Litman Gregory Masters Smaller Companies Fund Second Quarter 2018 Attribution

The Litman Gregory Masters Smaller Companies Fund gained 5.18% in the second quarter of 2018. The fund underperformed its Russell 2000 Index benchmark, which gained 7.75%, as well as the Morningstar Small Blend peer group, which gained 6.33%. Year to date, the fund has underperformed the Russell 2000 by 230 basis points (bps) while performing in line with the Morningstar category.

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
As an investor in the strategy, as the founder and lead principal of Cove Street Capital, and as a highly competitive and combative investment professional in his 35th year, I am extraordinarily annoyed and disappointed with our performance over the last 18 months. These results are unfortunately doing a lovely job of mathematically crushing our long-term performance record, at least for the time being.

I can talk about “long-term time horizon.” I can throw in pithy comments like this one from a Jefferies strategist. I’m paraphrasing here: We also found that valuations in the second quarter and so far in the first half of the year have not mattered. If a manager is focused on valuation factors, that has been the kiss of death.

I can talk about how we are concentrated, we are utterly index agnostic, and thus you are clearly not paying us to dance the tango with an index in the short run. I can clearly state that 2008 was really a lot worse in that losing money is a palpable real worse versus merely underperforming.

But so what? It doesn’t diminish the frustration and lack of wealth creation for you, nor does it obviate our own errors of omission and commission. It is important to properly understand the environment in which we operate, and while outside forces and the trends can clearly create headwinds, or tailwinds, the simple fact is that our top five positions, which represent roughly 56% of the portfolio, have been more boring than watching two teams in the World Cup trying not to win in order to be in a better bracket in the next round. We have often proffered that if we can invest such that our downside is boredom, and we buy 10-ish stocks with 50% upside in three years, we should do okay. Recently, we have only reconfirmed the former.

That matters more to us than the quarterly yack about the trends du jour. We make carefully researched bets on combinations of Business, Value, and People and we wait. It is always wonderful to have an obvious catalyst with an obvious timing, but anyone who has spent time investing directly or investing with someone else understands the fickle nature of timing. As suggested by even any cursory read of behavioral finance or psychology, it mentally helps to get off to a good start with either a new position or a money manager.

So here are some things that we aren’t going to do to “fix” our short-term performance. We aren’t going to wholesale sell half of the portfolio and chase what worked the last six months. We aren’t entirely revamping our investment philosophy and process. We aren’t firing people. We are a lean place that is based on a culture that does not mentally crush people for making mistakes that annoyingly form the basis of experience. Our process of recording our decisions, using a devil’s advocate as a key part of the process, and creating “constant mortem” vs. post-mortem analysis enables a mental environment that pushes investors to make new and interesting mistakes—we do not ground ourselves in a divot of repeating the same mistakes. Investing requires analysis of risk and reward and you cannot be “afraid” to take a thoroughly calculated risk (you don’t need help to self-loathe—Mr. Market is loud and clear on them). We aren’t mentally sitting on our hands.

I would also anecdotally note more signs of at least a relative bottom for us. As the wife of the portfolio manager (with over 28 years of experience) noted last week, “It’s a bottom when you finally start complaining to me how awful you are.”

So, what is interesting about our portfolio is that not only does our research suggest our “spring” has coiled more tightly as most of businesses have gotten more valuable while their stocks have lagged, but we also would suggest we have some highly visible catalysts for near-term improvement, which would be … nice.

Going forward, it is one thing to make a list of all the usual disasters and potential disasters in the world when stocks are cheap, and say, well “stocks are cheap and our risks are discounted in the market.” It’s more than somewhat difficult to make that case right now.

As an example, we plucked out this pithy quote on the trade nonsense:

“How this will play out is idiosyncratic to any given product and unique to each supply chain,” said Daniel Rosen, partner at the economic research firm Rhodium Group. “Nobody can honestly claim high confidence that they understand what the overall impact will be. You may as well project the weather on a Tuesday afternoon a year from now.”

