Litman Gregory Masters Smaller Companies Fund Fourth Quarter 2016 Attribution

During the fourth quarter of 2016, the Litman Gregory Masters Smaller Companies Fund rose 7.36%, trailing the Russell 2000 Index return of 8.83% and the Morningstar Small Blend Category return of 9.53%. For the year, the fund was up 18.82%, underperforming both the Russell 2000 and the peer category, which returned 21.31% and 20.62%, 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
This was a fascinating end to a fascinating year, and with the glow of the year-end holidays behind us, we will try to put some thoughts down about what we witnessed.

What is always interesting to professional investors is that there is sometimes confusion over what constitutes our common goals. If our goal is to intelligently achieve wealth creation by positioning our clients in small-cap stocks that have business models and asset values that appear to us to be unappreciated and thus possess less risk than do alternative propositions, then we had a great year. There is no actuarial hurdle or retirement goal that was not achieved by our performance in 2016. The year also clearly demonstrated a long-held investment tenet at Cove Street Capital: the future remains uncertain and thus one is well served by sticking to the long-term game plan and ignoring the hooting and hollering du jour. It also shows that it is very difficult for the human mind, much less an investment committee, to wake up and dramatically change course on a dime. You were either “there” on election night, or you mostly missed it. We were mostly there.

On the other hand, on a relative-to-the-index basis, we were “smoked” in the fourth quarter by a mad rush into the equity markets, particularly as it relates to small-cap stocks and financials. We would note in a questionable analogy that we are clearly running a very concentrated portfolio, and in certain market environments, owning a lot of “infantry” is helpful in the short run if your “generals” are going to sit still behind a broad advance. And as we have often noted, the Russell 2000 Value Index is heavily weighted with financials (31% as of 12/31/2016), and there are clearly short-term periods where we are either helped or hurt by this percentage. Post-election, with the specter of onerous Dodd-Frank regulations being relaxed and punitively low interest rates likely moving higher, this financial sector’s performance was up approximately 26% over the quarter. The other truism about investing in general, and regarding small cap in particular, is that you are either invested before market-moving events occur or you aren’t likely to participate at all given liquidity issues. We have been leery of bank stocks in general given they represent geographically narrow, highly leveraged bets on commercial real estate, a proposition we have fully considered and passed on given where we think we are in the real estate cycle and with valuations well north of book value. Let’s just say valuations are a lot farther north of book value at the end of 2016.

Going forward, we will reiterate that the future remains uncertain. Our present cognitive dissonance involves the following thoughts: huge moves in equities usually start from low expectations, low valuations, investor apathy and apprehension, and a move from higher to lower interest rates. It seems fairly obvious that these preconditions do not exist now. This is compared and contrasted to a long history of markets in which all big moves seem bewildering at the beginning, as prices move well ahead of actual fundamentals, and then earnings and cash flows magically catch-up. Waiting for the evidence to be delivered to your inbox is not a recipe for successful investing. “Things will be different” starting January 20, and many of them on a purely economic basis are likely to be highly beneficial to wealth creation and economic activity. How much benefit will be delivered and how much has been “pre-sold” by the markets in the fourth quarter will likely be revealed early in 2017. We close with yet another quote from Ben Graham, one of the founding fathers of value investing:

“The investor who buys securities only when the market price looks cheap on the basis of the company’s statements and sells them when they look high on the same basis, probably will not make spectacular profits. But on the other hand, he will probably avoid equally spectacular and more frequent losses. He should have a better-than-average chance of obtaining satisfactory results. And this is the chief objective of intelligent investing.”

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.

Dennis Bryan and Arik Ahitov, FPA
For the fourth quarter and year, small- to mid-capitalized stocks performed better than larger-cap stocks. For instance, the Russell 2500 Index rose 6.1% and 17.6%, respectively, in the fourth quarter and 2016, while the S&P 500 Index rose 3.8% and 11.9%, respectively, in the fourth quarter and 2016.

We have been asked a few times why small- to mid-cap stocks performed better than larger caps in the quarter and 2016, despite entering the year with much higher valuations than larger-cap stocks. While nobody knows the answer with perfect insight, one reasonable explanation is that small- and mid-cap companies generally have more domestic-oriented revenues and profits than the larger multinational corporations. If the expectation is that the U.S. economy will grow faster than Europe and Japan, for example, then the above is fairly intuitive.

Most stocks maintained an upward bias as 2016 progressed. Furthermore, the dollar strengthened when it became clear that the Federal government was going to try to stimulate the U.S. economy with large infrastructure projects—irrespective of who won the presidential election. A stronger dollar, all else being equal, typically has a negative impact on foreign earnings as those earnings are translated into U.S. GAAP net income. Generally, larger-cap companies earn more of their profits from overseas activities than smaller-cap companies. Hence, at the margin, investors gravitated more toward smaller- to mid-cap companies than larger-cap stocks.

Now looking prospectively, we believe the new White House administration, along with the Republican-controlled Congress, will try to restructure the regulatory framework for many U.S. industries. We believe Washington politicians will also attempt to simplify the labyrinth tax code, and we could see significant change to how imports and exports are treated at the Federal government level. Some of these potential changes could result in material, long-term structural adjustments to how industries are regulated.

