Litman Gregory Masters Equity Fund Third Quarter 2018 Attribution

During the third quarter of 2018, the Litman Gregory Masters Equity Fund gained 4.28%, underperforming its Russell 3000 Index benchmark (which gained 7.12%) and the Morningstar Large Blend Category (up 6.65%). It was an unusual three-month period as all seven of the fund’s managers lagged their respective benchmarks. Year to date, the fund has lagged the Russell 3000 by 345 basis points (bps) and the Morningstar category by 132 bps. Since its December 1996 inception, the fund’s 8.47% annualized return is in line with the Russell 3000 Index’s gain of 8.65% and ahead of the Morningstar category’s 7.10% return.

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 US bull market stretched into uncharted territory in the third calendar quarter, reaching its longest duration and one of its strongest up-cycle performances on record. Investors continued to focus on the good news—the US economy, Wall Street's version of earnings (“adjusted earnings”), and rising stock prices—while ignoring danger signals—overconfidence (as reflected in valuations), rising rates and inflation, unbridled debt accumulation, a burgeoning trade war, and perhaps some signs of fatigue in the economy. Faith in index funds and ETFs continued unabated, despite the "crowded trade" nature of many of these products. High confidence in technology shares harkens back to the 1990s, with exceptionally optimistic valuations for both established and start-up companies. Private equity transactions, in all but a small minority of cases, are taking place at record-high valuations and debt leverage. So-called covenant-lite conditions have returned to the high-yield arena. Across the board there appears to be little regard for safety and downside protection. Given this backdrop, the focus of the portfolio remains on maintaining a roster of outstanding business franchises with good balance sheets that trade at relatively attractive valuations.

Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices continued to be volatile last quarter due to trade fears, UK/European politics, and mixed though still generally positive economic data. These fears were largely discounted across US equity markets as investors focused on the positive fundamental backdrop, which led to rising stock prices. We share US investors’ optimism on certain segments of the market, particularly the more cyclical areas like industrials, consumer discretionary, financials, and certain communication stocks. We believe the outlook for underlying company fundamentals remains favorable and should lead to positive equity returns over the medium to long term.

We had two new holdings in our US equity portfolios last quarter: American Airlines and Charter Communications. We trimmed some positions on price strength and added to others on weakness. We sold our positions in Bank of America and Oshkosh.

Scott Moore, Nuance Investments
In our opinion, the opportunity set remains narrow as we enter the fourth quarter of 2018. Late economic and valuation cycle traits have clearly moved to the forefront in the last year or so, and the result is that few of our approximately 250 leading business franchises show significantly positive risk-reward opportunities. While the portfolio was relatively stable during the quarter, there were modest changes as our team continues to center on optimizing the best risk-reward situations we can find. During the quarter we lowered our weight in the health care sector as we exited our position in Becton Dickinson as the stock surpassed our view of fair value. We remain overweight to the health care sector as we continue to find select leaders like Dentsply Sirona and Smith & Nephew that we believe have better risk-reward profiles. We raised our weighting in the information technology sector as we have added Applied Materials to the portfolio after a period of significant underperformance due to cyclical issues in the semiconductor capital equipment space. Our weight in the financial sector is our largest sector weight, though it is in line with the benchmark. Within the financial sector, we are underweight to the bank and capital market industries and overweight to the insurance industry. We are seeing attractive opportunities in the insurance industry in both the property and casualty sub-industry due to under-earnings stemming from the relatively recent catastrophe impacts and the life and health insurance sub-industry largely due to continued low long-term interest rates coupled with some recent mortality issues. We continue to have an overweight position in the consumer staples sector where we see opportunities in names like Diageo, a leading spirits producer, and Sanderson Farms, a leading poultry producer. Our underweight position in the energy sector remains unchanged as we believe that crude oil–related companies are likely facing a multiyear period of competitive transition. We continue to be underweight in the utilities, real estate, and consumer discretionary sectors due to valuation concerns.

