Litman Gregory Masters Smaller Companies Fund First Quarter 2018 Attribution
The Litman Gregory Masters Smaller Companies Fund had a modest gain in the first quarter of 2018, returning 0.17%.i The fund outperformed its Russell 2000 Index benchmark, which declined 0.08%, as well as the Morningstar Small Blend peer group, which declined 0.93%.
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
“Get Used to It” is not a bad summary of the first quarter of 2018, as for the first time in a long time, security “prices” decided to fluctuate. As of this writing, the last nine days had more 1% daily moves in the S&P 500 Index than in all of 2017. It is a conceptual return to normalcy, and we should expect more of it.
While we are certainly far from perfect at it, having a margin of safety via a thoughtful approach to valuation helps us distinguish between temporary price swings and permanent loss. We agree with the man from Omaha that “… prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.” We are trying to be careful.
Going forward, we continue to sing a familiar tune. We generally see valuation as expensive, albeit small caps are a relative bargain versus the FANG and popular crowd in large caps. We think with or without rising interest rates, there is a big issue with margin of safety if odd things happen in the world, and history suggests more volatility is the norm, not the exception. We are here to take advantage of price swings in companies that we have researched well, and we are ready to act when specific valuation parameters are reached. We run a concentrated portfolio in which we have at least a handful of meaningful positions with catalysts for performance in the relatively near term, regardless of the general state of financial markets. Lastly, we think we have a relatively smaller basket of “risky” stocks than what we see in our benchmarks.
Dick Weiss, Wells Capital Management
The first quarter of the year started on a strong note in January with a continuation of many trends equity markets witnessed throughout 2017, including robust economic data, low unemployment, and strong sentiment. As the quarter progressed, several technical and geopolitical factors led to an increase in volatility over the final two months of the quarter. First, several large funds had to unwind long equity positions that were paired with short volatility positions. Second, the U.S./China trade talk and follow-through (albeit on a small scale as of now) left investors wondering if synchronized global growth may stall and what ripple effects this may have on the markets. Nonetheless, we did not change our bottom-up fundamental process over this period of geopolitical and macro concerns as the portfolio performed very well in the first quarter. Of particular note, strong fundamentals at the company level came to the fore as several companies reported strong quarterly results during the quarter while negative performance contributors were limited in both number and scale. Additionally, the avoidance of exposure in the “bond-proxy” sectors (real estate, utilities, telecom, and consumer staples) proved to be prudent as these areas tended to underperform the broader market as interest rates crept higher.
Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
We continue to see significant return-on-invested-capital (ROIC) improvement opportunities within our holdings over the next several years; however, we have become slightly more aggressive in trimming exposures that will have more risk due to what we view as a weakening economic environment. We continually measure the reward-to-risk ratios of our holdings through scenario/sensitivity analysis and size positions. We added two holdings during the quarter: Lancaster Colony and AngioDynamics. The thesis on Lancaster Colony centers around the new CEO’s aggressive focus on improving capital allocation, specifically in organic and inorganic reinvestment at returns above cost of capital. We believe AngioDynamics is undervalued due to its potential to grow at higher ROICs, as well as its attractiveness in a marketplace in which many of its competitors are struggling. We continue to look for new ideas for the portfolio; however, each name must meet certain criteria, particularly around improving ROIC tailwinds. We continue to see many companies being rewarded by the market even as they appear to destroy capital; however, when looking at capital allocation decision-making through an ROIC lens, we believe we are nearing an inflection point in such market dynamics based on more negative leading economic indicators. As a result, we have kept a larger cash balance in our portfolio, as our fundamental bottom-up analysis, along with our scenario-testing for differing macro environments, has not resulted in enough favorable reward-to-risk ratios to warrant full investment within our strategy. While volatility has started to occur in the market, in our view investors are not fully aware of the risks that companies incur through poor capital allocation. We have not managed the portfolio to avoid sectors, industries, or geographic regions and instead are completely focused on finding companies with what we believe are underappreciated ROIC catalysts and high reward-to-risk ratios with preservation of capital serving as the utmost importance.
* 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
- Stock selection was the main factor leading to the fund’s modest outperformance in the quarter, with sector allocation having minimal effect.
