Litman Gregory Masters Smaller Companies Fund Third Quarter 2017 Attribution

The Litman Gregory Masters Smaller Companies Fund gained 3.41% in the third quarter but failed to keep pace with its benchmark, the Russell 2000 Index, which rose 5.67%.i The fund also trailed the Morningstar Small Blend peer group’s gain of 5.14%. Year to date, the fund is now up 7.00% compared to 10.94% and 8.57% for the Russell 2000 Index and Morningstar peer group, 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*

Jeffrey Bronchick, Cove Street Capital
Our investment philosophy and process is centered on finding businesses whose intrinsic value differs materially from that suggested by the prevailing value offered by the stock market at large. We have rehashed many times the classic Ben Graham quote that in the short run the stock market is a voting machine, and in the long run it is a weighing machine. Ignoring the fantastically ironic political issues in our last sentence, many of the crosscurrents with which we began the year remain omnipresent:

  • Most asset classes remain expensive by most historical measures, suggesting muted future returns.
  • Federal Reserve policy remains accommodative, interest rates are low and stable, and credit is easily available for nearly any investment scheme. All of these are good things in the short run, but we continue to think that they are unlikely to remain a permanent state of affairs.
  • “Orange Swans” (defined as the promise or fear that any number of bold policy changes pushed by the new administration in Washington actually get enacted) remain dormant despite much chatter. It is beyond our paygrade to speculate with your capital on political “what-ifs,” other than to say lower and simpler tax rates would be nice.
  • There is a small cadre of high-growth, high-valuation stocks that until a very recent spurt late in the third quarter in “all other stocks,” seem to occupy every waking hour of the investment management industry’s day. That is not our sandbox.
  • There remains a large trend of dollars into “passive” investment vehicles. The practical effect is to create unusual movement in stock prices that can either exacerbate fundamental changes or obscure them—in the short run.

All this “stuff” aside, Cove Street Capital continues to bump along the same path. We have a focused team of five investment professionals (yes, we added one in September) that carefully and patiently scours publicly traded markets in search of business models that are underappreciated or statistical values that are simply too good to pass up. Suggesting this is passé activity in the modern age is like saying steak is a goner when one can live on kale chips. We pursue a process that is applicable to any asset class, and frankly, we see greater and greater value in this process when more and more investors are focusing their attention on trends du jour or on the thrill and excitement of new shiny technologies that “mine” shorter and shorter-term variability. We love the thrill of short-term performance as much as the next manager, but almost by definition with a concentrated, index-agnostic portfolio, we are not the “beta guys.” Our portfolio moves when specific fundamental changes in what we own get recognized by the other guys.

Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
As we look to the fourth quarter and 2018, we are encouraged by the prospects of tax reform, which can help drive return on invested capital (ROIC) higher, and the potential follow-on growth the market is excited about. However, Congressional action on this level is not easy, and we need to be cognizant of what is priced into companies’ valuations and the market in general, even apart from the low discount rate environment. Our team’s focus on ROIC improvements, scenario testing, and risk mitigation efforts help us to frame opportunities while weighing company-specific and macro risk, doing our best to ensure we are being paid enough for whatever risks we are accepting. In our view, the market has a tendency to extrapolate things linearly, ignoring risk while volatility is low (as well as the opposite in bear markets), but this should cause even more caution in today’s market and increased resolve to scenario test companies for good and bad times.

While we are not market timers or prognosticators of doom, we do believe we are never safe from risk and see too many companies choosing to misallocate capital toward projects that yield returns below a normalized cost of capital. These behaviors will (eventually) lead to permanent loss of capital and much consternation for investors that are not invested in management teams with a culture, philosophy, and incentive structure that drive continuous improvement in ROIC above the normalized cost of capital. While this doesn’t guarantee performance every quarter, or even year, we believe such focus will help us best avoid permanent losses of capital over cycles on the whole. We are proud of our team’s efforts over a multitude of market environs where constant vigilance and healthy skepticism has, largely, been helpful to our performance for our clients and partners. In closing, yes, we are more cautious than we can recall in quite some time, but we also acknowledge the supposed Keynes quote: “The market can remain irrational longer than you can remain solvent.” We thank our team, clients, and partners for the support.

