Litman Gregory Masters International Fund First Quarter 2017 Attribution

During the first quarter of 2017, the Litman Gregory Masters International Fund gained 8.19% and the MSCI ACWI ex USA Index was up 7.86%. The MSCI EAFE Index returned 7.24% in the quarter and the Morningstar Foreign Large Blend Category gained 7.76%.i Since its inception in December 1997, the fund has compounded returns at an annual rate of 7.20% after fees, while MSCI ACWI ex USA, MSCI EAFE, and its blend peers have gained 5.09%, 4.65%, and 4.08%, 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
Equity prices continued to climb last quarter on an improving outlook for the global economy. Though equity valuations aren’t as cheap as they once were, our outlook remains positive. We expect a combination of dividends and underlying value growth to be in the high single digits over the next couple of years. Our confidence is based on the strength of our companies’ balance sheets, low interest rates, low inflation, unprecedented 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’re finding attractive opportunities in the financial, industrial, and consumer discretionary sectors. We continue to avoid most companies that the market views as “stable” (like those in the telecom, utility, and consumer staples sectors) due to valuation. However, as always, we continue to view company opportunities on a case-by-case basis and believe any company can be attractive at the right price. Geographically, we remain primarily focused on developed markets based on our belief that they represent the best combination of price and quality. We are selectively exploring different opportunities in emerging markets, but our exposure in these markets remains modest.

Vinson Walden, Thornburg
Markets rallied worldwide to start the year, with all major bourses extending their gains from the second half of 2016. Underpinning this has been a host of factors including favorable macroeconomic developments in many regions and accommodative monetary policy from major central banks.

On the macroeconomic front, global growth expectations have risen, supporting a rotation of investor preferences from more defensive assets toward more economically sensitive ones. The U.S. election in November initially added fuel to budding growth expectations, though it now appears that political gridlock could persist in Washington, D.C. The Federal Reserve has signaled that a faster pace of federal funds target interest rate hikes is probable in 2017 and 2018, although most other major central banks continue to pursue easy monetary conditions. We are also following political elections and other developments in Europe this year.

Howard Appleby, Jean-François Ducrest and Jim LaTorre, Northern Cross
The Northern Cross team continues to pursue a balanced approach looking for growth companies at a discount and consistent compounders to drive outperformance. The team did not make many significant changes during the quarter. We continue to see significant upside in Las Vegas Sands (LVS) and believe that the recent data out of Macau supports our thesis of sustainable recovery. In addition, we are hopeful that LVS will eventually be awarded a concession to develop an integrated resort in Japan, adding an additional earnings driver (to the company’s current properties in the United States, Macau, and Singapore). As such, LVS remains our largest position in the portfolio. During the quarter, we increased the relative size of our position in media company Vivendi. The crown jewel in Vivendi is its ownership of Universal Music Group, which we expect to demonstrate significant earnings growth from the rapid rise in music subscription services. We don’t think this upcoming inflection in earnings power is reflected in the share price.

Mark Little, Lazard Asset Management
International equities were very strong in the first quarter as investors continue to believe in an acceleration of economic growth and inflation, accompanied by only a gradual rise in short- and long-term rates. A difficult start for the new U.S. president saw some momentum come out of reflation trades, but global growth optimism remains highly encouraged by an easing of the U.S. dollar. Sectors exposed to global capital expenditures such as mining, capital goods, domestic Australia, and technology continued to rise, as did emerging markets, while defensive sectors such as telecom lagged. Consumer staples were helped by emerging-market currencies and by a bid for Unilever, while auto stocks fell on concerns over a peaking cycle. Energy stocks also fell on a declining oil price as U.S. production recovers rapidly.