We think any government policy that arbitrarily favors x over y or deliberately shifts the playing field on poorly understood or absolutely incorrect terms is not helpful to anyone who is investing. And most asset classes are not cheap enough to provide margin of safety to any number of similar policy discussions. And if you are asking, what matters is not the actual “tariff” dollars as a percentage of GDP, which seems to have many people pretty blasé about the topic. It’s the gazillions of dollars of currency relationships and the fixed-income beneath it that is the real risk.

It has also been recently noted that small-cap stocks will “do better” because they in theory are less multinational and more domestic focused, and thus aren’t tied up in trade wars and have less currency exposure from the strength of the dollar. I think that is somewhat of a canard. Small companies tend to sell to bigger companies and thus when big daddy gets a cold, most of the family suffers as well down the line.

But, as we noted at the beginning, our results, particularly on a relative basis, are much more dependent on what is happening with what we own, given our concentration. And there we feel confident. (Or particularly frustrated, which is better than confident.) There is nothing wrong with the theory and practice of careful, focused value investing in small-cap stocks. There appears to be nothing wrong with the health and cognitive abilities of your portfolio manager, and the terrific people who support and surround him on every level, 82% of whom are owners in the firm. We have every financial and competitive incentive to deliver for our fellow shareholders as we have for most of the past.

Dick Weiss, Wells Capital Management
U.S. stocks posted strong returns in the second quarter, as seen by the 7.8% rise in the Russell 2000 Index and 3.4% return of the S&P 500 Index, leading to positive year-to-date performance of 7.7% and 2.7%, respectively. The broad market indexes moved higher on rising earnings expectations and continued strong economic data. Growth stocks continue to surge higher and have been leading the popular indexes. Mega-cap growth stocks Amazon and Netflix are up 45% and 55%, respectively, over the year-to-date period. These are large gains for big companies as performance leadership has been fairly narrow within popular indexes over the course of the year. We employ a bottom-up, fundamental approach and, as such, there are no particular themes represented in our positioning. However, we remain cognizant of increasing capital expenditure trends in several sectors and are seeing opportunities to deploy capital in names trading below our intrinsic value estimates.

Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
As we discussed in our first quarter commentary, we continue to see significant return on invested capital (ROIC) improvement opportunities within our holdings over the next several years. During the second quarter, we continued to trim exposures that we think have more risk due to what we view as late-cycle dynamics. These holdings—including, for example, Spartan Motors—reached reward-to-risk ratios that no longer justified maintaining the positions. We continually measure the reward-to-risk ratios of our holdings through scenario/sensitivity analysis and size positions accordingly. During the quarter, we added Equity Commonwealth, a Real Estate Investment Trust (REIT) that focuses on commercial office space. Historically, our strategy has maintained an underweight to REITs, but Equity Commonwealth appealed to us because the company’s management strategy mirrors how we would be allocating capital in real estate (selling assets and sitting on cash), and in our view Equity Commonwealth offers a good reward-to-risk ratio. We see this targeted exposure to REITs as warranted, though we believe it is unlikely for the sector weight to exceed 5%.

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. 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. This does not mean we are expecting an imminent recession, but we do see an inflection from accelerating growth dynamics to something more tepid. 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 don’t appreciate 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

