Litman Gregory Masters Smaller Companies Fund Third Quarter 2018 Attribution

The Litman Gregory Masters Smaller Companies Fund gained 2.24% in the third quarter of 2018. The fund underperformed its Russell 2000 Index benchmark, which gained 3.58%, and trailed the Morningstar Small Blend peer group, which gained 2.79%. Year to date, the fund gained 7.72%, compared to 11.51% for the Russell 2000 and 8.28% for the Morningstar category.

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 results are now a bit more satisfactory with the conclusion of the third calendar quarter, although we still have some work to do on a relative basis.

What changed? Nothing. It remains a universal mystery as to why some stocks move during the week of September 14 versus the third Thursday of October, and thus we endeavor not to pay much attention to the short run, no matter how much it seems to mock us. We simply bought more of what hadn’t moved and resisted the temptation to create activity for activity’s sake. Fortunately, enough “other people” came around to our viewpoint and bid some of our larger positions up. Not all of them, but enough.

Going forward, more of the same. The financial world improbably is holding up well in the face of political weirdness, rising interest rates, less liquidity, awful economic policy, and historically high valuations. Blending Herbert Stein and Lord Keynes, if it can’t go on forever, it won’t. But it certainly has gone on a lot longer than we would have thought and being positioned conservatively hasn’t helped us a bit over the last few years. We do what we do: look at what Mr. Market offers us, research the hell out of possible opportunities, pass on most of them. Then when we pick our spots; we try to buy them with conviction and in size.

We appreciate your continued partnership and are firmly convinced things are on track as it relates to Cove Street and the management of your capital.

Dick Weiss, Wells Capital Management
Over the period, US equities performed well and outpaced other global regions. The backdrop for the market remains fundamentally sound with low unemployment, still low inflation, and strong earnings growth that has helped to offset valuation concerns. Staying true to our process, the portfolio looks for opportunities through bottom-up stock selection. As such, there were no broad-based themes that have influenced portfolio positioning, but we remain cognizant that momentum factors in the market have performed well. We have trimmed these areas of the portfolio and have deployed capital to more “value” stocks that appear attractive relative to our intrinsic value assessment.

Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
During the third quarter of 2018, we made a number of changes to the portfolio. After meeting with executive teams (including CEOs) at NCR Corp. and Treehouse Foods, we were encouraged by their focus on improving returns on invested capital, as well as the reinvestment opportunities. Conversely, we sold Spartan Motors due reward to risk concerns, and Bemis due to a takeout offer.

In our view, the current environment is nearing a “return-free risk” market unless you employ an active approach that seeks to invest in undervalued assets in which management teams are transforming capital allocation to drive improving return on invested capital (ROIC). Our team’s ROIC analysis goes a long way in understanding each company’s embedded expectations, but more importantly, it helps identify what each management team is doing to improve the ROIC of the underlying assets to increase value for shareholders. While we have not yet seen cost of capital pressures in a massive way, more recently we have noticed the market has discerned between capital allocators by rewarding those with an improving ROIC lens. We are not market timers, but we are cognizant of risks that are out there in order to better assess which risks we are accepting when we buy/hold stocks in the strategy. We believe we can help reduce risk and hopefully position for relative outperformance over cycles by focusing on ROIC-improving opportunities with management teams that are improving employee behaviors by incentivizing better capital allocation. We are excited about the opportunity to add value regardless of whether we might be seeing the early signs of volatility’s return.

