Litman Gregory Masters Equity Fund Fourth Quarter 2018 Attribution

During a challenging period for stocks in the fourth quarter of 2018, the Litman Gregory Masters Equity Fund declined 15.90%, underperforming its Russell 3000 Index benchmark (which fell 14.30%) and the Morningstar Large Blend Category (down 13.55%). Over the full year, the fund’s 9.91% loss also lagged these benchmarks. In 2018, the Russell 3000 fell 5.24% and the Morningstar category fell 6.25%. Since its December 1996 inception, the fund’s 7.52% annualized return is roughly in line with the Russell 3000 Index’s gain of 7.79% and ahead of the Morningstar category’s 6.31% 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. As of the prospectus dated 4/30/2018, the gross and net expense ratios for the Institutional Class were 1.27% and 1.15%, respectively; and for the Investor Class were 1.52% and 1.40%, respectively. There are contractual fee waivers in effect through April 30, 2019. All performance discussions in this report refer to the performance of the Institutional share class

Themes, Trends, and Observations from the Managers*

Pat English and Andy Ramer, FMI
Markets are moving dramatically in both directions, although mostly down in the December quarter. It is too early to say whether this is the beginning of a bear market or just another “pause that refreshes.” The Federal Reserve has had an outsized role in trying to manage the economy, which has led to asset inflation far in excess of company fundamentals or the real economy. At some point, valuations will have to reflect the underlying reality of business. With the December quarter pullback, that reconciliation appears to have started, increasing the research opportunity set, although many of the higher-quality, less cyclical businesses and industries remain quite expensive. In general, cyclical, commodity-oriented, money-losing, and weaker balance sheet companies were hit the hardest. A couple of our high-quality cyclicals were caught in this downdraft and we added modestly to them. Conversely, we’ve trimmed a couple of stocks whose position sizes grew too large. The portfolio remains relatively conservatively postured.

Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices declined significantly last quarter as fears of a global slowdown dominated the market narrative. The U.S. equity markets suffered double-digit declines as investors fled the more cyclical parts of the market in search of smoother expected earnings/dividend streams. We recognize the possibility of slower earnings growth in 2019 but believe investors have become too pessimistic given the still favorable underlying economic conditions that exist. We believe the outlook for underlying company fundamentals remains more positive than many think, which should lead to positive equity returns over the medium term.

We had more activity than usual this past quarter due to the higher level of market volatility and some tax-loss harvesting. Across the two portfolios, we purchased Apache, Carlisle, CBRE, DXC Technology, Hilton, Netflix, and Southwest Airlines during the quarter. We trimmed some positions on price strength and added to others on weakness. We sold our positions in Chesapeake Energy, CommScope, Johnson Controls, Mastercard, and Oracle.

Scott Moore, Nuance Investments
As we’ve been discussing throughout the year, we have seen many traits from our bottoms-up research that would lead us to believe we are in a late cycle, and one of those traits is when many (if not most) investors actually perceive risk to be low as opposed to very high. These types of things happen when the market does not appear to care nor properly appreciate valuation traits or leverage traits, and when there is a very narrow group of stocks driving the vast majority of performance. For the first time in a while during the fourth quarter of 2018, the market did seem to care about some things we’ve talked about like valuation and leverage.

While our sector weights were stable during the quarter, the volatility did create some opportunities, in our opinion. We added to our overweight position in the financial sector as we added Northern Trust to the portfolio. We also continue to see attractive opportunities in the insurance industry in both the property & casualty sub-industry, due to underearnings stemming from the relatively recent catastrophe impacts, and the life and health sub-industry, largely due to continued low long-term interest rates. In the health care sector, we remain overweight and continue to own select leaders like Dentsply Sirona and Smith & Nephew, but we exited our position in Johnson & Johnson during the quarter after a period of outperformance. We continue to have an overweight position 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 weight in the information technology sector is slightly below the benchmark as valuation concerns persist broadly, but we have been able to purchase one-off leaders like Amphenol and Applied Materials. 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
For the year 2018, the S&P 500 Index declined 4.38%. Although we have witnessed somewhat more volatility in recent periods, U.S. economic fundamentals remain strong with historically low unemployment, robust gross domestic product (GDP) growth, and modest inflation. The Federal Reserve continues on its path to normalize interest rates now that the economy has clearly recovered from the last financial crisis but is doing so in a gradual, measured, and manageable fashion thus far. In brief, the U.S. economic backdrop and fundamentals appear favorable overall.