Smaller Companies Fund Attribution Chart

  • All Russell 2000 Index sectors saw positive returns in the second quarter of 2018.
  • Most of the fund’s underperformance relative to the index stemmed from sector allocation. No one sector stood out as particularly beneficial or negative in the quarter. But significant overweights to the underperforming materials and industrials sectors were the main detractors. The fund was overweight to both sectors by nearly eight percentage points during the quarter (see accompanying chart).
  • Stock selection overall had a modest negative impact on quarterly performance. Stock selection was strongest in the materials sector where Innophos Holdings, the fund’s largest holding, gained over 19%. This non-benchmark name has been a top holding in the SBH sleeve of the portfolio since they were added as a manager in mid-June 2017. The stock is discussed in detail below.
  • Stock selection was also strong overall in industrials, but some holdings in the sector were among the largest detractors. Long-time holding Axon Enterprises was the leading individual contributor in the quarter. Owned by Weiss, the stock gained over 62% in the quarter. Two meaningful detractors in the sector were Avis Budget Group (owned by Weiss and down over 31%) and Heritage-Crystal Clean (owned by Bronchick and down over 14%). Both Avis and Heritage-Crystal Clean are discussed below.
  • Stock selection was weakest in the telecom sector where the sole holding in the sector, Millicom International Cellular fell 14.45%. The stock was the third-largest holding, and the single-largest individual detractor at quarter-end. Below, Bronchick discusses his thesis for continuing to own this name. The fund’s average cash position during the quarter was 12%. Cash was one of the largest overall detractors in the quarter as the small-cap market advanced.
Top 10 Contributors as of the Quarter Ended June 30, 2018
Company Name Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Axon Enterprise Inc. 2.55 0.13 62.91 1.36 Industrials
Innophos Holdings, Inc. 6.31 0.04 19.41 1.13 Materials
Pandora Media Inc. 1.32 0.00 58.25 0.62 Information Technology
The E W Scripps Co. Class A 3.38 0.03 14.59 0.54 Consumer Discretionary
MacQuarie Infrastructure Corp. 1.94 0.00 17.38 0.38 Industrials
Avid Technology Inc. 2.36 0.01 16.30 0.37 Information Technology
CommVault Systems Inc 2.10 0.12 16.61 0.36 Information Technology
HRG Group Inc. 1.41 0.07 19.42 0.35 Consumer Staples
Seacoast Banking Corp. 1.63 0.06 20.63 0.35 Financials
Haemonetics Corp. 1.14 0.21 30.88 0.35 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 Contributors

Innophos Holdings (Mark Dickherber and Shaun Nicholson, SBH)

Management has aggressively moved to reposition the company into a focused specialty chemical company that aims to drive significantly higher margins and ROIC levels under a new leadership team. Our thesis for significant value creation happening over the next several years has not changed. In our view, even with a solid rise in the share price in the second quarter, Innophos’s valuation levels remain very attractive given the company’s continued progress on cost initiatives being executed in the near term, along with the company’s solid capital allocation discipline, which we believe is underappreciated by the market. The reason for the stronger stock performance in the quarter was primarily driven by a very solid first quarter report that showed improving margins, ROIC, and growth solidifying success early on in this transition. We have not increased, decreased, or exited our position due to the performance of the stock in the second quarter.  

Pandora Media (Jeffrey Bronchick, Cove Street Capital)

The company was the first “online” and ad-supported music provider, and it was a material contributor this quarter. After some terrific misadventures by prior “dot-com brain” management, the Liberty Media/Sirius-XM gang bought a material minority position with three board seats. We paid half their price in one of our better timing moves. Simply said, the company has never been allowed to be profitable. We think there is a lot of room for progress between what is now breakeven and the earnings before interest, taxes, depreciation and amortization (EBITDA) margins of terrestrial radio, which are north of 20%. There appears to be a fair amount of low-hanging fruit in that just basic blocking and tackling should lead to much better margins and returns. While it will take some time for all the recent actions to show up in the financial statements, the company generated two consecutive quarters of positive free cash. Our research suggests that there remains significant demand for an ad-supported music streaming service, even in a very competitive world that includes Spotify Technologies and Apple Music. In addition, we have yet to see the benefits of any partnerships between Sirius-XM and Pandora. In fact, our recent meeting with Sirius-XM reinforced our belief that there are tremendous opportunities for the companies to collaborate and obvious synergies if Pandora were to become a part of Sirius-XM. Accordingly, despite the appreciation of the stock, we remain holders.

The E.W. Scripps Co. (Jeffrey Bronchick, Cove Street Capital)

The broadcast television world remains incredibly dynamic, but there recently have been a number of developments that look positive for E.W. Scripps. First off, 2017 was indeed a tough year as it relates to the ongoing reduction in the number of cable and satellite subscribers for which E.W. Scripps gets paid (via retransmission revenues). However, so far in 2018, the company has seen no further losses and is actually regaining subs as the total number of over-the-top customers is now becoming meaningful. Additionally, as discussed above, a recent large mergers and acquisitions deal—Gray Television buying privately held Raycom Media—included a seller’s multiple much higher than the multiples at which E.W. Scripps and Tegna (also in the portfolio) trade. Finally, 2018 is shaping up to be a big year for political spending and the market has begun to anticipate that E.W. Scripps will see a large benefit. For all the aforementioned reasons, shares of E.W. Scripps rebounded during the quarter. However, our valuation analysis suggests that E.W. Scripps continues to trade at a meaningful discount to its intrinsic value.

