Litman Gregory Masters Smaller Companies Fund First Quarter 2017 Attribution

During the first quarter of 2017 the Litman Gregory Masters Smaller Companies Fund rose 0.68%, trailing the Russell 2000 Index return of 2.47% and the Morningstar Small Blend Category return of 1.75%.

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
We are here, in the blessed sunshine of post-election America, and the remarkable events of daily life remain remarkable. We have often talked about being in completely uncharted waters as far as Federal Reserve policy and the true unknowability of how financial markets will react to an ever more likely new era of irregularly higher interest rates and a diminution of the impact of monetary policy in the face of massive changes in fiscal policy. But clearly the election has dumped a new ocean full of water in the “ain’t seen nothing like this” tub.

Some thoughts about the overall environment—we are betwixt and between. Every monstrous bull market starts with something that looks like the last four months: a stampede from an inflection point that looks obvious six months from now, but in its infancy is picked to death by articulate purveyors of the obvious. And the world is full of the highly educated, the highly articulate, and the data driven, and now they have the Internet and access to our inbox with little claim to better forecasting. As noted in Berkshire’s recent shareholder letter and in these ramblings for over 20 years, the beauty of bearishness is that it is full of precision-laden facts based upon trailing data that can always suggest we are on the verge of imminent disaster. (Go ahead and google news pieces around the great inflection points of 1982, 1988, 2001, 2009, etc.) In comparison, the bullish case for the future almost always sounds dopey: this is America, we are a democracy and a free market that is still the envy of the world, and somewhere and somehow, we manage to grow the economy, and as of yet unidentified people will create companies and hire people, and ... so on.

Irrespective of the tweeting issues, there remains a very reasonable animal spirits–based case for upside surprises when businesses are encouraged to invest with lower tax rates and with fewer regulations. Every “survey” of business expectations from small business to large corporations is off the charts high, as is arguably the “great survey,” the stock market. And isn’t it nice to see people with business experience overseeing business regulation and finance experience overseeing financial regulation? No dear reader, a PhD, a law degree, and/or a tenured position at an Ivy League school is not a qualification for thoughtful economic foresight.

Our real area of concern is simply the valuation of many common stocks and what assumptions have to be made to justify their valuation. The future remains full of probability-weighted possibilities and x% is clearly tied to a 3%-plus gross domestic product (GDP) growth rate with awesome earnings power well in excess of what we are “used to.” Yet, as anyone who has walked into an institutional client meeting two and a half years into a relationship knows, eight years is a veritable eternity in the minds of the economic and financial community, so a backend-weighted set of economic goodness is now well priced in today’s equity market. There is simply a lot that has to go right—and go right right away—or prices will adjust accordingly. Understanding expectations implied by valuation is critically important to the process of not losing money, and it is correct that in investing and marriage, if you start with low expectations, you are less likely to be disappointed.

But this is not 1981 with stocks trading at book values that are wildly understated due to the ravages of double-digit inflation and interest rates about to go from 18% to effectively zero. We are much closer to full employment today, versus double-digit levels in 1981, and take a serious look at the demographic trends that conspire against the pure math of economic growth. There are some narrative parallels and we all know we behaviorally love a good narrative, but I sense they are much slimmer than perceived in some camps.

One thing we think you can take to the bank about the interim future is the recognition that stocks can and should be much more volatile than they have been in a zero interest rate world, and frankly we look forward to those days. We had a pretty decent year last year, ex-banks, but frankly we hate markets that go up every day. We like a certain degree of mess and uncertainty, and I am quite certain we are going to get our fair share in 2017.

So we have adjusted accordingly and have leaned into some wonderful winners bought in the economic dog days of late 2015, partially or in their entirety. Their replacements and our short list of candidates are eclectic: mattresses, aerospace, consulting, post-bankruptcy companies, nursing homes, media, and, gulp, some retail. We acknowledge that might be a little too eclectic—an outcome of the paucity of choices available—but we have nice optionality in our portfolios that is not necessarily beta driven. Throw in a concentrated portfolio, and in theory we can be defensive and create upside if enough internally generated ideas work on their own accord without much help from the outside world. That’s the plan.