Chris Davis and Danton Goei, Davis Advisors
In the year-to-date period the US stock market returned 10.55%. Although we have witnessed somewhat more volatility in recent periods, US economic fundamentals remain strong with historically low unemployment, robust gross domestic product (GDP) growth, and modest inflation. The Federal Reserve continues on its path to normalize interest rates now that the economy has clearly recovered from the last financial crisis but is doing so in a gradual, measured, and manageable fashion thus far. In brief, the US economic backdrop and fundamentals appear favorable overall.

The portfolio performed in line with the S&P 500 Index during the year-to-date period. Our investments in Amazon.com, Alphabet, and Berkshire Hathaway were particularly accretive to performance during the period. Similarly, in the third quarter, Amazon, Berkshire Hathaway, and Alphabet were contributors to performance, while Wells Fargo was a detractor.

In terms of opportunities and risks, prospective growth rates and current valuations vary greatly by business and by industry at the moment. On average, the trailing price-to-earnings ratio of the S&P 500 Index is approximately 17x, which is neither inexpensive relative to history nor indicative of an overall market bubble. Today we see the greatest number of value opportunities in out-of-favor or out-of-the-spotlight businesses such as leading companies in the financial services industry, reasonably priced industrial companies, and attractively priced North American shale companies as well as a focused list of technology companies whose long-term growth rates justify somewhat higher multiples.

At the same time, we are consciously avoiding certain risks with an eye to preserving capital. For example, we are not meaningfully invested at this time in consumer staples, telecommunication stocks, or utilities stocks—groups normally associated with the so-called dividend darlings. While currently offering above-market dividend yields, these sectors remain fairly expensive especially in light of their rather anemic (and in some cases negative) top-line growth and high payout ratios. Furthermore, they become even more expensive if operating margins, which are at the high end of their historical range, are normalized. In other words, as a truly active manager we will continue to focus on businesses that our analysis indicates are compelling risk/reward opportunities and avoid those that do not meet our standards.

Consistent with our philosophy of buying durable businesses at value prices and holding them for the long term, we are investing selectively in businesses that meet our investment criteria of strong balance sheets, durable competitive moats, and the potential for earnings to expand over time with attractive valuations.

Frank Sands, Jr. and Michael Sramek, Sands Capital
We view secular trends, innovation, and company-specific competitive advantages as key to driving growth through a variety of economic environments. We believe the majority of businesses in the portfolio benefit from one or more secular trends, including e-commerce, the union of health care and technology, data-driven decision making, and software-as-a-service (SaaS) and cloud adoption.

Secular trends are distinct from short-term economic factors as they tend to persist through market cycles and can provide powerful structural tailwinds that enhance the sustainability of a business’s growth for many years. We believe our long-term investment horizon allows us to capture the benefit of these characteristics and realize the ultimate earnings power of a company, while weathering volatility over shorter periods. Furthermore, our approach—active, concentrated, and benchmark-agnostic—enables us to have outsized exposure to companies within this sphere that are the best fits with our six investment criteria (namely sustainable above-average growth, leadership in a promising business space, significant competitive advantage, clear mission and value-added focus, financial strength, and rational valuation and terms).

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, we look 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.