Thus far, rising inflation has been driven in part by tightening labor markets in the United States but mainly by commodity rises spurred in great part by China’s return to debt-fueled investment growth. This pressures profit margins and interest rates, both negative for profits and valuations. However, the market is now assuming that inflation and fiscal loosening will lead to a generalized pick up in growth—“good” inflation—hence the rise in cyclical stocks. The major short-term risk to this scenario is that rising rates could quickly drag down economic activity and the ability of governments to loosen fiscally, given the very high and still rising levels of debt around the world. In emerging markets, much of the debt is in U.S. dollars, exacerbating the risk. Over a longer period, rising inflation and rates tend to de-rate equities, while fiscal expansion may give only a temporary boost to activity, and China will have to rein back on debt growth again at some stage. Recent events have also shown that not all the new U.S. president’s proposed policies may be positive for global economic activity.

While risk control is important, rotations of the type witnessed over the last few months tend to wash out over time leaving stock selection as the key driver of returns. With the level of macroeconomic and political uncertainty very high, the team is working especially hard to identify investment ideas that have a strong internal or structural dynamic not correlated to, or dependent upon, a certain external environment. At the same time, some of the higher-return companies the portfolio tends to favor have fallen sharply through the rotation period and are starting to offer interesting relative value again.

Fabio Paolini and Benjamin Beneche, Pictet Asset Management
The trajectory of economic growth appears to have good momentum, and we believe this will continue to put upward pressure on inflation and interest rates. However, tighter monetary policy (perhaps coupled with fiscal easing) is a double-edged sword. On the one hand, higher interest rates will facilitate a normalization of global finance and prove supportive to some business models (most notably financials), but on the other, it could reduce the attraction of assets held for their yield (“defensive” companies trading at elevated multiples) and/or business models that have come to rely on ultra-cheap funding.

Whilst markets have clearly welcomed this perceived shift in global policy and the improved prospects of nominal growth, on balance we are finding it more difficult to find attractive opportunities and, as such, we believe that what is known is largely discounted. From here on, the risk of U.S. policy surprises (both positive and negative) is large and could prove a wild card for the outlook. In Europe, the political calendar will continue to drive the headlines with the April/May French presidential election being one of the key events. Depending on the outcome, it could drive either further consolidation in Europe, or hasten the ultimate demise of the European project. As bottom-up investors we refrain from taking a view on the outcome of the elections, but so far, these potential risks haven’t offered us any buying opportunity as investors seem to have taken a sanguine view.

Whilst we are finding it more challenging to uncover attractive opportunities given the level of market valuations, we remain enthusiastic about the companies we have in the portfolio, which continue to offer healthy cash generation and are attractively valued. The forthcoming elections in Europe will inevitably generate some volatility, but we look forward to exploiting those concerns to add or buy companies that will be unduly penalized by their postal code or country of listing.

* 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

Stock selection was the primary driver behind the fund’s outperformance for the quarter. Regional and sector overweights and underweights were a modest headwind for the fund. 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

  • The fund continues to be overweight consumer discretionary stocks. It remains the fund’s largest sector overweight. This sector marginally underperformed the broader index, leading to a small drag on returns. However, the fund’s positions within the sector outperformed the benchmark and contributed strongly to performance.
  • The industrial sector was another positive contributor to returns during the quarter due to good stock selection. Aena and IWG were the largest contributors to performance within the industrials sector.
  • Stock-selection contribution within the health care sector was negative during the quarter. The main detractors were Teva Pharmaceutical Industries and Novo Nordisk.
  • The top-performing sector in the quarter was information technology. The fund has a modest underweight to this sector, resulting in a slight drag on relative performance.
  • Energy was the worst-performing sector within the benchmark in the first quarter (after being the top-performing sector in the fourth quarter of 2016). The fund benefited from having less-than-benchmark exposure to energy companies.
Top 10 Contributors as of the Quarter Ended March 31, 2017

Company Name

Fund Weight (%)

Benchmark Weight (%)

Three-month Return (%)

Contribution to Return (%)