Dick Weiss, Wells Capital Management
The U.S. markets entered the first quarter of 2017 on a high note after rallying post the nomination of now President Donald Trump in November 2016. At the start of the year, investors were optimistic about the reflation trade, which started to work in 2016, and seemed encouraged that the late 2016 market rally would continue into 2017. As the quarter progressed, the markets reached an all-time high on March 1. As the month of March progressed, the markets pulled back as optimism turned to pessimism. However, the market finished the quarter in positive territory.

Further, large caps tended to fair better than small caps, which was a stark reversal of trend from the fourth quarter of 2016. Additionally, growth outperformed value and the reflation theme faded as financial and energy stocks tended to underperform while information technology performed well. As the quarter came to a close, the stock market had risen while the 10-year yield, U.S. dollar, and investor confidence had fallen.

For the portfolio, the whipsaw of returns among sectors has created the opportunity to deploy capital. In particular, we are seeing opportunity in the beaten up soft line retail space and subsectors of health care. On the contrary, we have avoided the banking sector post a large run in the fourth quarter of 2016 due to prospects of a steepening yield curve. However, there may be opportunity if we see a pullback in this sector and valuations become more reasonable.

Dennis Bryan and Arik Ahitov, FPA
One of the side effects of running a highly concentrated portfolio is volatility. We do not mind that volatility because, paraphrasing Warren Buffett, we prefer a higher return that is lumpy over a lower return that is smooth. This is especially true if that volatility allows us to add to our positions at a low price and trim our positions at elevated prices. Broadly speaking, when prices rise, there are fewer and fewer opportunities to purchase undervalued stocks. What’s more, existing stocks in the portfolio begin to approach our exit prices. While this part of the cycle can be frustrating for value investors like ourselves because our hunting grounds shrink, we hold firm to the belief that stock prices cannot remain untethered from fundamentals indefinitely.

* 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

  • Stock selection was a positive contributor to relative performance in the first quarter, but this was more than offset by sector allocation.
  • Financials was the leading sector contributor in the portfolio during the period. This was due to both strong stock picking and a significant underweight (10.5% versus 19.5%) to this modestly declining sector. Leucadia National, the second-largest portfolio holding and owned by Jeffrey Bronchick, gained 12.09% in the period and was the largest single contributor to performance in this sector.
  • The second-biggest sector contributor was consumer discretionary. Stock selection drove the relative outperformance. Portfolio holdings in aggregate gained 6.76% versus 1.09% in the benchmark. Two of the strongest individual performers were MDC Partners, owned by Dick Weiss, and Tegna, owned by Bronchick. These positions were up 43.51% and 20.42%, respectively, in the quarter. The portfolio’s 24.70% exposure is roughly twice that of the benchmark and was a mild detractor in the period.
  • The most significant detractor from a sector perspective was industrials, due to poor stock selection. Power generation company Babcock & Wilcox Enterprises, owned by FPA, was the largest individual detractor in the period. This position had an average weight in the portfolio of 1.9% and fell 43.70% during the quarter. The stock is discussed in greater detail below.
  • The energy sector also detracted from relative performance in the quarter, with both stock selection and sector allocation having negative effects. The portfolio’s energy exposure was nearly 3x that of the benchmark (10.22% versus 3.56%) during a period when the sector was by far the worst-performing sector in the period. The sector declined over 10% for the benchmark, compared to just over 12% for the portfolio’s energy holdings. Cimarex Energy was the main individual detractor for the quarter. This position, held by both Weiss and FPA with a 3.5% average portfolio weight, fell 12.02% in the quarter.
  • The fund’s cash allocation—just under 12%, on average—was a drag on relative performance during the quarter, given the positive return of the Russell 2000 benchmark.
Top 10 Contributors as of the Quarter Ended March 31, 2017
Company Name Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Millicom International Cellular SA 4.16 0.00 32.02 1.10 Telecommunications
Integer Holdings Corp. 2.63 0.06 36.50 0.85 Health Care
Western Digital Corp. 4.11 0.00 22.20 0.83 Technology
MDC Partners Inc. A 1.88 0.02 43.51 0.78 Consumer Discretionary
Tegna Inc. 3.03 0.00 20.42 0.77 Consumer Discretionary
Leucadia National Corp. 4.64 0.00 12.09 0.56 Financials
Select Comfort Corp. 1.18 0.05 22.84 0.35 Consumer Discretionary
Norwegian Cruise Line Holdings Ltd. 1.58 0.00 19.28 0.30 Consumer Discretionary
Best Buy Co. Inc. 1.38 0.00 16.05 0.22 Consumer Discretionary
Liberty Global PLC LILAC A 3.01 0.00 1.28 0.19 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