* 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

  • All 11 sectors comprising the Russell 3000 Index saw gains in the quarter.
  • Both stock selection and sector allocation detracted from the fund’s relative performance in the quarter, though stock selection had the more adverse effect. While consumer discretionary and information technology stocks in the fund were up overall during the quarter, they detracted from relative performance.
  • The fund’s consumer discretionary stocks gained over 4% in the period, falling short of their peers in the benchmark, which gained over 6.5%. While Amazon.com (owned by Davis Advisors and Sands Capital and discussed below by the Sands team) was the leading individual contributor to performance in the period with a gain of nearly 20%, other consumer discretionary stocks disappointed. The leading laggard in the space (and the portfolio as a whole) was Lear, which declined by almost 19% in the period. Sub-advisor Clyde McGregor discusses this position in greater detail below.
  • Facebook was a leading detractor within the information technology sector and the portfolio as a whole in the quarter. This stock, owned by the Sands team and discussed below, fell over 14%. What cost the portfolio more in terms of relative performance, however, was not owning Apple and Microsoft. These two benchmark positions are the top two holdings in the Russell 3000 Index, and gained over 22% and 16%, respectively.
  • Stock selection within financials was incrementally additive to relative performance in the quarter. In particular, Berkshire Hathaway gained over 15% in the period. The company’s two share classes are owned by FMI and Davis, and each discuss this holding below.
  • From an allocation perspective, other than health care, no sector had a notable impact on performance, either positive or negative. Health care detracted from relative performance as the fund’s average allocation to health care (nearly 7%) was slightly less than half that of the Russell 3000 Index benchmark. This hurt relative performance as the benchmark’s health care stocks were up nearly 14% in the quarter, compared to a 7.1% gain for the fund.
  • The fund’s cash position increased slightly from last quarter, averaging around 10.4%. The allocation to cash was among the biggest detractors from relative performance amid a rising equity market.

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
Amazon.com Inc. 3.8 2.6 19.78 0.72 Consumer Discretionary
Visa Inc. Class A 3.09 0.87 14.11 0.43 Information Technology
Arconic Inc. 1.45 0.03 33.22 0.43 Industrials
Berkshire Hathaway Inc. A 2.47 0.00 15.06 0.36 Financials
Alphabet Inc. A 3.63 1.23 8.13 0.29 Information Technology
Illumina Inc. 0.98 0.16 30.65 0.28 Health Care
C.H. Robinson Worldwide Inc. 1.49 0.04 16.61 0.26 Industrials
Salesforce.com Inc. 1.46 0.36 17.13 0.24 Information Technology
Zendesk Inc. 0.83 0.02 30.52 0.24 Information Technology
Berkshire Hathaway Inc. B 1.4 1.35 16.43 0.22 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 Contributors

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

Amazon is one of the largest Internet-based retailers in the United States and a growing global leader in the computing infrastructure-as-a-service (IaaS) space. We believe each business is positioned to participate in a long-duration growth opportunity. As a retailer, Amazon is a customer-centric company where people can find nearly anything they want to buy online. We expect e-commerce growth to continue to outpace overall retail spending for the foreseeable future and believe Amazon should be a primary beneficiary of this global secular trend. The company’s IaaS offering, Amazon Web Services (AWS), provides organizations with on-demand access to computing, storage, and other services through its cloud platform. Over the coming decades, we expect AWS will be a key player in the paradigm shift toward shared infrastructure services. We view Amazon’s two core franchises as attractive and rapidly growing businesses that each meet our investment criteria. We anticipate robust top-line growth, scale-based expense leverage, and higher-margin sales mix to drive above-average revenue and earnings growth over the next five years.

Amazon reported a great quarter, in our view. Retail profits and Amazon Web Services (AWS) were the standouts, but results were solid across the board. Within retail, reported profit of approximately $1.4 billion (versus a $290 million loss last year) was driven by continued growth in the high-margin advertising business and leverage on every expense line item this quarter. We expect large and growing retail profits will continue, but we’ll likely see ebbs and flows depending on Amazon’s investment levels. Additionally, gross merchandise volume grew 25 percent. In AWS, the movement to the public cloud is accelerating and more services are being adopted, which is benefiting all players in the industry. We believe the public cloud providers are going to be the biggest beneficiaries of artificial intelligence and machine learning, as they provide the tools that are resources for these computing- and storage-intensive applications.

As long-term growth investors, we view valuations through a five-year lens. In our view, Amazon is rationally valued based on our longer time horizon and our assessment of its growth prospects.