Furthermore, when we throw into the mix the possibility of higher interest rates and potentially large swings in currencies, we would not be surprised to see increased volatility as the year develops.

Finally, several important European countries have national elections in 2017, and some leading candidates are calling for radical changes—including replacing the euro currency with the former currencies from their respective countries. However, we believe the fund is well positioned to seize opportunities that may arise should we experience an increase in volatility, and we are ready to buy stocks that meet our strict investment philosophy.

* 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

  • All Russell 2000 sectors but one (health care) were positive for the fourth quarter. The fund’s sector allocation was a positive contributor to relative performance, but this was more than offset by stock selection, which detracted overall.
  • Health care, despite falling 6.09% in the benchmark during the period, was by far the portfolio’s leading sector contributor. This was not only due to the portfolio’s significant underweight position (3.57% versus 13.01%) to this worst-performing sector, but also due to strong stock picking within health care. (The average health care stock in the portfolio gained 25.71%.) Medical device company Integer Holdings, owned by Dick Weiss and discussed below, was up 35.78% in the quarter, and was the second-largest individual contributor to relative performance.
  • The second-biggest sector contributor was information technology, with stock selection driving relative outperformance. This sector gained 10.52% in the portfolio, versus 5.01% in the benchmark. Two of the strong individual performers were long-term holdings, Brocade Communications Systems, owned by Weiss, and Western Digital, owned by FPA. These positions were up 35.92% and 17.05%, respectively, in the quarter.
  • The most significant detractor from a sector perspective was financials. Financials benefited in the wake of the U.S. presidential election result, and ended the quarter up 23.39% in the benchmark—more than any other sector. However, the portfolio was underweight this sector during the quarter (18.88% versus 23.39%). Nevertheless, Leucadia National was the largest individual contributor to the portfolio’s return. Owned by Jeffrey Bronchick and discussed in greater detail below, this position held an average weight in the portfolio of over four percent, and returned 22.43%.
  • Stock selection within the consumer discretionary sector detracted from relative performance. While the sector gained 7.91% for the benchmark, it was up just 1.90% in the fund. Two names account for much of this underperformance: MDC Partners, owned by Weiss, and Liberty Global, owned by Bronchick. During the quarter, these stocks were down 38.90% and 20.41%, respectively, and are discussed below.
  • The fund’s cash allocation—just under 13%, on average—was a drag on relative performance during the quarter given the positive return of the Russell 2000 benchmark.
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
Leucadia National Corp. 4.55 0.00 22.43 0.85 Financials
Integer Holdings Corp. 2.20 0.04 35.78 0.71 Health Care
Heritage-Crystal Clean Inc. 3.95 0.01 18.22 0.67 Industrials
Western Digital Corp. 3.94 0.00 17.05 0.66 Technology
Aaron's Inc. 2.34 0.10 25.95 0.64 Consumer Discretionary
Delta Air Lines Inc. 2.52 0.00 25.54 0.57 Industrials
Microsemi Corp. 2.10 0.31 28.56 0.57 Technology
DeVry Education Group Inc. 1.64 0.09 36.12 0.55 Consumer Discretionary
Tegna Inc. 2.20 0.00 17.78 0.54 Consumer Discretionary
CNO Financial Group Inc. 2.23 0.17 25.95 0.54 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

Leucadia National (Jeffrey Bronchick, Cove Street Capital)
Leucadia National is a holding company that owns stakes in a number of companies in businesses that range from financial services to car dealerships to beef processing. Until very recently, the financial services side that is mostly made up of Jefferies has been suffering from low interest rates and limited volatility in financial markets. However, with the Federal Reserve announcement of its intention to raise rates throughout 2017 and the U.S. election results causing an increase in trading activity, the market has (finally) begun to factor in the earnings power of Jefferies in a more favorable environment. Additionally, after a few years of producing terrible results, the beef processing business (Natural Beef) has begun to rebound and the management team has given guidance for much higher margins in the future. The increase in the stock price during the quarter reflects a number of these positives, but our research suggests that the market is still undervaluing the various assets and is underestimating the quality of the capital allocators who run the company.

Integer Holdings (Dick Weiss, Wells Capital Management)
Integer Holdings manufactures and develops medical devices and components. The stock had a strong fourth quarter, appreciating 35%. During the quarter, the company reported sales of $347 million, which were in line with estimates of $347 million. Further, the company reported free cash flow of $22 million in the quarter and expects quarterly free cash flow to be positive going forward. This should allow Integer to pay down debt and improve its debt ratios. As such, the stock benefited from multiple expansion as its valuation has been depressed for much of the year. We currently have a private market value on the stock in the high $40s.

