Litman Gregory Masters Equity Fund First Quarter 2019 Attribution

Over the first quarter of 2019, the Litman Gregory Masters Equity Fund gained 14.05%, performing in line with its Russell 3000 Index benchmark (which gained 14.04%) and outperforming the Morningstar Large Blend Category (up 12.91%). Since its December 1996 inception, the fund’s 8.07% annualized return narrowly lags the Russell 3000 Index’s gain of 8.34% and is ahead of the Morningstar category’s 6.83% 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 market roared ahead in the first quarter, sending valuations for the popular benchmarks back near historic highs. Stocks appear to still be under the spell of low interest rates. Fed chair Jerome Powell and other central bankers appear to be just as sensitive to market moves as their predecessors, delaying the return to normal interest rates and giving confidence to investors that nothing bad can happen. Although some of the deeper cyclical sectors have lagged, we are reluctant to invest in those areas given how late we are in the economic cycle, both here and abroad. The portfolio contains high-quality businesses with good balance sheets and is diversified across a wide variety of end markets. Although very few if any quality businesses have low absolute valuations, the portfolio is attractive from a relative valuation standpoint.

Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices rebounded significantly last quarter as fears of a global slowdown began to dissipate, China trade talks showed some progress, and the Fed reversed course on a tighter monetary policy. The U.S. equity markets rallied double digits, in sharp contrast to the significant fourth quarter declines, as investors became more enthusiastic about stable and potentially growing global growth. The equity market volatility over the last six months is a great reminder of the futility in trying to time the market. At Harris Associates, we embrace the market’s price volatility to enhance our portfolio positioning but remain stalwart in not letting price movements affect our determination of underlying business value. As we look forward, we continue to believe the outlook for underlying company fundamentals is positive, which should lead to positive returns over the medium term.

Across the two portfolios, we purchased U.S. Silica and Thor Industries during the quarter. There were no sales for the quarter.

Scott Moore, Nuance Investments
In the first quarter of 2019, it appears investors’ appetites for expensive valuations, leverage, and a general lack of focus on risks have returned. In our opinion, those risks include an acceleration of technology competitive disruptions, lower corporate income taxes that we do not believe sustainably raised returns on capital and thus created a short-term overearning period for companies, and above-average debt levels in the broad industrial space as well as governments around the world. As always, our team continues to center on optimizing the best risk/reward situations we can find within the sea of investment opportunities that exist. In today’s market, we are seeing opportunities in the financial, health care, and consumer staples sectors. In the financial sector, we are overweight to the insurance industry. Within the insurance industry, we are finding attractive risk/rewards in the Property & Casualty and Life & Health sub-industries. In the Property & Casualty sub-industry, we believe we are finding opportunities in select leaders such as Travelers Companies and Everest Re Group, due to under-earnings stemming from the relatively recent catastrophe impacts. In the Life & Health sub-industry, we believe we are finding attractive risk/rewards in leaders like MetLife and Reinsurance Group of America, largely due to continued low long-term interest rates. We continue to see one-off opportunities in the health care sector, but we have lowered our weights in both Dentsply Sirona and Smith & Nephew after periods of outperformance. We remain overweight in the consumer staples sector where we see opportunities in leaders 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, communication services, and consumer discretionary sectors due to valuation concerns.

Chris Davis and Danton Goei, Davis Advisors
In first quarter 2019, the portfolio generated a positive return but lagged the S&P 500’s 13.7% return primarily due to the portfolio’s larger weighting in financials, which lagged the broader market.

Currently, the portfolio holds 15 securities primarily in the financials, consumer discretionary, and communication services sectors. While the portfolio is concentrated, we believe the types of businesses we hold—even within certain sectors—are not only dominant in most instances but are also quite distinct in their respective earnings drivers, providing a reasonable balance of offense and defense at the business level.

To illustrate this point it is useful to note that the top five holdings as of March 31 were: Berkshire Hathaway, Capital One Financial, Wells Fargo, Amazon.com, and United Technologies—all very substantial companies with strong competitive positions in different markets.

Looking ahead, we are very encouraged by the value we are uncovering in today’s market. For instance, the forward P/E of our portfolio is approximately 13x versus 17x for the S&P 500, yet our companies have been growing earnings per share at a superior double-digit rate over the past five years, which compares favorably against the market. Furthermore, we believe we own superior businesses as defined by their durability of earnings power, balance sheet strength, and competitive positions trading at attractive prices.