Country

Economic Sector

IWG PLC 2.33 0.00 32.80 0.76 Switzerland Industrials
ASML Holding ADR NV 2.92 0.27 19.28 0.57 Netherlands Technology
Wynn Macau Ltd. 1.77 0.02 27.90 0.47 Hong Kong Consumer Discretionary
Aena SA 2.81 0.04 15.99 0.44 Spain Industrials
Lloyds Banking Group 4.13 0.28 8.65 0.41 United Kingdom Financials
Cie Financiere Richemont SA 1.86 0.23 19.23 0.37 Switzerland Consumer Discretionary
Barratt Developments PLC 1.96 0.04 19.60 0.37 United Kingdom Consumer Discretionary
Valeo SA 2.12 0.07 17.55 0.37 France Consumer Discretionary
Altice NV A 2.33 0.04 14.19 0.33 Netherlands Consumer Discretionary
Liberty Global PLC C 1.79 0.00 17.98 0.31 United Kingdom 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 Contributors

IWG (David Herro, Harris Associates)
We like that IWG is the leader in the flexible office space industry and is subsequently best positioned to capitalize on the structural shift that is resulting from the secular growth of the flexible workspace business. We believe IWG is building up a highly scalable operating structure and economic moat that smaller players will find extremely difficult (if not impossible) to emulate. In our view, IWG runs a capital-light business model, which lends itself to attractive returns on capital and free cash flow generation.

IWG’s share price reacted favorably after the release of the company’s fiscal year 2016 earnings results in late February. IWG reported 5% constant-currency revenue growth, which was admittedly slightly weaker than we had expected, but this was more than offset by a 13% constant-currency decline in overhead expense. This was achieved despite expanding the network by 6% and further illustrated IWG’s excellent progress in restructuring its cost base. The strong operating leverage culminated in robust free cash flow generation and a material improvement in return on invested capital, in our view. We expect these trends to continue as management further rationalizes its overhead expense while increasing the mix of capital contributions from third parties. In our estimation, these partnering relationships enable IWG to grow in a capital-light manner while further reinforcing its significant scale advantage (IWG has nearly 20x the locations as the no. 2 player). While IWG’s shares performed quite strongly in the first quarter, we see substantial upside from current levels.

ASML Holdings (Fabio Paolini and Benjamin Beneche, Pictet Asset Management)
ASML is a truly unique company that will enjoy an effective global monopoly over the supply of the next generation of lithography equipment to the world’s increasingly consolidated and ordered semiconductor industry. Already the dominant force in the current immersion technology in lithography equipment, our purchase of the stock was made shortly after Taiwan Semiconductor Manufacturing announced that it has successfully trialed ASML’s new Extreme Ultraviolet (EUV) lithography tool at a power level and capacity needed for full-scale production. With greater evidence over the quarter that the economic viability of EUV has been proven, over the next three to five years, this new technology will become the global platform to continue the stepped process of ever increasing resolution in semiconductor production. With this established, the investment case rests on the assumptions made about a limited set of variables: (1) ASML’s ability to increase the power and throughput of EUV systems, (2) foundry operator capital expenditure intensity levels over the next five years; (3) the length of the cycle (or “cadence”) of lithography unit purchases in order to upgrade foundry capacities and move to higher resolution production; and (4) how this translates into the number of EUV tools sold. Based on conservative assumptions about the future progression, the current ASML stock price looks attractive for a monopoly provider in a critical industry.

Wynn Macau (Vinson Walden, Thornburg Investment Management)
Wynn Macau is a holding company principally engaged in the development, ownership, and operation of destination casino gaming and entertainment resort facilities. The company operates through two business segments: Wynn Macau and Wynn Palace. The Wynn Macau segment is engaged in the operation of a hotel and destination casino resort in Macau. The Wynn Palace is a project under development. The company’s Macau operations feature approximately 284,000 square feet of casino space with 498 table games and 625 slot machines and two hotel towers.

Over the years, Wynn has established itself as a leading global casino and resort company and chairman and CEO Steve Wynn has a terrific long-term record of creating value for shareholders. With new properties coming online, we see meaningful upside to the shares provided the company can successfully navigate operations over the next few years.

After a prolonged period of underperformance, the industry finally started to recover last year. Visitation trends have shown signs of healthy improvement and gross gaming revenue is climbing steadily. Wynn in particular has seen strong performance due to the opening of its new property in Macau. Shares of Wynn appreciated strongly during the quarter.