* 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

  • The majority of Russell 2000 sectors had positive returns in the third quarter of 2018.
  • Most of the fund’s relative underperformance stemmed from stock selection in the communications services, consumer discretionary, and energy sectors.
  • Telecommunications company Millicom International Cellular (the sole communications services name in the portfolio), owned by Jeff Bronchick at Cove Street Capital, declined around 3% in the period. While the stock-price decline was modest, the stock is the portfolio’s third-largest position (3.4%), which magnified the effect of the decline. Communication services stocks account for less than 1% of the benchmark but gained nearly 22% in the period.
  • Within consumer discretionary, EW Scripps (owned by Bronchick) gained over 25% in the period and was the leading individual stock contributor. Unfortunately, this was not able to fully offset the declines of other consumer discretionary holdings such as Shutterfly and Groupon, which fell over 25% and 12%, respectively, in the quarter. Shutterfly is owned by Dick Weiss of Wells Capital, who discusses the position in greater detail below.
  • Within energy, Alta Mesa Resources was the fund’s largest single detractor in the period, falling more than 37%. Weiss added the stock to the portfolio early this year, and it is discussed below.
  • The contribution from stock selection was strongest in the industrials sector. One of the portfolio’s newest holdings Southwest Airlines (added late in the second quarter) gained more than 23% in the period, while HNI gained 18%. Both names were owned by Weiss and were top-10 holdings during the quarter.
  • At the individual stock level, medical device manufacturer Integer Holdings gained 28% and was the second-largest contributor in the period. The stock is owned by Weiss and discussed below. Another top contributor was materials company Bemis, which gained nearly 15% before being sold by the SBH team at the very end of the quarter; the stock is discussed below.
  • Cash averaged over 11% in the quarter and was a meaningful detractor to relative performance as the small-cap market advanced.
Top 10 Contributors as of the Quarter Ended September 30, 2018
Company Name Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
The E W Scripps Co. Class A 2.99 0.03 25.43 0.66 Consumer Discretionary
Integer Holdings Corp. 2.14 0.1 28.31 0.56 Health Care
Avid Technology Inc. 3.00 0.01 16.76 0.46 Information Technology
Bemis Co. Inc. 1.62 0.00 14.96 0.45 Materials
GTT Communications Inc. 1.22 0.07 24.44 0.44 Information Technology
Southwest Airlines Co. 1.95 0.00 23.34 0.42 Industrials
HNI Corp. 2.04 0.08 18.47 0.37 Industrials
Bank of N.T Butterfield & Son Ltd. 1.95 0.12 15.38 0.29 Financials
MacQuarie Infrastructure Corp. 2.58 0.00 10.85 0.28 Industrials
Pandora Media Inc. 1.58 0.09 14.9 0.27 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 Selected Contributors

Integer Holdings (Dick Weiss, Wells Capital Management)

Integer Holdings is a medical device developer and manufacturer. The stock benefited from very strong quarterly results, which was highlighted by accelerating organic revenue growth in all its business segments apart from electrochem, with total organic growth accelerating to 8% from 6% last quarter, margin expansion, and strong free cash flow generation used to pay down debt. Including the $550 million debt paydown that was done in the third quarter with proceeds from a recent divestiture, leverage improved to 4x, which is down from 5.6x at year-end 2017, and the company expects to bring it down to 3.5x by year-end 2018. Integer’s two-year forward price-to-earnings multiple expanded from 17x to 20x during the quarter as the market gained incremental confidence in the new management’s team portfolio optimization strategy, which should result in stronger-than-industry top-line growth, higher margins, and higher returns. We’ve taken advantage of the strength in the stock to trim the position; however, we continue to like the company as a core holding given its improving growth trajectory, debt reduction via free cash flow generation, and the new management team’s focus on driving returns.

Bemis (Mark Dickherber and Shaun Nicholson, SBH)

Our thesis for Bemis reflected the company’s improving ROIC story as new management has focused on lean manufacturing and facility consolidation to drive incremental ROIC improvements. The involvement of Starboard, an activist investor, provided us with more confidence in not only the urgency in the level of change, but also in the potential pursuit of alternatives as new board members and a change to the board’s charter made it apparent that all value creation avenues would likely be pursued. In early August, Bemis announced its intention to sell to Amcor in a stock deal for a reasonable premium. We used the announced sale as an opportunity to sell shares in Bemis given upside was completely contingent on Amcor’s stock price as opposed to management decisions surrounding ROIC.

GTT Communications (Jeffrey Bronchick, Cove Street Capital)

GTT Communications is a provider of cloud networking services and broadband connectivity to multinational enterprises and government customers. Increasing margins, due to owning physical infrastructure assets, combined with a low-capital-intensity service/integration business, create an interesting hybrid model that is poised to grow well in a world of ever-expanding international interconnectedness. The prior quarter’s relatively poor results created an over-reaction in the stock price and provided the opportunity for us to buy more, and we were well positioned for the rebound off the lows that occurred this quarter.