The portfolio underperformed the S&P 500 during the year-to-date period. Our investments in Amazon.com and Berkshire Hathaway were particularly accretive to performance during the period.

Still, starting in mid-2018, investors have turned more cautious due to a confluence of factors including the U.S.-China trade dispute, rising interest rates, and the economic outlook.

In the second half of the year, when volatility increased, it became a tale of two markets. A number of stocks and sectors that had contributed meaningfully to our strong results over the previous three to four years underperformed, as investors sought sectors with historically lower share price volatility. In our minds, the tradeoff is clear: We can continue to own and purchase more shares of companies that in our estimation have a high probability of delivering competitive results over the long term but that are somewhat out of favor or more volatile than other groups in the near term. Or we could theoretically follow nervous investors into areas of the market that we regard as marginal long-term investment choices given their extremely low to negative topline growth, bloated balance sheets where debt has increased considerably, and margins and dividend payout ratios that may be unsustainable over time. Hence while 2018 was a period in which we underperformed, we believe many of those companies that were detractors in the year will ultimately be among the long-term wealth builders in the portfolio in the years ahead.

In our experience, the capital markets eventually tend to direct capital to those businesses that deliver evidence of strong long-term earnings power, and we recognize being selective about owning the right businesses is ultimately more important than trying to avoid short-term price fluctuations. As Peter Lynch famously said, “Investors have lost more money trying to avoid market corrections than in the corrections themselves.” We absolutely agree having navigated markets for the last 50 years.

In brief, we believe investment success over the long term requires building a portfolio that is superior to the broader market. We hold above-average businesses trading at below-average prices that can reliably compound capital over the long term, which should allow the power of compounding to drive total returns for our clients. We remain steadfastly focused on ensuring our businesses continue to demonstrate the potential to deliver superior long-term results for shareholders, regardless of short-term price volatility, which is a normal part of the investment equation.

While we have seen only one side of the “valley” in terms of the market correction of the last six months, we encourage investors to keep in mind that the market is incredibly resilient and tends to march upward with corporate profit growth over time, that the backdrop and underpinnings of the overall economy are strong, and that this environment of uncertainty and low prices makes this an especially attractive time to increase ownership in great long-term businesses, disconcerting as short-term price fluctuations can be.

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 Select Growth 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 (namely sustainable above-average growth, leadership in a promising business space, significant competitive advantage, clear mission and value-added focus, financial strength, and rational valuation and terms).

Dick Weiss, Wells Capital Management
The volatility in the equity markets for the fourth quarter, and in particular December, has been reflected upon by many market pundits and investors, whether they have been bullish (“the selling is overdone”) or less bullish (“this has been overdue”). Many have speculated what this means and where the market could be going.

The market environment for the quarter has several different narratives, from (1) concerns over a potential policy error by the Fed after raising interest rates for the fourth time in 2018 to (2) the U.S. trade war with China could get worse before it gets better to (3) a potential deceleration in U.S. corporate earnings growth. These concerns were on investors’ minds as the month progressed. However, there are a few things to consider when looking at the broader landscape of the market as we close the chapter on 2018:

  • December tends to be a month with very low market liquidity as many market observers step away as the month progresses toward the holidays. As such, the markets can be susceptible to buy and sell orders of any meaningful size, influenced by electronic trading programs that can compound directional market moves in a market with low liquidity.
  • The market decline over the past year has been entirely driven by P/E multiple compression while earnings growth has been robust, north of 25% year over year. The market multiple has declined approximately 30% since the beginning of the year; this decline has been driven by falling sentiment as fundamentals have remained strong.
  • The fundamental backdrop for the United States remains compelling with unemployment at less than 4.0%, low to mid-single-digit GDP growth, and the potential for double-digit earnings-per-share growth in 2019.
During periods of elevated market volatility like we experienced in the fourth quarter, December in particular, we look for compelling opportunities to own high-quality companies that would normally be too expensive to own. 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. Companies with these characteristics have the ability to create tremendous value over time and expand, like weight being removed from a coiled spring. We may have the opportunity to add to these companies at very compelling entry points in the months ahead. History has shown us that stock prices are more volatile than the value of the underlying business; our Private Market Value (PMV) process allows us to take advantage of “market emotion” during periods of market stress.