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 strategy 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 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.

Dick Weiss, Wells Capital Management
In the first quarter of 2019, U.S. equity markets saw a sharp recovery after the selloff during the fourth quarter of 2018. The sharp reversal was largely driven by a more dovish tone from the Federal Reserve on the monetary policy front and what appeared to be progress on the U.S.-China trade front.

During the market decline in the fourth quarter and subsequent reversal in the first quarter, we were able to add several high-quality companies to the portfolio as our Private Market Value (PMV) process allowed us to take advantage of “market emotion” during a period of market stress. Consistent with our process, we look for companies with a sustainable competitive advantage, defensible market niche, strong recurring revenue, high return on incremental capital spending, and reasonable exposure to economic cycles. As our goal is to build an “all-weather portfolio” helping our clients grow their assets over the long term, companies with the aforementioned characteristics have the ability to create tremendous value over time.  
Over the first quarter, several of the portfolio’s health care and financials holdings performed well as several companies reported better than expected earnings results and showed strong performance after a weaker fourth quarter.

* 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

  • In what was a strong quarter, all Russell 3000 Index sectors moved higher.
  • Stock selection was additive during the quarter. This was offset, however, by sector allocation.
  • Stock selection was most beneficial within health care, the sector to which the fund had the biggest underweight. The fund’s holdings in this sector gained nearly 18% in the quarter, on average, compared to a gain of just over 8% for the benchmark’s health care names. Alexion Pharmaceuticals, owned by Dick Weiss of Wells Capital Management, was up 38.85%. Weiss discusses this name below.
  • Another sector with additive stock selection was communication services. These stocks gained around 17% in the quarter, versus around 14% for the benchmark’s communication names. The fund’s largest individual contributor during the quarter, Netflix, had an average weight of 2.5% and was up over 33%. This stock is owned by the team at Sands Capital as well as by Bill Nygren of Harris Associates; both managers discuss this holding in greater detail below. One of the fund’s leading detractors also came from the communications services sector. Global Eagle Entertainment, owned by Weiss, fell over 68% in the quarter.
  • From a sector allocation perspective, the fund’s significant overweight to underperforming financials (see table above) detracted from relative performance. In addition, the fund’s nearly 4.5% average underweight to information technology (which outperformed the broader benchmark) also detracted from relative performance. However, several information technology names were leading contributors to the fund’s performance over the quarter, including ServiceNow (up 38.44% and owned by Sands) and Visa (up 18.59% and owned by Sands and Clyde McGregor at Harris Associates). Both names are discussed below.
  • The fund’s cash position decreased slightly from last quarter, averaging just under six percent. Given the equity market’s advance during the quarter, the allocation to cash detracted from relative performance.

Top 10 Contributors as of the Quarter Ended March 31, 2019

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
ServiceNow Inc. 1.64 0.14 38.44 0.57 Information Technology
Visa Inc. Class A 2.96 0.92 18.59 0.57 Information Technology
Alibaba Group Holding 1.86 0 33.11 0.5 Consumer Discretionary
Alphabet Inc. A 3.69 1.23 12.63 0.48 Communication Services
Zendesk Inc. 0.83 0.03 45.62 0.34 Information Technology
United Technologies Corp. 1.43 0.36 21.76 0.32 Industrials
Apache Corp. 1.05 0.05 33.07 0.31 Energy
Alexion Pharmaceuticals Inc. 0.88 0.1 38.85 0.3 Health Care
Amazon.com Inc. 3.33 2.46 18.56 0.62 Consumer Discretionary
Netflix Inc. 2.53 0.52 33.21 0.71 Communication Services

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

Netflix (Bill Nygren, Harris Associates)

  • We like that Netflix’s significant spend on programming requires little incremental investment as new users subscribe, and we think superior content provides a formidable barrier to entry.
  • Netflix has added more subscribers year over year since launching its streaming business, and we believe this growth will be perpetuated by increasing broadband penetration, more robust payments infrastructure, the proliferation of smart TVs, and reinvestment into content.
  • In our view, founder and CEO Reed Hastings has displayed the patience and fortitude to guide the company through multiple business model evolutions and is an excellent steward of shareholder capital.