Arconic (Clyde McGregor, Harris Associates)

  • Arconic’s three primary operating divisions (engineered products and solutions, global rolled products, and transportation and construction solutions) possess unique strengths that we think works in the company’s favor for robust long-term revenue growth; we expect Arconic’s operating margins to expand materially, as reductions in corporate overhead, sourcing, and plant optimization are met with increases in capacity utilization.
  • Its engineered products and solutions division operates in a highly technical market with strong barriers to entry given the stringent certification process, high switching costs, and product quality/engineering demands.
  • Arconic’s recently developed Micromill technology is capable of producing aero and automotive parts that are twice as formable and at least 30% lighter than competing high-strength steel.

During the quarter, Arconic announced agreements with Lockheed Martin to develop advanced materials and manufacturing processes and with Boeing to supply aluminum parts for its commercial airplanes. Arconic also received multiple private equity inquiries in July to purchase some or all of the company. We appreciated signs of increased demand and improved execution at Arconic within its second quarter earnings results. Revenues increased 9.6% for the quarter, while automotive (up 14%), aero engines (up 10%) and aero defense (up 20%) all experienced double-digit organic growth during the reporting period. We believe the company’s end markets remain strong and its competitive position is solid.

Berkshire Hathaway Class A (Chris Davis and Danton Goei, Davis Advisors)

Berkshire Hathaway is a diversified holding company with interests in insurance, reinsurance, railroads, utilities, manufacturing, retailing, and a host of other business lines. Under the strong leadership of Warren Buffett and team, the company has compounded book value at 19% per year since 1965. During that time Berkshire has quietly evolved from a textile manufacturer to a well-run insurance operation and more recently to a diversified business with almost two-thirds of its earnings generated by nonfinancial operations. We believe Berkshire is a financial powerhouse and well positioned for continued steady growth, although at a somewhat slower pace given its already large size. In the year-to-date period, Berkshire Hathaway was a contributor to portfolio results, returning 7.5% in the period.

Berkshire Hathaway Class B (Pat English, FMI)

The thesis for owning Berkshire Hathaway was that the company traded at a discount valuation despite superior asset allocators at the helm. This thesis has not changed. Currently, the stock still sells at a discount to its intrinsic value and a sum-of-the-parts valuation. If one measures intrinsic value by what an outsider would pay for each of the Berkshire businesses, and added investments net of debt, the stock is still undervalued by approximately 15%–20%.

Top 10 Detractors as of the Quarter Ended September 30, 2018

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Lear Corp. 1.84 0.04 -18.87 -0.39 Consumer Discretionary
Facebook Inc. A 1.22 1.48 -14.85 -0.2 Information Technology
General Motors Co. 1.32 0.17 -12.37 -0.18 Consumer Discretionary
Agnico Eagle Mines Ltd. 0.59 0.00 -25.06 -0.18 Materials
Alibaba Group Holdings SP 1.34 0.00 -9.56 -0.14 Information Technology
Tencent Holdings Ltd. 0.66 0.00 -17.19 -0.13 Information Technology
Chesapeake Energy Corp. 0.66 0.01 -14.5 -0.11 Energy
Dentsply Sirona Inc. 0.65 0.03 -15.67 -0.11 Health Care
Adecco Group AG 0.85 0.00 -11.18 -0.1 Industrials
General Electric Co. 0.59 0.38 -16.14 -0.1 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 Detractors

Lear (Clyde McGregor, Harris Associates)

We think that Lear’s management team, which was reorganized in the past few years, has vastly improved since we last held a position in this company. In our assessment, Lear maintains a strong balance sheet and has a history of returning excess cash to shareholders through share repurchases. We believe Lear is well positioned to benefit from increasing automobile demand.