* 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

  • All but one sector in the Russell 3000 Index declined in the quarter. The only positive sector was utilities, which was up just 0.83%.
  • Stock selection accounted for virtually all the fund’s relative underperformance in the quarter. Energy was by far the fund’s worst-performing sector in the period. The fund’s holdings in this sector declined over 40%, on average, compared to over 25% for benchmark names. Encana, owned by Davis Advisors, declined over 50% and was the biggest individual detractor within the sector.
  • Health care stock selection detracted from relative performance. An underweight to this outperforming sector (relatively speaking) was also a detractor.
  • The biggest contributing sector (overall) in the quarter was information technology, driven by stock selection. Stocks that were particularly strong contributors to relative performance were Workday (which gained over nine percent in the quarter and is owned by the team at Sands Capital), and Red Hat (which gained over 28% in the quarter and is discussed below by Dick Weiss from Wells Capital). Apple declined nearly 30% in the quarter so not owning this index name was a positive, further helping the fund’s relative performance.
  • Another sector where stock selection contributed to relative performance was materials. In particular, Agnico Eagle Mines (owned by Weiss and discussed below) gained 18.50%.
  • At the individual stock level, Amazon.com was the leading detractor from performance. The stock, owned by both Sands Capital and Davis Advisors, declined by around 25% in the quarter. Both managers discuss this stock below. Another meaningful individual detractor was American Airlines, which fell over 34% in the period. Harris Associates’ Bill Nygren, who owns this stock, discusses its performance in greater detail below.
  • The fund’s cash position decreased from last quarter, averaging around seven percent. Given the sharp equity decline during the quarter, the allocation to cash was a significant contributor to relative performance.

Top 10 Contributors as of the Quarter Ended December 31, 2018

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Red Hat Inc 0.58 0.10 28.88 0.14 Information Technology
Agnico Eagle Mines Ltd 0.73 0.00 18.5 0.11 Materials
Workday Inc Class A 0.98 0.08 9.38 0.09 Information Technology
HDFC Bank Ltd ADR 0.72 0.00 10.09 0.07 Financials
Ferguson PLC 0.40 0.00 5.30 0.04 Industrials
Carlisle Companies Inc 0.49 0.02 6.06 0.03 Industrials
Procter & Gamble Co 0.07 0.82 8.12 0.02 Consumer Staples
Johnson & Johnson 0.20 1.37 7.00 0.02 Health Care
Chubb Ltd 0.24 0.22 3.64 0.01 Financials
CBRE Group Inc 0.63 0.05 1.91 0.01 Real Estate

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

Red Hat (Dick Weiss, Wells Capital Management)

Red Hat (RHT), a software company providing open-source software products, was a strong performer for the quarter returning close to 30%. During the quarter, it was announced that IBM agreed to terms to acquire RHT for $190 per share (all cash to RHT shareholders, funded by a mix of cash on hand and debt), a premium of approximately 63% over the closing price of around $117 per share on the day the deal was announced. We feel the valuation reflects RHT's strategic positioning around hybrid cloud longer term, and we think this is a favorable outcome for shareholders in light of recent short-term headwinds and lingering concerns regarding free Linux competition. The $190-per-share offer was in line with our private market value estimate of $192.

Agnico Eagle Mines (Dick Weiss, Wells Capital Management)

Agnico Eagle Mines (AEM), a gold miner, benefited not only from rising underlying commodity prices, but the free cash flow inflection occurring later in 2019 becoming closer to reality as well as its differentiated position as one of the only senior miners to have an increasing production profile. During the fourth quarter, the market was willing to pay up for this growth and AEM's shareholder-friendly capital-allocation track record, catalyzed by a strong third quarter report, highlighted better production and lower costs than expected. Further, both gold and silver moved up in late December as investors questioned the Fed’s interest rate tightening policy, and thus the momentum behind the stronger U.S. dollar in the fourth quarter of 2018. While we have been trimming back the position recently to manage the weighting, we are still very positive on AEM’s prospects given its gold production is set to grow approximately 30% from 2018 to 2020, with a significant increase in free cash flow contributing to the potential for a two-fold dividend increase.