Netflix delivered strong full-year earnings results, in our view, as global subscriber additions totaled 28.6 million in 2018 compared with 21.6 million in 2017. Notably, the company produced the best annual U.S. subscriber additions since 2015, despite U.S. subscriptions that are already more than two times the size of rival Hulu and about 50% higher than HBO. We believe the number of subscribers is the most important driver of long-term value at Netflix and, by our measure, the company continues to grow at a remarkably stable rate. In addition, Netflix gained some distinction in February when its film “Roma” won four Academy Awards and was the first film distributed primarily by a streaming service that was nominated in the “Best Picture” category. We remain pleased with the underlying performance at the company.

Netflix (Frank Sands, Jr. and Michael Sramek, Sands Capital)

Thesis: Netflix is the leading online video streaming subscription service in the United States in terms of subscribers with a strong and growing international presence. Our research indicates on-demand viewing is becoming a preferred way to access entertainment, and we believe Netflix is well positioned to benefit from this trend. Ultimately, we expect on-demand video streaming services will reach 90 percent penetration of broadband homes worldwide over the next five to 10 years. While we expect Netflix to increase its U.S. subscriber base, we believe its international expansion opportunity will be the primary driver of long-term growth. We estimate international subscribers will more than triple as Netflix enters new geographies and global broadband usage continues to grow. As Netflix continues to scale its business, it should enable funding for further development of proprietary television shows and movies, helping to distinguish it from competition. We expect significant subscriber growth internationally combined with the increased profitability of the U.S. business will enable Netflix to produce above-average earnings growth over the next five years.

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

First quarter share performance: Netflix reported strong fourth quarter 2018 results. Total streaming revenue grew 29 percent year over year to $4.1 billion, and the company added a record 8.8 million paid customers, growing the subscriber base 26 percent year over year. Netflix added 5.8 million U.S. subscribers, the highest since fiscal year 2013, despite being twice as large as then. The opportunity remains early ex-U.S., with 25 million new international subscribers versus 18 million in 2017. In addition to strong growth, Netflix also reported impressive viewership stats. For example, over 80 million member households (54 percent of subscribers) watched Bird Box, and recent debuts Sex Education and You were both on track for more than 40 million households within their first four weeks. This reach demonstrates to us that Netflix has become the “home screen” for more and more people when they want to find something to watch. That is a powerful habit, in our view, that has significant implications for attracting and maintaining subscribers, expanding its completive moat, and generating long-term pricing power. Management’s guidance reflects this momentum, calling for increases in streaming revenue and global net adds of 21 and 25 percent, respectively, for the first quarter 2019.

ServiceNow (Frank Sands, Jr. and Michael Sramek, Sands Capital)

Thesis: ServiceNow is an innovative software-as-a-service provider to large enterprises focused on the information technology service management (ITSM) space. ServiceNow’s ITSM products enable customers to manage, track, and automate the services workflow between a requestor and a fulfiller. While ServiceNow got its start developing IT help desk applications, the company has been able to grow beyond the help desk to use cases in human resources, facilities management, finance, and customer service, among others. In our view, ServiceNow is the leading ITSM provider, as the competitive environment is fairly benign. More recently, the company has been expanding into IT operations management (ITOM), which significantly increases its total addressable market. We believe ITOM, which encompasses everything related to the day-to-day operations of IT infrastructure, is a natural complement to ServiceNow’s ITSM offering. Given its leading position in ITSM and early-stage opportunities in ITOM, we believe ServiceNow can grow its revenue at an above-average rate over the next five years.

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

First quarter share performance: Shares of ServiceNow rose after reporting strong fourth quarter 2018 earnings. Management pointed to broad-based success across products and geographies, with the key highlight being a reacceleration of the core ITSM product, a strong indicator of sustained demand in the market. A suite of emerging products also continues to see strong adoption—with 42 percent of net new annual contract value spent on these emerging products—and we estimate that emerging products now account for approximately 25 percent of total revenue. Preliminary fiscal year 2019 guidance was strong with management expecting little to no deceleration, and we see considerable possibility for a topline acceleration in 2019. Management also expects to deliver consistent operating leverage over the next several years and continued free cash flow expansion. Overall, we believe that ServiceNow is showing impressive execution at scale, and it continues to exceed our expectations.