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 three 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 Smaller Companies Fund Attribution

Smaller Companies Fund Attribution Chart

  • Small-cap stocks posted a 5.67% gain in the third quarter, marking their sixth consecutive quarter of positive returns. All sectors in the benchmark were positive during the three-month period.
  • Two sectors were the culprits of the fund’s relative underperformance in the period, both due to stock selection. Most other sectors were incremental contributors or detractors.
  • Consumer discretionary was the fund’s largest detractor in the three-month period, costing the fund approximately two percentage points of relative performance. Clothing retailer Cherokee (owned by Cove Street), and recent additions Foot Locker (owned by Wells) and Buffalo Wild Wings (owned by SBH), were among the fund’s top detractors in the period, falling 60.43%, 25.40%, and 16.57%, respectively. All three positions are discussed in more detail below.
  • Information technology was the other leading detractor. Avid Technology, one of four technology holdings in the fund, fell nearly 14% in the period. Cove Street added the stock in December of last year.
  • Industrials was a bright spot, benefiting from both an underweight to an underperforming sector as well as stock selection. Heritage-Crystal Clean (Cove Street) and Avis Budget Group (Wells) were the two largest stock contributors, gaining 36.79% and 39.57%, respectively, in the three-month period. Both stocks are discussed below.
  • Given the strong performance of small-cap stocks during the quarter, the portfolio’s average cash position of over 14% detracted from performance. As of the end of the third quarter, the fund’s cash position stands at 10.25% (down from 15.41% at the end of the second 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
Heritage-Crystal Clean Inc. 3.39 0.01 36.79 1.02 Industrials
Avis Budget Group Inc. 2.08 0.13 39.57 0.70 Industrials
MDC Partners Inc. A 2.78 0.03 11.11 0.65 Consumer Discretionary
Innophos Holdings Inc. 4.64 0.05 13.40 0.64 Materials
Haemonetics Corp. 4.20 0.11 13.62 0.56 Health Care
Millicom International Cellular SA 5.16 0.00 10.62 0.53 Telecommunications
Spartan Motors Inc. 1.94 0.02 24.86 0.48 Industrials
SPX Corp 2.59 0.06 16.61 0.43 Industrials
Cimarex Energy Co 2.02 0.00 21.01 0.41 Energy
Integer Holdings Corp 2.25 0.07 18.27 0.38 Health Care

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

Heritage-Crystal Clean (Jeffrey Bronchick, Cove Street Capital)
Heritage-Crystal Clean is a provider of environmental services as well as the re-refining of used motor oil. The company benefited from the upward move of base oil prices over those realized last year, as well as the supply disruptions caused by Hurricane Harvey, which knocked out the largest base oil producer on the Gulf Coast and increased pricing and demand for Heritage’s re-refined base oil. Heritage’s environmental services business returned to growth after a down year in 2016, helping drive overall corporate margins higher. We continue to see the normalization of margins within the re-refined oil segment, in addition to continued long-term growth of environmental services, as the two future drivers for earnings and therefore returns in the stock. Given the appreciation and the overweight position, we trimmed back our Heritage holdings during the quarter.

Avis Budget Group (Dick Weiss, Wells Capital Management)
Avis Budget Group, a car rental and vehicle sharing company, performed well in the quarter returning nearly 40%. We originally purchased the company as management discussed investing cash flow back into the business to improve their platforms and customer experience, which should help propel topline growth longer term. Further, the industry has seen more disciplined fleet management than in the past, which is favorable for the pricing environment. During the quarter, the company reported second quarter results generally in line with expectations while management commented that industry fleet tightening should further help pricing and noted July pricing in the Americas was up 1% year over year with the trend continuing into August. This has helped propel the stock price higher as sentiment continues to improve. Our PMV estimate for the company is near the $50 range as we have been trimming back the position into strength.

