44 8.57 0.26 Belgium Consumer Staples
Exor NV 1.62 0.05 17.34 0.26 Netherlands Financials
Aurelius Equity Opportunitie 1.13 0.00 22.61 0.24 Germany Financials
Lloyds Banking Group 3.03 0.29 7.39 0.24 United Kingdom Financials
Wynn Macau Ltd. 1.29 0.02 16.75 0.23 Macau 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 Contributors

Lloyds Banking Group (Vinson Walden, Thornburg Investment Management)
Lloyds Banking Group provides financial services to individual and business customers in the United Kingdom and overseas. The company's business activities include retail and commercial banking, long-term savings, protection (general and life insurance), and investment. We initially viewed Lloyds as a good organic capital generation and capital return story trading at a reasonable valuation for one of the best return profiles within the European banking space. Full-year 2015 results confirmed, in our view, that the bank would be willing and able to pay out capital to shareholders in excess of 13% Common Equity Tier 1 (CET1). Furthermore, we expected in excess of 200 basis points of organic capital generation per annum via low- to mid-single-digit percentage loan growth and stable to growing margins. We also liked that U.K. banks didn't have the structural headwinds of “lower-for-longer” rates that other European banks had. We believe Lloyds can maintain its attractive dividend and the share price can increase with earnings and with a moderate valuation re-rate toward sector average multiples as the market gains confidence in the bank’s ability to navigate economic complexity around Brexit and potential regulatory changes.

With respect to valuation, we review traditional fundamental metrics such as price-to-book and price-to-earnings ratios, while triangulating the appropriate valuation against Lloyds’s current and prospective ability to earn attractive returns (from U.K.-specific macro factors and internal business execution), which is measured through traditional metrics like return on equity and return on assets. We also consider its ability to meet regulatory capital requirements, and whether these requirements compromise the bank’s ability to fund growth and to fund its dividend. When triangulating these factors, we believe Lloyds’s valuation is too low on an absolute basis (considering its returns and earnings power) and on a relative basis compared to the European banking sector.

Over the last three months, Lloyds’s share price performance was better than or in line with various U.K. and eurozone financial stock indexes (if considered in the same currency). Over the period there was limited new information available about Lloyds or macro news that would impact the banking sector. Consequently, it makes sense that Lloyds would perform about in line with the sector. Overall, our investment process focuses on normalized earnings power over the medium to long term, so we are not highly focused on quarterly catalysts, unless there is a significant milestone related to our investment thesis.

Looking forward, the company continues to execute its corporate strategy of defending and strengthening brand equity to support new business generation, and continuing to manage the cost structure. We are watching for new risks, such as macro headwinds from Brexit negotiations, a softer housing market, or uncertainty caused by the regulatory environment, but we don’t believe there have been significant changes in the last few months. We are aware of the Bank of England’s stance on raising rates but don’t believe we can make a differentiated prediction of their decision process. Instead, we believe Lloyds will do well if rates remain low, and we think the bank’s earnings and valuation have positive sensitivity to rate increases.

ASML Holding (Howard Appleby, Jean-François Ducrest, and Jim LaTorre, Northern Cross)
A key contributor this quarter was ASML, the global leader in lithography equipment used for the manufacturing of advanced microchips. We invested in the company because of its strong research and development leadership position, which we think will manifest itself in a higher share of semiconductor capital spending in the coming years. The company is by far the leading provider of current generation immersion lithography equipment and is currently in the process of developing a next generation of equipment referred to as Extreme Ultra Violet (EUV). We think the strong performance during the quarter reflects continued robust trends in semiconductor spending, driven by both smartphones, advanced servers, and the growing market for Internet-connected devices. In addition, the company has made progress in moving EUV technology to introduction, which has resulted in early orders from ASML’s core customers. During this quarter in particular, the company showed better progress toward its long-term earnings targets, which has resulted in a rise in earnings expectations. We continue to see considerable earnings upside from the company in the coming years, and thus ASML remains a core holding.

NN Group (David Marcus, Evermore Global Advisors)
NN Group is a €12 billion ($14.2 billion) market cap life and non-life insurance company based in the Netherlands. It is the largest insurance provider in the Netherlands and has market-leading positions in select European markets (Poland, Hungary, Romania, and Turkey).

Since we purchased NN Group for the portfolio, the company has completed the acquisition of Delta Lloyd, a transformative deal that we believe has not yet been fully appreciated by the market. On a standalone basis, NN continues to generate strong cash flows, which puts NN in a strong position to increase dividends and to continue to repurchase shares after successfully integrating Delta Lloyd. Management has outlined preliminary expectations of €150 million ($177.3 million) of synergies from Delta Lloyd in addition to the previously announced €120 million ($141.8 million) in cost cuts (pre-acquisition). We have met with management on multiple occasions and continue to have a high degree of confidence that management can successfully execute on their plans. Since the company’s initial public offering (IPO), management has successfully realized €200 million of cost savings a year ahead of schedule and has continuously grown its book value from its ongoing businesses. 