Millicom International Cellular (Jeffrey Bronchick, Cove Street Capital)
Millicom International Cellular is the leading cable and wireless provider in Colombia and Central America. The company is refocusing on its pole position in the quickly growing cable triple play market in Colombia, while shedding valuable but disparate African media assets under the direction of a CEO who hails from Liberty Global. This past quarter’s results were in line with expectations, but thanks to the dollar’s fall relative to the Colombian peso, Millicom’s value increased. Looking past short-term macroeconomic noise, we still see a severely undervalued stock that is continuing to develop into a premier Latin American cable/telecom player.

Western Digital (Dennis Bryan and Arik Ahitov, FPA)
Western Digital advanced 22% in the first quarter of 2017. The company designs, develops, manufactures, and sells hard disk drives (HDD) and solid state drives (SSDs). The company’s hard disk drives are used in desktop and notebook computers, enterprise applications, and consumer electronic applications. Western Digital is a long-time holding and one which we have reduced exposure to as a result of the stock’s substantial appreciation over the years. The hard drive industry has become substantially more rational and, therefore, profitable than it was historically thanks to consolidation. Western Digital’s stock price started declining in 2015 when the company announced its intention to acquire SanDisk in a $17 billion deal. The selling pressure was due to the high sticker price on the deal, the increased debt load, and the foray into a new business (NAND flash semiconductors). We, on the other hand, saw this as an incredible opportunity to almost double our position because we believed the deal would catapult Western Digital into a leadership position in the NAND memory business. While the acquisition did not come cheaply, Western Digital now has a very competitive NAND offering that should put to rest fears that the company could be disintermediated by NAND memory companies. Western Digital immediately started integrating the business and used its strong cash flow to decrease its debt load. The big news now involves its flash manufacturing joint venture (JV) partner Toshiba, which has recently run into major financial difficulty due to its unrelated nuclear business. These issues forced Toshiba to put its memory business on the selling block, which includes its ownership interest in the JV. While it is very difficult to know the impact of a future transaction, we think Western Digital may be well situated to benefit if they participate in a deal. We trimmed the portfolio’s exposure to Western Digital on strength throughout the quarter.

MDC Partners (Dick Weiss, Wells Capital Management)
MDC Partners operates advertising, public relations, branding, digital, and social media marketing agencies. Through the end of the first quarter, the stock has outperformed the Russell 2000 Index by 40.5% and advertising peers Omnicom Group and IPG by 41.0% and 38.0%, respectively. Helping drive the strong performance was the $95 million investment by Goldman Sachs in the form of convertible preferred shares, which convert at $10, representing a premium of approximately 49.0% from the price immediately prior to the announcement in mid-February. This capital raise was the end result of the review of the company’s capital structure by an outside advisor. When this review was announced in November 2016, there was significant fear in the stock given the high amount of financial leverage and the company’s worsening trajectory over the course of 2016. However, it appears that these concerns have been alleviated, as the investment de-risked the balance sheet and the company’s growth prospects now appear brighter after dealing with a host of one-time negative events in 2016. MDC guided to organic revenue growth of approximately 4.0% and approximately 100 basis points of EBITDA margin improvement, which compared to expectations of around 3.5% organic growth, and more importantly an improvement from the 2.3% growth in 2016. Management’s 2017 target of 4.0% organic growth is likely conservative and embeds first half 2017 headwinds associated with significant client losses in 2016. The margin guidance is also likely conservative, as we believe 4.0% organic growth should allow for more expansion than suggested by the 100-basis-point guide. We currently have a Private Market Value (PMV) for the company in the mid-teens. [The stock traded at $9.40 per share on 3/31/2017.]