Top 10 Detractors as of the Quarter Ended September 30, 2018
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Alta Mesa Resources Inc. A 1.06 0.02 -37.35 -0.5 Energy
Innophos Holdings, Inc. 6.35 0.04 -6.05 -0.42 Materials
Shutterfly Inc. A 1.34 0.12 -25.72 -0.4 Consumer Discretionary
Criteo SA 0.98 0.00 -29.88 -0.35 Consumer Discretionary
MAM Software Group Inc. 3.16 0.00 -10.13 -0.33 Information Technology
Groupon Inc. 1.79 0.09 -12.88 -0.23 Consumer Discretionary
Cimarex Energy Co. 1.89 0.00 -9.32 -0.2 Energy
Orthofix Medical Inc. 1.41 0.04 -5.98 -0.15 Health Care
Viasat Inc. 4.65 0.16 -4.19 -0.13 Information Technology
SPX Corp. 2.4 0.07 -5.02 -0.13 Industrials

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

Alta Mesa Resources (Dick Weiss, Wells Capital Management)

Alta Mesa Resources is an exploration and production company. Three issues have hurt the stock recently: One, third-party volumes were lost earlier in 2018 as a result of not having the capital available, largely as a result of the late closing of an acquisition in February 2018. Two, fears around other SCOOP/STACK (groups of production basins) operators lowering type curves and the implications for Alta Mesa. The STACK is nuanced depending on what specific part of the basin is being discussed, and while this adds an element of complexity to the investment thesis, there is a common misconception with Alta Mesa’s acreage where the acreage is located in the shallower, normally pressured area of black oil window. This gives Alta Mesa advantaged porosity and deliverability for those intervals in this area and helps mitigate the loss in productivity associated with the reservoirs’ phase window and pressure regime. Three, in the most recent quarter, the company issued initial 2018 production exit rate guidance 23% below consensus and completely withdrew prior 2018 midstream EBITDA (earnings before interest, taxes, depreciation, and amortization) guidance. Second quarter oil volumes were light due to shut-ins for offset well completions, and midstream EBITDA in the quarter was light due to lower than anticipated Alta Mesa gas processing volumes and to a lesser extent lower operating margins and lower third-party volume forecasts. The withdrawal of 2018 midstream EBITDA guidance was attributable to the delayed ramp of third-party production volumes, but also the timing uncertainty related to the transfer of a produced water system to Kingfisher Midstream. After talking with the management team several times following the quarter, the issue was timing as well as the geographic orientation of the wells, both of which appear to have been resolved, but we believe the stock is firmly a show-me story with the valuation at 4x upstream 2019 EV/EBITDA. We are currently evaluating exit strategies for the stock.

Shutterfly (Dick Weiss, Wells Capital Management)

Shutterfly is a provider of digital personalized photo products and services. After strong stock performance earlier in the year in which the valuation expanded from 6.8x 2019 EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization) to 10x EV/EBITDA in June following two consecutive strong quarters as well as the LifeTouch acquisition announcement, the stock has since traded back to 7x 2019 EV/EBITDA following the last quarterly print. In addition to weakness in the broader small- to mid-cap Internet space recently, Shutterfly is experiencing lingering questions around the durability of the consumer business after posting slower than expected results in the prior quarter. However, these results were largely due to the company intentionally pulling back the use of free promotions, thus improving the quality of the revenue and earnings. For the stock to work, the market needs to believe the consumer business has stabilized for the stock to hold that premium multiple that was driven by the step-up in growth. After meeting with management and analyzing the impact of the LifeTouch acquisition, we concluded that the market is giving Shutterfly very little, if any, credit for the acquisition, associated synergies, or the improvement in the consumer business, considering the public multiples are within a few percentage points of where they were at the beginning of this year. Thus, we are taking advantage of the recent weakness and have been slowly adding at current levels.

MAM Software Group (Jeffrey Bronchick, Cove Street Capital)

MAM Software is a provider of software applications to tire store chains, auto warehouse distributors, and auto parts stores. While organic growth for the company exceeded 10%, the main disappointment in the stock this quarter was a further delay in the rollout of their new ERP (enterprise resource planning) software system for the Goodyear dealership network. The Goodyear opportunity could nearly double the recurring revenue profile of MAM, building an excellent base for additional revenue and customer expansion upon which MAM can continue to build its niche software solutions. Our research indicates that significant upside exists both on an organic basis as well as for the private market value of the company.