 

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

Company Name

Fund Weight (%)

Benchmark Weight (%)

Three-month Return (%)

Contribution to Return (%)

Country

Economic Sector

Teva Pharmaceutical Industries Ltd. 0.36 0.11 -44.94 -0.40 Israel Health Care
Altice NV A 2.75 0.04 -13.05 -0.38 Netherlands Consumer Discretionary
Shire PLC 2.80 0.24 -7.59 -0.23 United Kingdom Health Care
Inmarsat PLC 1.50 0.03 -11.35 -0.19 United Kingdom Telecommunications
Merida Industry Co. Ltd 0.93 0.00 -16.55 -0.18 Taiwan Consumer Discretionary
Aena SME SA 2.19 0.00 -7.08 -0.16 Spain Industrials
Japan Tobacco Inc. 1.46 0.18 -6.73 -0.10 Japan Consumer Staples
GlaxoSmithKline PLC 1.43 0.49 -4.79 -0.07 United Kingdom Health Care
Israel Discount Bank Ltd. 1.57 0.00 -4.32 -0.07 Israel Financials
JD.com Inc. 1.10 0.13 -2.60 -0.07 China 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

Teva Pharmaceutical Industries (Fabio Paolini and Benjamin Beneche, Pictet Asset Management)
Teva, a generic and branded pharmaceutical business, fell sharply in the quarter because of a very disappointing second quarter results announcement (far lower cash generation than expected), and news that the potential (and long overdue) appointment of a new CEO had fallen through. The dynamics driving the cash generation shortfall prompted us to sell the holding. The weak performance has been driven by lingering concerns that the company paid too much to acquire generic rival Actavis, an imminent decline in the branded business’s Copaxone franchise after its patent expires (a multiple sclerosis treatment accounting for 30% of group cash generation), ongoing fears of price regulation, an industry investigation, lower guidance, and changes in management. However, we had continued to hold the stock because we took the view that none of this would have a material impact on our underlying investment thesis. Key elements of this thesis have in fact been playing out. First, because it is not simple to manufacture drugs, and it has been the subject of residual patent litigation, the Copaxone franchise appears set to erode more slowly than the market feared. Second, time has shown the branded division’s pipeline of new drugs to have more potential than investors were giving it credit for. Third, most of the group’s international generics operations have continued to show steady growth. So why sell now? The bedrock of the investment case was an assumption that secular growth in generic demand (particularly in the United States) would more than offset steady pricing pressure and so preserve and grow the generic business’s prodigious ability to generate cash. We believed that this cash, augmented by a margin boost from Actavis’s huge pipeline of filings to launch new generic drugs (for which the first to market has 180 days of pricing exclusivity), would be directed toward more branded drug development and to paying down the sizeable Actavis acquisition debt. Teva’s second quarter results put a big question mark over this assumption by revealing a radical change of tack by the U.S. Federal Drug Administration (FDA). This shift has seen a big increase in approvals for the sales of generic drugs already on the market (so increasing competition), at the expense of approvals for new generics to challenge expired patents. The result has been a “double whammy” for Teva: far more aggressive price pressure on its base U.S. generics business, and far less of the “kicker” from new generic filings coming to market. If this trend were to continue, Teva’s fundamentals could rapidly deteriorate to the point where a rights issue to raise new capital—a move that was out of the question only a few months ago—would become a real possibility. The FDA’s tack may change again, but with little visibility as to whether or when it will, and with the continued vacuum in the CEO seat, we elected to cut the portfolio’s losses and exit the position.

Shire (Howard Appleby, Jean-François Ducrest, and Jim LaTorre, Northern Cross)
Shire was a detractor to performance this quarter. While near-term earnings expectations have been broadly met, the market is concerned about the durability of Shire’s franchises, particularly in hemophilia (where new competitors are emerging) and in rare diseases (where the market is worried about pricing competition). The stock has de-rated significantly, now trading at 9.5x price to earnings and 10.5x EBITA (earnings before interest, taxes, and amortization), which is down from 13x and 14x a year ago, respectively. We believe that the Shire asset base is durable and that its market position in rare diseases and blood disorders remains strong. While the company has seen some generic competition, it has also overdelivered on cost reduction efforts since the acquisition of Baxalta, and thus our earnings and cash flow outlook has not changed since we invested in the company. While we do not expect all these concerns on competition and pricing to erode quickly, the company should grow earnings and cash flow solidly in the next several years, which we think will drive the shares higher with time.