Aaron’s (Dennis Bryan and Arik Ahitov, FPA)
Aaron’s appreciated nearly 26% in the last quarter of the year. Aaron’s is a rent-to-own company. If a customer cannot pay for a product in full because they have no credit, they lease it for 24 months with the option of returning the product any time they like. At the end of the term, the customer will own the product. At the time of the investment, Aaron’s fit our criteria in the following ways:

  • Market leading company: Aaron’s and Rent-A-Center control two-thirds of the market
  • It has a history of profitability and grew its revenues through the recession
  • It had a very low-levered balance sheet

We were able to double our investment following Aaron’s purchase of Progressive in mid-2014. Progressive is a virtual finance company with thousands of merchant partners that give them access to more than 15,000 doors. Their software and algorithm, which is directly connected to the merchant’s point-of-sales device, can make underwriting decisions instantly looking at 500 attributes. Unlike some competitors, there are no kiosks or employees needed.

Following the Progressive acquisition, the CEO of that business became the CEO of the overall company—a move that we endorsed and are really excited about. Soon afterward, the new CEO sold the corporate headquarters, cut frivolous advertising expenses, bolstered the management team, and sold a small business.

We think that the inclusion of Progressive will improve revenue growth and current efforts by the management team will result in cost cuts. The combination of the two should be very good for future results.

Top 10 Individual Detractors as of the Quarter Ended December 31, 2016
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
MDC Partners Inc. A 1.80 0.02 -38.90 -0.90 Consumer Discretionary
Millicom International Cellular SA 2.96 0.00 -18.87 -0.65 Telecommunications
Liberty Global PLC LILAC 2.51 0.00 -20.41 -0.63 Consumer Discretionary
Viasat Inc. 4.14 0.18 -11.29 -0.56 Technology
Taser International Inc. 1.90 0.07 -15.27 -0.33 Industrials
Goldcorp Inc. 1.30 0.00 -17.55 -0.26 Materials
Entravision Communications Corp. 0.87 0.02 -12.84 -0.22 Consumer Discretionary
Houghton Mifflin Harcourt Co. 0.98 0.08 -19.09 -0.22 Consumer Discretionary
Range Resources Corp. 1.39 0.00 -11.28 -0.14 Energy
Etsy Inc. 0.84 0.08 -17.51 -0.11 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 Selected Detractors

MDC Partners (Dick Weiss, Wells Capital Management)
MDC Partners is an advertising agency that engages in global marketing, advertising, communication, and strategic consulting solutions. During the quarter, the company reported disappointing third quarter results as organic revenue growth came in at 2.7% and EBITDA margins of 13.2% were below expectations. Management commented on seeing a slowdown in the U.S. market with some clients delaying projects. As a result, management is taking the appropriate steps to cut costs with a goal of reducing 2017 run-rate operating expenses by $30 million annually. After an initial selloff on the quarter print, the stock has recovered most of its decline. We currently have a private market value on the stock in the low double digits.

Liberty Global LiLAC (Jeffrey Bronchick, Cove Street Capital)
Liberty Global LiLAC is a tracking stock for the Latin America assets of Liberty Global. The initial returns make it clear that we have been early in our investment. Not long after we purchased the shares, LiLAC announced the acquisition of Cable & Wireless, a deal which added more scale within the Caribbean and Central America. Unfortunately, the subsequent results suggest that LiLAC overpaid for Cable & Wireless and underestimated the impact of competitive pressures in the acquired markets. However, despite the rocky start to this marriage, our analysis indicates that the combination creates a platform to continue to consolidate the Latin American and South American cable markets. In addition, even absent further acquisitions, increasing pay-TV penetration and high-return capital investments should allow LiLAC to grow its cash flows at a very respectable rate. As a result, we view the stock as materially undervalued in the low $20s.

ViaSat (Jeffrey Bronchick, Cove Street Capital)
ViaSat, a provider of defense systems and satellite connectivity, performed poorly for the quarter as the company underwent an equity raise in order to accelerate funding of its future third-generation satellites. However, the fundamental results have all been positive with defense revenues and profits growing at 20% and satellite services margins approaching 45%. Continued penetration by the company into airborne services for the military and government are providing excellent high-margin growth to the government segment and generating additional contract wins for future deployments. We continue to see this as a long-term compounder driven by technological moats that its competitors cannot surmount in the short or medium term.

Houghton Mifflin Harcourt (Dennis Bryan and Arik Ahitov, FPA)
Houghton Mifflin Harcourt is a leading provider of K-12 instruction materials for the classroom and part of an oligopoly of three players that control about 90% of the market. The stock has been battered by a series of guidance reductions, fears of lost market share, and poor communication with the investment community. These missteps ultimately led to the dismissal of the CEO in late September. As the stock price corrected, we have increased our position significantly from where we started the year.

While the issues facing Houghton Mifflin are concerning, we still see a lot to like. It is a leading company in the education space and controls about 40% market share in the top disciplines of math, reading, and science. There are significant barriers to entry, as new education material needs to prove its efficacy prior to being adopted, and attacking local school districts on a national scale requires a huge salesforce. Furthermore, the transition to digital could be a margin expansion opportunity as physical printing costs come down. Over the cycle, this business has a history of delivering strong free cash flows, and we expect that to continue.

Our downside price of $8 assumes that the education market share falls to 33% and our upside price of $19 assumes the education market share expands to 42%. We are also making what we consider to be relatively conservative assumptions around cash EBITDA margins and multiples. (At year-end, the stock traded at $10.85.)