Litman Gregory Masters International Fund Fourth Quarter 2018 Attribution

During the fourth quarter of 2018, the Litman Gregory Masters International Fund fell 16.52% and the MSCI ACWI ex USA Index was down 11.46%. The MSCI EAFE Index dropped 12.54% in the quarter and the Morningstar Foreign Large Blend Category lost 12.68%1. Since its inception in December 1997, the fund has compounded returns at an annual rate of 6.11% after fees, while the MSCI ACWI ex USA, MSCI EAFE, and foreign blend category have gained 4.71%, 4.28%, and 3.70%, respectively.

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 1.26% and 1.03%, respectively; and for the Investor Class were 1.55% and 1.32%, 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*

David Herro, Harris Associates
Global equity prices declined significantly last quarter as fears of a global slowdown dominated the market narrative. Major foreign equity markets suffered double-digit declines adding to the weakness we saw earlier in the year. Despite a seemingly higher level of caution among investors, 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.

In our international equity portfolio, we opportunistically repositioned the portfolio across existing holdings and added one new position, ASML, a leading developer of semiconductor equipment. Geographically, our portfolio exposure remains tilted toward developed markets though many of the businesses we hold possess global revenue streams. We continue to focus our research on unique opportunities across both developed and emerging markets.

Vinson Walden, Thornburg Investment Management
Performance dispersion ran high among global equity markets in 2018. Yet a common factor was declining valuations. Concerns about political risks were widespread, and some of the loftier expectations for global growth early in the year had to be tempered. Although geopolitical risks and events were essentially unavoidable, corporate fundamentals held up relatively well throughout the year.

Chart 1 below illustrates the changing outlook for regional earnings (denominated in U.S. dollars) since the end of 2016. In 2017, international earnings growth appeared particularly strong because foreign currencies strengthened against the dollar. In 2018, U.S. earnings were buoyed by tax cuts, and the outlook for international earnings declined in U.S. dollar terms primarily because those currencies reversed course and weakened to mid-2017 levels.

International Fund Chart
Source: Bloomberg

Investors have become less confident in the durability of European economic expansion. Consequently, money has flocked to the relative safety (and higher interest rates) in the United States. With our focus on earnings progress and the absolute and relative intrinsic values of the businesses in the portfolio, we remain constructive about the long-term prospects for the portfolio.

Mark Little, Lazard Asset Management
International equities fell sharply in the fourth quarter as tighter U.S. monetary policy, slowing global growth, a collapsing oil price, and continued trade tensions combined to generate significant risk aversion. Not surprisingly, in this environment, the most defensive sectors held up best, led by utilities, telecoms, health care, and consumer staples. The weakest sectors were the most cyclical, with energy, industrial, consumer discretionary, and financial stocks falling sharply. Technology was also hurt by cyclical fears.

On the macroeconomic side, China continued to slow as tighter credit policies were exacerbated by trade war fears. Europe also slowed, not helped by volatile domestic politics and the lingering effects of an auto regulatory change. Meanwhile, the first cracks appeared in the U.S. economic data, despite continued strong payroll figures, as rising rates and cooling global growth started to bite. Tightening liquidity also started to impact credit markets, with spreads expanding rapidly through the quarter, which is a particular concern given the overwhelming amount of debt that has continued to pile up on public and private sector balance sheets since the financial crisis. However, we are already starting to see policy softening in the United States, alongside the first signs of stimulus in China, while many cyclical stocks have fallen to intriguing valuations, absent a full-blown recession. While the outcome of trade discussions is hard to predict, this combination, if it continues, is starting to improve the risk-reward of equity markets.

Overall, the portfolio team remains confident that, by continuing to focus on stock selection, and seeking to find stocks with sustainably high or improving returns trading at attractive valuations, the strong long-term track record of the portfolio will continue.

Fabio Paolini and Benjamin Beneche, Pictet Asset Management
The past quarter has seen a remarkable increase in aggregate volatility with our favored benchmark, MSCI EAFE, down nearly 14% over the period. At the company level the volatility has been even more pronounced—we sometimes question the extent to which passive investments (85% of all trading volume according to a recent JPMorgan report) are driving prices. Our response to this volatility is not to try and predict these wild moves but to use them to our advantage. Over time, we believe intrinsic value, as always, will drive returns.