Lloyds Banking Group (David Herro, Harris Associates)
We believe Lloyds Banking Group has the preeminent retail banking franchise in a consolidated U.K. market, and its balance sheet has improved greatly in recent years, with strong levels of capital, liquidity, and reserves. The United Kingdom’s recent decision to withdraw from the European Union caused an outsized decline in Lloyds’s share price, from our perspective, as we believe the bank’s intrinsic value remains largely intact. In our view, Lloyds’s management has successfully simplified the business and achieved significant cost savings by capitalizing on acquisition synergies, reducing headcounts, and decreasing its number of branches.

Fiscal full-year core results from Lloyds were almost precisely what we expected, though non-core costs were roughly GBP 500 million higher than our estimates. Lloyds finished the year strong, in our view, as fourth quarter total revenue of GBP 4.35 billion and profit before tax of GBP 1.79 billion both exceeded market forecasts, while impairment costs were roughly 32% lower than estimated. For the full year, core total revenues reached GBP 17.5 billion and operating profit amounted to GBP 7.9 billion. Management issued 2017 guidance that includes a net interest margin of greater than 2.7% and an increase in the asset quality ratio to about 25 basis points (before the impact of recent acquisition MBNA). In March, we met with CEO Antonio Horta-Osorio, who indicated that Lloyds has done much better in the wake of the United Kingdom’s decision to withdraw from the European Union than he expected.

Barratt Developments (Vinson Walden, Thornburg Investment Management)
Barratt Developments is a large U.K. homebuilder that we purchased last summer after the share price collapsed in late June 2016 following Brexit. Barratt shares then recovered over 20% in the third quarter. Barratt is well capitalized (with net cash on hand) and has a contracted backlog of profitable business. In the event of a downturn, Barratt's land costs could decline, setting the stage for future profit expansion. In September, Barratt reported that “business is going as usual post Brexit,” with reservations (i.e., contracted sales) up 5.6% versus last year for the two-month period following the June 23 Brexit vote. The company has not seen any changes in mortgage availability or cancellations post Brexit.

The broader U.K. housing industry dynamics seem constructive: The United Kingdom has seen steady population growth since the 1980s, and demography suggests this will continue. The housing market appears supply constrained, with household formations above 200,000 versus housing starts of circa 130,000 annually. This has led to broad bipartisan government support for the housing sector. Comparing incomes to financing terms suggests that housing affordability is healthy. Outside of London, U.K. home prices began rising in 2012; the Department for Communities and Local Government reports that the previous three cycles, beginning in the 1950s, lasted 27, eight, and 12 years, respectively.

Barratt appears to have room to boost efficiency and margins somewhat from existing healthy levels. It doesn’t seem like Brexit has so far made a substantial impact on the U.K. housing market, though any longer-term impact is still uncertain. Low mortgage rates and government policy support (i.e., help-to-buy) are helping the housing industry more broadly.

Valeo (Mark Little, Lazard Asset Management)
Valeo’s order book continues to expand, potentially justifying further expectations for strong growth in revenues. We believe a combination of further operating leverage could raise margins 100 bps over the next four years leading to up to 13% earnings-per-share growth per year. Analyst upgrades continue to come through and with the stock trading at 12.5x 2018 earnings per share, it still looks attractively valued relative to the profitability it can generate in our opinion.

Top 10 Detractors as of the Quarter Ended March 31, 2017

Company Name

Fund Weight (%)

Benchmark Weight (%)

Three-month Return (%)

Contribution to Return (%)

Country

Economic Sector

Aurelius Equity Opportunity 0.06 0.00 -39.42 -0.36 Germany Financials
Codere SA 0.02 0.00 -22.75 -0.21 Spain Consumer Discretionary
Don Quijote Holdings Co. Ltd. 2.60 0.00 -6.58 -0.18 Japan Consumer Discretionary
Schlumberger Ltd. 1.86 0.00 -6.40 -0.13 United States Energy
Informa PLC 2.35 0.00 -2.97 -0.08 United Kingdom Consumer Discretionary
Teva Pharmaceutical Industries Ltd. ADR 0.53 0.18 -6.60 -0.06 Israel Health Care
Teekay Lng Partners LP 0.32 0.00 -8.36 -0.04 Bermuda Energy
Universal Entertainment Corp. 0.04 0.00 -6.18 -0.04 Japan Consumer Discretionary
NN Group NV 0.09 0.00 -1.43 -0.03 Netherlands Financials
Novo Nordisk A/S B 1.05 0.38 -2.76 -0.03 Denmark 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 Detractors