- Stock selection was particularly strong within the industrials sector. Wesco Aircraft Holdings, owned by Jeffrey Bronchick of Cove Street Capital, was the leading individual contributor to the fund in the quarter. The position gained 38.51% and made up nearly 3% of the fund on average. (The stock was one of the largest detractors in 2017.) Another successful position was long-time holding Axon Enterprise (formerly Taser International), owned by Dick Weiss of Wells Capital Management, which gained 48.34% in the quarter. These positions more than offset the 25.48% decline of industrial company Quanex Building Products, owned by Mark Dickherber and Shaun Nicholson of SBH. Each of these names is discussed in greater detail below.
- Strong stock picking within industrials was partially offset by underperforming stocks (relative to the benchmark) within information technology, consumer discretionary, and materials.
- Within information technology the largest detractor was global communications company Viasat, which fell 12.20% in the period. The company was the largest position in Bronchick’s portfolio and the second-largest holding in the fund at 4.2% of assets. Within consumer discretionary, despite a 63.32% gain in Shutterfly (owned by Weiss) other names detracted from relative performance, including top-10 holding E. W. Scripps, owned by Bronchick, which fell over 23%. Within materials, Innophos Holdings, owned by SBH and the fund’s largest position as of quarter-end at 5.3% of assets, fell 12.98% in the quarter. Shutterfly, E.W. Scripps, and Innophos Holdings are discussed in greater detail below.
- At the sector level, most allocations had a negligible impact. The two sectors with the largest but still mild impact were health care and real estate. An underweight (6.90% vs. 16.14%) to the outperforming health care sector was a detractor, but was offset by a lack of exposure to the underperforming real estate sector.
- The fund’s average cash position during the quarter was 12.3%, a percentage point lower than year-end levels. The cash allocation was mildly positive for relative performance as the small-cap market declined marginally.
|Top 10 Contributors as of the Quarter Ended March 31, 2018|
|Company Name||Fund Wt. (%)||Benchmark Wt. (%)||Three-month Return (%)||Contribution to Return (%)||Economic Sector|
|Wesco Aircraft Holdings Inc.||2.92||0.02||38.51||0.98||Industrials|
|Axon Enterprise Inc.||2.32||0.08||48.34||0.95||Industrials|
|Shutterfly Inc. A||1.77||0.11||63.32||0.92||Consumer Discretionary|
|Haemonetics Corp.||2.13||0.17||25.96||0.58||Health Care|
|Integer Holdings Corp.||2.09||0.07||24.83||0.48||Health Care|
|GTT Communications Inc.||2.30||0.07||20.77||0.44||Information Technology|
|Bank of N.T Butterfield & Son Ltd.||1.96||0.11||24.67||0.43||Financials|
|Heritage-Crystal Clean Inc.||2.94||0.02||8.28||0.24||Industrials|
|Spartan Motors Inc.||2.11||0.03||9.21||0.19||Industrials|
|AllianceBernstein Holding L.P.||1.87||0.00||10.51||0.19||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
Wesco Aircraft Holdings (Jeffrey Bronchick, Cove Street Capital)
Wesco Aircraft distributes aerospace bearing products and provides supply chain management services to the aerospace industry in North America and internationally. This is a stock that has regularly made the best or worst quarterly performer list as the company’s new CEO has had to unwind the previous CEO’s operational mistakes while attempting to solve poor execution issues in their ad hoc business. The company’s margins have been hurt in the short term. Through our additional due diligence, our research indicates that Wesco’s core business is intact and customers are still beholden to the services that Wesco provides with several mentioning to us that they are just waiting for operational issues to be resolved before giving more work to Wesco. This past quarter showed improvement in customer satisfaction and revenue traction that has not been seen over the past year. These positive indicators as well as our own research leads us to expect continued operational improvement and additional upside going forward.
Axon Enterprise (Dick Weiss, Wells Capital Management)
Axon Enterprise, a producer of conductive electrical equipment and software systems, posted strong quarterly results with revenue above expectations and an earnings-per-share beat driven by the higher revenue and much better gross margin. Clearly things are turning around. Last quarter, and at the investor day in particular, there were green shoots around the heightened expense discipline, acknowledgement that there was a margin problem, and the addition of profitability metrics to incentive compensation, and now we are seeing these efforts bear fruit in the margins. While we have been recently trimming to manage the weighting, after visiting with the management team, we still think it makes sense to have a position here. They are still in the early stages of the expense discipline story, they are focused on innovating and deploying new products which expand the total addressable market, and we like the CEO’s new compensation structure—he has foregone a salary and won’t see any type of payout until the market cap hits $2.5 billion vs. $2.2 billion today.