HDFC Bank (Frank Sands, Jr. and Mike Sramek, Sands Capital)

HFDC Bank is India’s largest private bank, with a customer base of approximately 40 million. Though the company offers both retail and corporate lending, retail is its most visible business, with a distribution network of nearly 5,000 branches. Spanning every Indian geography from major metro cities to rural areas, HDFC Bank’s retail footprint has contributed to its leading position in every major retail lending segment, including auto loans, credit cards, and personal loans. Corporate lending accounts for approximately half of HDFC Bank’s loan book, and most loans are made to high-quality blue chip and middle-market companies. Outside of lending activities, the bank is a major distributor and provider of other financial products and services, such as insurance, asset management, and corporate finance.

We believe the current valuation for HDFC Bank is rational based on its historical trading range (price-to-earnings ratio of 23x vs. a historical range of 21x–25x) and long-term earnings growth potential in the high teens to low 20s. HDFC Bank trades at a valuation premium to its local peers, but we believe this is justified due to its strong brand and leadership in the private banking sector in India, exceptional track record on risk management, good earnings visibility, and high-quality customer base. The American depositary receipt (ADR) has also historically traded at a significant premium to the local stock, which can be explained as a liquidity premium as foreign ownership of the local stock is capped above a certain level. Therefore, most investors looking to build meaningful long-term position in the stock typically choose to own the ADR. We believe the ADR premium over the local stock is sustainable as long as the ownership cap is maintained.

HDFC Bank was a relative outperformer in a turbulent market environment for India and emerging markets during the fourth quarter, as it stood out in terms of its steady growth, operating efficiency, and asset quality, which were reflected in its most recently reported results. Following the default of a prominent Indian financing business, investors looked to exit high-risk financials businesses. As a result, HDFC Bank benefited, due to its status as a relative safe haven for many domestic and foreign investors in Indian banks. Beyond the bank’s relative stability within its industry, the company’s growth is supported by what we believe is a secular shift within India’s lending market; while state-owned banks have historically dominated the market, they are becoming increasingly burdened by impaired assets. We believe HDFC Bank’s strong brand, extensive distribution network, business stability, and experienced management team will drive continued success over the long term.

Top 10 Detractors as of the Quarter Ended December 31, 2018

Company Name
Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Amazon.com Inc 3.54 2.46 -25.01 -0.97 Consumer Discretionary
American Airlines Group Inc. 0.78 0.05 -34.14 -0.64 Industrials
Encana Corp 0.78 0.00 -55.81 -0.61 Energy
Capital One Financial Corp 2.85 0.15 -20.02 -0.57 Financials
Alphabet Inc A 3.66 1.18 -13.43 -0.49 Communication Services
Parsley Energy Inc A 0.74 0.02 -45.37 -0.40 Energy
United Technologies Corp 1.59 0.35 -23.41 -0.38 Industrials
Visa Inc Class A 3.18 0.90 -11.94 -0.37 Information Technology
Apache Corp 0.59 0.05 -44.61 -0.34 Energy
DXC Technology Co. 0.89 0.07 -27.06 -0.34 Information Technology

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

Amazon.com (Chris Davis and Danton Goei, Davis Advisors)

Amazon, an e-commerce giant that has profoundly reshaped the retail industry over the years, is an example of a market leader in the portfolio. Amazon offers an optional membership-based business model through its Amazon Prime service. In addition to its retail business, Amazon has a state-of-the-art, rapidly growing web services business that enables companies and other organizations to outsource their computer systems to Amazon’s digital cloud. In the fourth quarter, Amazon.com was a detractor to portfolio results, declining 25.0%. Conversely, in the year-to-date period, Amazon.com was a contributor to portfolio results, returning 28.4% in the period.