Visa (Clyde McGregor, Harris Associates)

  • We continue to believe that Visa is a well-managed company, it has significant competitive advantages in the banking industry through its deep payments network, and that its business model remains robust.
  • We think that the accelerating trend of paper to electronic forms of payment on a global basis will promote Visa’s growth for some time to come.
  • Visa’s acquisition of Visa Europe will widen its global market exposure and, in our view, provides the company with a significant value-enhancing opportunity.

Visa’s fiscal first quarter results included revenue and earnings per share that were better than market expectations. Payments volume growth of 11% year over year translated to comparable earnings-per-share growth of 21%. However, investors were mildly alarmed that cross-border volume grew only 7%. Our analysis revealed that some one-time factors impacted cross-border transactions in the period. Excluding these, growth would likely have reached 10% for the first quarter. Management reaffirmed full-year net revenue growth at a rate in the low double digits while expressing a cautious stance due to potential fallout from global macroeconomic issues (e.g., trade disputes and Brexit). In our view, Visa remains a compelling investment with shares that are trading at a discount to our estimate of its intrinsic value.

Alexion Pharmaceuticals (Dick Weiss, Wells Capital Management)

Alexion, a pharmaceutical company, reported solid fourth quarter earnings results and announced positive results for its longer-acting next-generation complement molecule called Ultomiris and a quicker switch from its predecessor molecule Solaris plus a couple smaller but focused rare disease molecule acquisitions. We continue to like Alexion and think it remains one of the most attractive biotech companies with excellent long-term patent protection.

Top 10 Detractors as of the Quarter Ended March 31, 2019

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Global Eagle Entertainment Inc. 0.13 0 -68.19 -0.09 Communication Services
Qurate Retail Inc. 0.84 0.03 -18.14 -0.18 Consumer Discretionary
Henkel AG & Co. KGaA 1.13 0 -2.92 -0.04 Consumer Staples
Berkshire Hathaway Inc. A 2.59 0 -1.56 -0.04 Financials
Berkshire Hathaway Inc. B 1.43 1.43 -1.61 -0.03 Financials
Everest RE Group LTD 0.32 0.03 -0.2 0 Financials
Markel Corp. 0.62 0.05 -2.67 -0.03 Financials
American Airlines Group Inc. 0.8 0.05 -0.82 -0.01 Industrials
Ferguson PLC 0.99 0 -0.4 -0.01 Industrials
Stericycle Inc. 0 0.01 0.49 0 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

Qurate Retail (Bill Nygren, Harris Associates)

  • In comparison to its retail peers, we believe Qurate Retail’s seven leading brands including QVC and HSN, exhibit superior economics in terms of return on invested capital and economic growth.
  • We believe Qurate Retail’s management team has historically demonstrated strong capital allocation and is working to enhance shareholder value.
  • We appreciate that the company requires little investment to support growth, as capital expenditures amount to a smaller amount of cash flow than required by department stores.

Qurate Retail’s share price dropped sharply following the release of its fourth quarter earnings report in late February. The HSN acquisition has, thus far, produced disappointing results while various international QVC assets also underperformed. In our view, the stock looks very inexpensive as share repurchases and expected HSN synergies alone should drive earnings per share higher in 2019. We believe the company is an above-average retailer with little investment needed to support growth. We continue to believe the valuation for Qurate remains attractive, offering a compelling reason to own it.

Henkel AG (Pat English and Andy Ramer, FMI)

Henkel is the global leader in adhesives and a regional player in laundry, home care, and beauty products. The thesis for this investment was that Henkel’s number one position in adhesives allowed them economies of scale and gave investors exposure to a wide variety of end markets. Additionally, the company had a margin opportunity in adhesives. Henkel also had a strong German laundry and home care business and a weak U.S. business that we thought was poised to improve.

Early in the first quarter, Henkel decided that they needed to significantly increase promotional spending in the U.S. laundry and home care segment, which hurt near-term earnings expectations and the stock. Since it is unknown whether this additional spending is permanent or temporary, we are not adding to the stock at the current time, even though the valuation appears attractive at 14x earnings. Tactically, we took some losses on the stock to offset some gains in the portfolio.