Top 10 Detractors as of the Quarter Ended June 30, 2018
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Millicom International Cellular SA 3.63 0.00 -14.45 -0.59 Telecommunications
Avis Budget Group Inc. 1.51 0.15 -31.30 -0.55 Industrials
Heritage-Crystal Clean Inc. 2.74 0.01 -14.65 -0.47 Industrials
MDC Partners Inc. A 1.04 0.02 -35.42 -0.42 Consumer Discretionary
GTT Communications Inc. 1.52 0.07 -18.69 -0.34 Information Technology
Cherokee Inc. 0.31 0.00 -55.00 -0.25 Consumer Discretionary
Alta Mesa Resources Inc. A 1.17 0.00 -15.13 -0.21 Energy
Spartan Motors Inc. 0.83 0.03 -13.68 -0.15 Industrials
Tegna Inc. 0.86 0.00 -9.83 -0.13 Consumer Discretionary
Delta Air Lines Inc. 1.89 0.00 -5.84 -0.13 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

Millicom International Cellular (Jeffrey Bronchick, Cove Street Capital)

The company 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, as well as other assets such as cell phone towers—under the direction of a CEO who hails from Liberty Global. The stock declined due to a selloff by investors of all emerging-market-related assets. Focusing on the long term, we still see a severely undervalued stock that is continuing to develop into a premier Latin American cable/telecom player and is approaching a crossover point where its legacy voice revenues will be eclipsed by new cable and 4G customers.

Avis Budget Group (Dick Weiss, Wells Capital Management)

Avis Budget Group, a car rental service company, declined 3.3% during the quarter. Avis reported modestly good results, but given the bar was high going into the quarter (chatter was for a 2%–3% increase in pricing in the Americas and potential for a guidance raise vs. negative 0.2% and re-affirmation of guidance), it wasn’t enough for the stock to work, particularly as the data points on used vehicle pricing and rental pricing were positive intra-quarter. This was followed up a few weeks later by a negative sell-side initiation that cited rising off-lease supply and increased tech penetration in new vehicles, providing downward pressure to used car prices at what is already a late point in the cycle, and a belief that the U.S. car rental industry may struggle to raise prices sufficiently to offset rising vehicle depreciation expenses. The net result has been a de-rating in the multiple as fiscal-year 2018 earnings per share (EPS) has moved from $3.34 at the end of April to $3.53 today and fiscal-year 2019 EPS has moved from $3.85 to $3.89 over that same time frame, resulting in the one-year forward price-to-earnings (P/E) multiple contracting by 34% and the two-year forward P/E multiple contracting by 31%. We reduced our 2019 private value (PV) by 5% to account for slightly lower rental pricing than previously assumed given intra-quarter checks offset by a slightly higher PV multiple. After speaking to management several times over the quarter, we have a high degree of confidence that (a) the industry is in a much more rational position vs. a year ago and (b) Avis will be able to demonstrate to the market tangible progress on leveraging the in-place assets and core competencies to evolve the business model to be a critical player as the shift to autonomous vehicles gains momentum. As such, we have been adding around current levels. 

Heritage-Crystal Clean (Jeffrey Bronchick, Cove Street Capital)

The company is a provider of environmental services as well as a re-refiner of used motor oil. It declined due to an outage at their re-refinery and a late winter that caused many of their waste collection routes to be out of service during the first weeks of spring. We view these as temporary setbacks and point to the continued production of good free cash flow and increased margins by the company as indicators for value creation. Heritage’s environmental services business has returned to high single-digit growth, helping drive free cash flow higher. We continue to see the normalization of margins within the re-refined oil segment in addition to continued long-term growth of environmental services as the two future drivers for earnings and therefore returns in the stock. This has been an excellent long-term holding.