Lear’s second quarter results aligned with information previously provided at the company’s analyst day in late June. Revenue totaled $5.58 billion, which was 9% higher than in the prior year. Core operating earnings increased 7% year over year and reached a record of $471 million, which led to record adjusted earnings per share of $4.95, up 13% from a year ago. Management reaffirmed full-year guidance, which reiterated expectations for $21.8–$22 billion of total revenue and roughly $1.8 billion of core operating earnings, as well as other metrics. Despite these solid results, Lear’s stock price declined. The unchanged financial outlook appears to have disappointed investors because over the past three years, management typically raised full-year guidance on a quarterly basis. Nevertheless, we are satisfied with management’s full-year expectations and believe that Lear is a high-quality company with shares that remain attractively priced.

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

Facebook is the leading social networking business globally, engaging approximately a fourth of the world’s population on a monthly basis across a family of apps, each with more than one billion users, including core Facebook, Instagram, Messenger, and WhatsApp. Facebook leverages the information it captures on users’ social connections and interests to sell highly targeted ads. We believe Facebook’s massive user base and ability to deliver highly relevant and high-performing ads at scale will allow the company to continue to benefit disproportionately from the growth of digital advertising budgets globally. In the near term, we believe continued growth in users and user engagement on the company’s core Facebook and Instagram applications will sustain above-average growth. Longer term, we believe efforts to make Facebook more of a destination for video content, along with monetization of Messenger and WhatsApp, will help extend the duration of the company’s growth opportunity.

Facebook’s share price was pressured due to (1) the company’s first advertising revenue miss relative to expectations in many years, (2) guidance which calls for a sharper-than-expected deceleration in the back half of the year, and (3) long-term guidance for mid-30%-range operating margins, down from the mid-40% range today. We believe the revenue guidance for the second half of the year can largely be attributed to foreign exchange as well as mix-shift toward Stories, which are monetized at a lower rate than Facebook’s newsfeed today. Over the long term, we expect Stories to monetize at least as well as the Facebook newsfeed, and view greater use of Stories as a long-term positive for engagement. We view margin guidance as a reset and believe it reflects the growing costs of addressing recent privacy issues. We think the opportunity to layer on incremental revenue from services such as Messenger, WhatsApp, and video likely drive upside to revenue over our investment horizon. With respect to Facebook’s core business, increases in ad load are no longer a tailwind for core Facebook or Instagram feeds.

As long-term growth investors, we view valuations through a five-year lens. In our view, Facebook is rationally valued based on our longer time horizon and our assessment of its growth prospects.

Agnico Eagle Mines (Dick Weiss, Wells Capital Management)

Agnico Eagle Mines is a gold mining company. The entire gold space has been under pressure recently as the underlying commodity has declined from approximately $1300 per ounce to $1200 per ounce over the past three months, largely due to US dollar and real bond yield strength, both of which appear to be topping out as of late. Mining stocks in the space have underperformed the broader market during the quarter due to leverage to the underlying commodity weakness. However, on several valuation metrics, gold stocks are trading close to all-time lows, and we feel optimistic about Agnico in particular. Beyond macro and seasonal factors, there are other sector-specific dynamics that could lift gold stocks, including potential further industry consolidation sparked by the Barrick-Randgold merger deal and an increased focus on improving margins rather than chasing costly replacement ounces. The consensus view seems to be that there needs to be catalysts other than gold prices to drive generalist investor interest, and mergers and acquisitions and more efficient operations might be those catalysts. Agnico is especially well positioned in the current environment as most operators are facing declining production profiles driven by a combination of limited new discoveries, longer permitting, and an increased number of development surprises like Rainy River and Rubicon, which will lead to falling mine supply. And with miners’ more complex relationships with host countries like the Democratic Republic of the Congo and Tanzania, the number of countries where miners feel comfortable investing has fallen significantly. By contrast Agnico is growing its production toward 2 million oz. per annum and has other projects that could take this higher, so that when generalist money comes back into the space, Agnico should benefit disproportionately. Hence, we have been adding to the position around recent lows.