Aurelius Equity Opportunities (David Marcus, Evermore Global Advisors)
Aurelius Equity Opportunities is a German publicly traded private equity firm that seeks to buy non-core, non-performing assets, often from large conglomerates, and works on turning the companies around. The company will only purchase businesses when the problems are the kind they have the expertise to solve. They do not typically pay much, if anything, for these assets and even sometimes get paid to acquire assets. As an example, in 2016, Aurelius acquired the European operations of Office Depot, which had approximately $2.25 billion of revenues, for nominal consideration. We believe that Aurelius’s founder and CEO, Dirk Markus, is a proven value creator, who will continue to take advantage of the opportunities that the high level of restructuring activity in Europe and even Brexit may present. 

In late March, Gotham City Research, a short-selling firm, issued a report stating why they had taken a major short position in Aurelius. The company’s stock tumbled over 46% over the next couple of days before showing a slight movement higher. We carefully evaluated the report issued by Gotham City and felt that most of their allegations were off the mark and without merit. We also carefully evaluated the company’s formal response, which we found to be an excellent rejoinder to most of Gotham City’s claims. The company’s response, along with conversations we have had with the company and other market constituents, give us continued confidence in our investment in the company. We used this severe decline in the company’s stock price as an opportunity to add to our Aurelius position.

We continue to believe in the value of Aurelius’s business model and their solid history of value creation.

Don Quijote (Mark Little, Lazard Asset Management)
We have been long-term holders of shares of Don Quijote. After a strong first quarter in fiscal year 2017, the second quarter was a disappointment with the company down year over year as a result of the continued strategy to grow traffic through discounting everyday items. The company has continued to compound despite the poor consumer environment in Japan and at good returns. With wages starting to rise in Japan, there is the hope that the consumer will eventually spend more and save less, in which case Don Quijote would be very well positioned.

Informa (Mark Little, Lazard Asset Management)
Informa continued its recent trend of improving organic growth with its problematic division now turning into positive sales growth territory. The only concern is their academic books business is shrinking, but it is a small percentage of sales. The stock is very attractively valued, in our opinion, at 13.6x earnings per share with an over 3% dividend yield. It is generating approximately GBP 400 million of free cash flow per annum giving it an approximate 8% free cash flow yield.

Teva Pharmaceutical Industries (Fabio Paolini and Benjamin Beneche, Pictet Asset Management)
Our investment thesis on Teva (a global provider of generic pharmaceuticals) is based on the sustainability of its core franchise, which should enable it to sustain attractive returns and a consistent generation of free cash flow.

Teva operates in two segments, generic medicines and specialty pharma. We see the generics division as a consistent cash generator where annual pricing pressure is more than compensated by volumes, enabling it to sustain its high returns. In this division, Teva’s scale, diversification, and synergies following the recent acquisition of Actavis should enable it to generate a consistent level of cash. The specialty pharma division is more dependent on a few core franchises, with the largest one being Copaxone for multiple sclerosis that generates close to a third of the cash flow of the group and is facing generic competition. This is particularly relevant given the leverage of the group; however, we don’t expect a collapse of this franchise but rather a decline that can be compensated by the launch of new products therefore enabling the company to continue to generate cash flow in a range of $4 billion (full loss of Copaxone) in the worst case scenario to $6 billion (in both cases a double-digit free cash flow yield). Continued fears of price regulation, a lowering of guidance, and changes in management have left the company trading at a significant discount to our assessment of fair value. Given our confidence in the sustainability of its franchise, this has offered us the opportunity to initiate a position.

During the first quarter, despite a delay in the launch of a generic version of Copaxone, the same concerns have continued to affect the evolution of Teva’s share price. With an unchanged investment thesis, we remain holders.