Shutterfly (Dick Weiss, Wells Capital Management)
Shutterfly, the producer of personalized photo products, posted strong quarterly results. Not only did the core business have a strong quarter in which it allayed customer attrition fears from the planned brand migration, but the main driver of the outperformance was the announced acquisition of LifeTouch, a national leader in school photography. The strategic rationale makes sense as Shutterfly can drive scale and incremental profitability through its ownership of the asset, and Shutterfly paid a very reasonable multiple. The key takeaway is that, on a pro forma basis, we’re looking at a company that will almost double EBITDA (earnings before interest, taxes, depreciation, and amortization) by 2020 compared to 2017, and this doesn’t even assume much growth in the underlying businesses. We have been trimming back the position recently as it has run to the high end of our private-value ranges and are currently evaluating replacements.
|Top 10 Detractors as of the Quarter Ended March 31, 2018|
|Company Name||Fund Weight (%)||Benchmark Weight (%)||Three-month Return (%)||Contribution to Return (%)||Economic Sector|
|The E W Scripps Co. Class A||3.12||0.04||-23.01||-0.85||Consumer Discretionary|
|Innophos Holdings, Inc.||5.49||0.04||-12.98||-0.75||Materials|
|Viasat Inc.||4.85||0.18||-12.20||-0.55||Information Technology|
|Quanex Buliding Products||1.58||0.03||-25.48||-0.49||Industrials|
|Cimarex Energy Co.||1.90||0.00||-23.31||-0.47||Energy|
|Leucadia National Corp.||3.09||0.00||-13.85||-0.45||Financials|
|Avid Technology Inc.||2.50||0.01||-15.77||-0.42||Information Technology|
|MDC Partners Inc. A||1.35||0.02||-26.15||-0.40||Consumer Discretionary|
|Tegna Inc.||1.52||0.00||-18.66||-0.30||Consumer Discretionary|
|Alta Mesa Resources Inc. A||0.92||0.00||-21.80||-0.29||Energy|
Edited Commentary from the Respective Managers on Selected Detractors
The E.W. Scripps Co. (Jeffrey Bronchick, Cove Street Capital)
We continued to, fruitlessly to date, add to E.W. Scripps in the broadcasting space. The network broadcast business is changing but not remotely at the speed at which public valuations have changed. There is also an upcoming cycle that might be entitled, “The Mother of All Political Ad Spends,” which will reinforce the resiliency of the broadcast business model. Scripps is also neatly pivoting in the digital media space with a variety of bets that are getting negative love from investors. We wait.
Innophos Holdings (Mark Dickherber and Shaun Nicholson, SBH)
Management has aggressively moved to reposition the company as a specialized chemical company that drives higher margins and ROIC levels. Our thesis for significant value creation occurring in the next several years has not changed and actually has led us to buy more on the weakness in the quarter as valuation levels have become even more attractive. The reason for the weaker stock performance in the quarter is not easy to identify, as the company provided guidance for 2018 that was in line with Wall Street expectations and has continued down its strategic value creation path. In short, the pullback appears to be due to a price-to-earnings multiple contraction as opposed to price estimates moving down.
Quanex Building Products (Mark Dickherber and Shaun Nicholson, SBH)
Our thesis centers around a change in management with a significantly more disciplined approach to ROIC improvement versus a pure sales volume focus under prior leadership. Over the last three months, the company has started to see momentum in its automation program to drive higher margins but has faced headwinds due to the higher cost of raw materials. It is worth mentioning that even with the raw material headwinds, the company’s expectations for 2018 were in line with Wall Street estimates. In our view, the valuation of the stock is very attractive against the backdrop of the company’s margin improvement potential over the next several years. We did not add to our position during the quarter, though that decision was driven more by higher interest rates that might impact the housing market rather than by company-specific factors. The new management continues to raise prices and walk away from less profitable areas, which over time should drive ROICs higher throughout a cycle.