Top 10 Detractors as of the Quarter Ended March 31, 2017
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Babcock & Wilcox Enterprises Inc. 1.87 0.03 -43.70 -0.91 Industrials
Cherokee Inc. 2.88 0.00 -18.10 -0.59 Consumer Discretionary
Heritage-Crystal Clean Inc. 3.22 0.01 -12.74 -0.46 Industrials
Cimarex Energy Co. 3.53 0.00 -12.02 -0.44 Energy
Avis Budget Group Inc. 2.01 0.00 -19.36 -0.42 Industrials
Arris International PLC 3.09 0.00 -12.21 -0.39 Technology
Range Resources Corp. 1.59 0.00 -15.25 -0.25 Energy
Noble Energy Inc. 1.72 0.00 -9.55 -0.17 Energy
Viasat Inc. 4.46 0.18 -3.62 -0.16 Technology
Delta Air Lines Inc. 2.50 0.00 -6.19 -0.16 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

Babcock & Wilcox Enterprises (Dennis Bryan and Arik Ahitov, FPA)
Babcock & Wilcox Enterprises (BW) declined 44% in the first quarter of 2017. The company is a leader in the construction of power generation systems. The company operates in three segments: Power (62% of revenues), Renewables (22% of revenues), and Industrial (16% of revenues). Our thesis for owning the stock centers on the company’s leadership position in its markets, its CEO’s experience at larger companies and keen focus on cost cutting, the company’s large backlog that provides visibility to future revenues, and our belief in BW’s ability to apply its expertise to similar products and different geographies. We initiated a positon in the third quarter of 2015, and the company executed in line with our expectations. BW spun out its nuclear business, which we subsequently sold at a healthy profit. The company generated strong free cash flow and used it to either buy back stock or make acquisitions that diversify them away from coal. On March 1, 2017, BW reported its fourth quarter 2016 earnings and announced a number of project errors in the Renewables division (the other two divisions performed well). We believe such errors occurred because the Company has been emphasizing its goal to increase BW’s valuation multiple by decreasing its reliance on coal. In order to achieve this, the company may have grown the Renewables business too fast. Upon bidding and successfully winning a number of projects with its superior technology, BW simply did not have enough engineers at the right time. The company trades at an attractive absolute valuation, and we took advantage of the depressed stock price to add to our position.

Cherokee (Jeffrey Bronchick, Cove Street Capital)
Cherokee is a global brand manager focused on products such as apparel and footwear. Cove Street has owned shares of Cherokee for a number of years and unfortunately the recent period has been somewhat of a rollercoaster. Cherokee officially lost its largest U.S. customer (Target) early this year and has been hard at work trying to find other partners to fill the void. In addition, the company recently made its largest acquisition—buying a footwear company by the name of Hi-Tec—and had to issue a fair amount of stock to close the deal. While there is a fair amount of uncertainty regarding the future earnings power of this company, based on 2017 expectations, Cherokee trades at a material discount to the other listed apparel license companies as well as our estimate of intrinsic value. The stock is pretty illiquid and shares have fallen in sympathy with the rest of companies in the retail world. Our analysis suggests that the recent drop in the price represents an extremely compelling entry point, and we have added to our position.

Avis Budget Group (Dick Weiss, Wells Capital Management)
Avis Budget Group operates vehicle sharing and rental services. The stock was a relative detractor to performance during the quarter as negative first quarter pricing commentary on the fourth quarter 2016 earnings call (negative in the sense of lower than last year) weighed on sentiment. They cited industry over-fleeting as continuing into the first quarter. The pricing may be impacted by Avis increasing its weight toward risk vehicles (away from program), which has the effect of compounding a bad pricing environment. Avis was over-fleeted based on the utilization ticking down 110 basis points in the Americas. However, we feel this was due to Avis not wanting to chase really low-end business as its competitor Hertz was over-fleeted and decided to slash prices. However, we think there is still a good opportunity with the company as sentiment is extremely low (mid-single-digit earnings multiple). If we extrapolate negative used car pricing through 2017, this would put earnings per share for Avis at about $3.00 or at the low end of guidance. A $0.50 decline in earnings estimates and the corresponding $10 fall in share price implies a decremental multiple of 20x (or how far the stock price declines for a given reduction in earnings estimates). This multiple approaches a level of stress in the stock and an opportunity to deploy capital. We currently have a PMV for the company in the low $50s. [The stock traded at $29.58 per share on 3/31/2017.]