Amazon.com (Frank Sands, Jr. and Mike Sramek, Sands Capital)

Amazon is one of the largest Internet-based retailers in the United States and is a growing global leader in the computing infrastructure-as-a-service (IaaS) space. We believe each of its two core businesses is positioned for long-duration growth opportunities. As a retailer, Amazon is a customer-centric company where people can find nearly anything they want to buy online. We expect e-commerce growth to continue to outpace overall retail spending for the foreseeable future and believe Amazon should be a primary beneficiary of this global secular trend. The company’s IaaS offering, Amazon Web Services (AWS), provides organizations with on-demand access to computing, storage, and other services through its cloud platform. Over the coming decades, we expect AWS will be a key player in the paradigm shift toward shared infrastructure services. We view Amazon’s two core franchises as attractive and rapidly growing businesses that each meet our investment criteria. We anticipate robust topline growth, scale-based expense leverage, and a higher-margin sales mix to drive above-average revenue and earnings growth over the next five years. As long-term growth investors, we view valuations through a five-year lens. In our view, Amazon is rationally valued based on our longer time horizon and our assessment of its growth prospects.

Amazon’s shares were pressured during the fourth quarter due to the market’s strong selloff of FAANG stocks and growth equities in general. In addition, the company reported good third quarter results, but issued fourth quarter revenue guidance that was lower than we expected. We believe lowered revenue guidance is a result of currency headwinds, a typical deceleration in the fourth quarter due to higher than average e-commerce penetration around the holidays, changes to accounting around its Prime business, Whole Foods underperforming, and the ongoing shift to subscriptions within media.

American Airlines (Bill Nygren, Harris Associates)

  • American Airlines is a long-tenured member of an industry in the United States that historically lacked pricing power and faced problems related to poor corporate cultures; after years of consolidation capped by the merger of US Airways and American Airlines in 2013, the industry has become more mature and disciplined, in our view.
  • American Airlines is one of four large carriers in the United States that collectively control 75% of the domestic market; CEO Doug Parker sees substantial opportunity to grow value as the company completes the US Airways merger integration.
  • We think Parker’s efforts to improve the company’s culture and restore credibility with employees will prove beneficial over the long term.
  • Management expects $1 billion of revenue growth initiatives (such as optimizing basic economy and expanding premium economy offerings) and $300 million of cost savings that the company has planned to initiate next year to drive significant margin expansion and earnings-per-share growth in 2019. 

American Airlines’ share price was pressured early in the fourth quarter after it warned third quarter revenue would be about $55 million lower due to the effects of flight cancellations caused by Hurricane Florence. However, third quarter results were in line with our expectations, and both revenue and earnings per share met market projections. Management reaffirmed full-year earnings-per-share guidance of $4.50–$5.00, which proved reassuring to investors who feared the company would again reduce the range owing to higher fuel costs. Another highlight was improved domestic yields in the third quarter, with expectations for further improvement in the fourth quarter. More importantly, management expects $1 billion of revenue growth initiatives (such as optimizing basic economy and expanding premium economy offerings) and $300 million of cost savings that the company has planned to initiate next year to drive significant margin expansion and earnings-per-share growth in 2019. 

Capital One Financial (Bill Nygren, Harris Associates)

  • Capital One Financial’s revenues are spread over three business units: consumer banking, commercial banking, and its credit card business; although the credit card business generates most of its revenues, the consumer and commercial banking businesses have performed near the top of the industry.
  • Its credit card business carries strong brand recognition and, importantly, produces industry-leading profitability.
  • We believe Capital One is a well-managed company with a strong capital base that is trading at a discount to our perception of its underlying value.

Despite no fundamental changes, Capital One finished lower for the fourth quarter. In our view, third quarter results were good, with adjusted earnings per share ($3.12) well in excess of market expectations ($2.86). Net interest margins increased 35 basis points quarter over quarter, while credit card charge-offs declined 52 basis points to 4.15%. Additionally, the company executed $570 million in share repurchases in the third quarter, adding to our confidence in the investment. We appreciate that despite an economic slump a few years ago, Capital One remained profitable owing to management’s efforts. We continue to believe the company’s share price is undervalued relative to our perception of its true worth.

Capital One Financial (Chris Davis and Danton Goei, Davis Advisors)

Capital One Financial is the eleventh-largest U.S. bank based on deposits, with branches located primarily in the New York to Washington, D.C. corridor as well as in Texas and Louisiana. This out-of-the-spotlight company may be best known for its competitive credit card offerings and is among the top 10 issuers of Mastercard and Visa cards. In our view, Capital One has a strong balance sheet, has solid capital ratios, and is well positioned for future growth. In the fourth quarter, Capital One was a detractor to portfolio results, declining 20.0%. Similarly, in the year-to-date period, Capital One was a detractor to portfolio results, declining 22.8% in the period.