Innophos Holdings (Mark Dickherber and Shaun Nicholson, SBH)
The thesis for owning this stock is the aggressive cultural shift at the company toward a significantly improved capital allocation strategy driven by the new CEO and CFO, anchored by improving ROIC. This has not changed over the last three months. In our opinion, the stock is still significantly undervalued, assuming a successful rollout of the company’s capital allocation strategy over the next several years.

The stock performed well in the third quarter after underperforming in the second quarter. The primary reason was a strong second quarter with very solid execution, highlighted by a very attractive acquisition announcement. We added to the position in the early part of the quarter after it initially sold off post the positive second quarter earnings.

Top 10 Detractors as of the Quarter Ended September 30, 2017
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Cherokee Inc. 1.67 0.00 -60.43 -1.49 Consumer Discretionary
Avid Technology Inc. 3.22 0.01 -13.69 -0.48 Information Technology
Foot Locker Inc. 1.30 0.00 -25.40 -0.46 Consumer Discretionary
Wesco Aircraft Holdings Inc. 4.21 0.03 -13.36 -0.41 Industrials
Buffalo Wild Wings Inc. 1.96 0.09 -16.57 -0.37 Consumer Discretionary
Delta Air Lines Inc. 2.30 0.00 -9.70 -0.23 Industrials
Axon Enterprise Inc. 1.96 0.06 -9.82 -0.19 Industrials
Viasat Inc. 4.88 0.17 -2.84 -0.13 Information Technology
Tegna Inc. 1.50 0.00 -6.97 -0.11 Consumer Discretionary
Leucadia National Corp. 3.24 0.00 -3.06 -0.07 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 Detractors

Cherokee (Jeffrey Bronchick, Cove Street Capital)
Cherokee has continued to struggle to manage the acquisition of Hi-Tec Sports, a compilation of non-U.S. brands that continues to be ripe for growth as they gain more U.S. distribution. Management has not successfully scaled up the financial and back office operations required to do things like translate “IFRS to GAAP” in timely fashion. Subsequently, these internal issues have led to the company being late on reporting to the SEC and being unable to stay current with its lending covenants. We are “close” to the situation and can vouch for the fact that now Cherokee is focused intently on improving financial controls; leveraging the talents of the new chairman of the company, who has direct industry experience and can thus take some of the load off the CEO; making other financial and personnel changes at the company; and slimming down the brand portfolio to concentrate on material and viable growth opportunities. The current price reflects the fear and lack of output by the company as they work through non-public issues. We think there is a viable path for north of $10 with little good news, but more so a cessation of self-inflicted wounds.

Foot Locker (Dick Weiss, Wells Capital Management)
Foot Locker, a global retailer of athletic shoes and apparel, underperformed during the quarter. The company operates over 3,300 stores across the United States, Canada, Europe, and Australia with its highest margin sales coming from younger demographics, many of whom purchase athletic footwear and athletic and licensed apparel for both performance and fashion. The share price retreated during the quarter as the channel has gotten slightly more promotional. As such, sales were weaker than expected, which negatively impacted margins as well. However, the company remains a top destination for branded athletic footwear and should produce mid-single-digit topline growth with margin expansion as fixed costs are leveraged. Our PMV estimate for the company is near the $60 range and the stock is currently trading at an attractive valuation near 8x 2017 estimated earnings.

Buffalo Wild Wings (Mark Dickherber and Shaun Nicholson, SBH)
The thesis is predicated on an iconic restaurant brand that taps into strong consumer trends of beer, wings, and sports while offering some of the best public sports viewing experiences apart from being at the game. This has not changed over the last three months.

In the last three months, Buffalo Wild Wings has suffered from four issues, in our view: (1) a continued weak restaurant environment; (2) an unsuccessful promotion, which negatively impacted profitability; (3) record-high wing costs; and (4) investor fatigue waiting for new management. Our view is that today represents a very attractive reward-to-risk opportunity, and we have added to the position as we view many of the above pressures as transitory. As new management is appointed and strategic clarity is provided, we believe that investors will come to appreciate the multiyear ROIC improvement opportunity present. We have maintained our position overall as we also await the announcement of the new leadership team.