Although we are resolutely bottom-up in approach, certain sectors and regions have sold off disproportionately. Two areas of note, financials and emerging markets more broadly, present attractive opportunities in our opinion. Within the portfolio, this has manifested itself in the purchase of Moscow Exchange, the dominant stock and financial instrument exchange in Russia, which benefits from a long runway for growth, high returns on capital, and a resilient business model. All for only 10x cash earnings. We also see significant opportunities in China. Through JD.com, CK Hutchison, and Softbank, the portfolio has significant exposure to the Chinese consumer. While we refrain from making bold macroeconomic statements, one needs to understand the broader business and credit cycles driving certain purchasing decisions. In the case of China, after significant credit growth in the past decade (from around 150% to 270% total debt/GDP), it is reasonable to question the potential for a credit downturn. In a nutshell, our conclusion is that of China’s debt pile, only 40% is household related, so the risk is reduced. More importantly, we believe that the fundamental qualities and prices of the businesses we hold afford a significant margin of safety. To put this into perspective, JD.com, the largest retailer in China and second-largest e-commerce platform, trades at 0.4x sales today. Assuming the business never grows again and is able to make a 5% operating margin (hardly a heroic level), the stock trades at 10x earnings. This gives no value to any future growth in Chinese consumption, the significant negative working capital inherent to the business model, or the 20 billion USD private market values for their stakes in JD Finance and JD Logistics.

David Marcus, Evermore Global Advisors
The volatility in the fourth quarter of 2018 was dramatic and, as international markets sold off precipitously, many of our portfolio securities suffered steep price declines. The market selloff was driven by a long list of investor fears, including a global market slowdown, a China slowdown, an Italy crisis, the looming Brexit and U.K. government instability, a continued trade war, oil price volatility, and increasing interest rates, just to name a few. Investors reacted to these concerns with sheer panic. Asset values appeared to become meaningless as investors just wanted to sell their holdings. The downward spiral in prices accelerated as investors put in their sell notices to all types of investment funds, which in many cases were forced to sell portions of their holdings to meet these redemption requests.

As long-term investors, we are mindful of the macro environment, but try to avoid the noise and the incessant “end of the world” conversations. A multi-year view gives us the ability to focus on many types of special situations and not have our investment decisions driven by short-term thinking. Ultimately, our focus is always on the value we are getting for the price we are paying. When the discount is wide enough we are interested. We want to understand what could happen to close this valuation gap and what could cause it to widen and lose money. This is why we focus on value with catalysts rather than just value on its own.

I do not view the last three months as anything more than an opportunity to take advantage of the gift of more attractive valuations by adding to existing positions and initiating new ones. If history has proved one thing over and over, the best time to buy is when it appears everyone is selling. We are strong believers in buying crisis but not buying it blindly. It has served us well over many years. As a result, we added to many of our positions during the quarter at lower and lower prices. We are confident that this is an excellent time to be investing in the markets where we traffic, although it is vitally important to remember that restructurings and corporate strategic changes take time.

In conclusion, we continue to believe Europe offers some of the most compelling investment opportunities, as the region has been a perennial underperformer over the last few years despite the valuation discounts vs. the U.S. and many other markets. In addition, financial and operational restructuring activities continue to accelerate across the region.

* 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

During the quarter, the fund underperformed its benchmark. Stock selection drove the underperformance over the last three months of 2018. Stock selection across four different sectors (communication services, financials, industrials, and materials) drove the majority of the underperformance. It’s important, however, to understand that the portfolio is built stock by stock so the fund’s overweight to consumer discretionary has always been a residual of stock picking, not a macro or sector call by the fund’s sub-advisors.

Litman Gregory Masters International Fund Sector Attribution

International Fund Sector Attribution

  • As part of the GICS reclassification last year, shareholders will notice different sector weightings compared to last quarter.
  • The fund has an overweight to the newly created communication services sector. Many positions previously in information technology and consumer discretionary were recently reclassified as belonging to this sector. Declines in the share prices of Informa and Baidu were among the largest detractors from within this sector.
  • Stock picking within the consumer discretionary sector contributed to performance. The strong contribution from this sector was largely driven by Don Quijote, a Japanese retailer, whose share price rose nearly 23% during the quarter.
  • Being underweight to the two worst-performing sectors (energy and information technology) was positive from a sector allocation standpoint.
  • Stock selection within the industrials sector was a headwind during the quarter. Three of the top 10 detractors reside in this sector: CNH Industrial, CK Hutchison, and Bombardier.
  • In a declining market, utility stocks held up well relative to other sectors. The fund does not hold any stocks within this sector, which detracted from a sector allocation standpoint.

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

Company Name

Fund Weight (%)

Benchmark Weight (%)

Three-month Return (%)

Contribution to Return (%)

Country

Economic Sector

Don Quijote Holdings Co. Ltd. 1.59 0.02 22.88 0.39 Japan Consumer Discretionary
MGM China Holdings Ltd. 1.48 0.00 5.91 0.12 Hong Kong Consumer Discretionary
Willis Towers Watson PLC 0.80 0.00 8.18 0.08 United Kingdom Financials
Philip Morris International Inc. 0.31 0.00 8.35 0.07 United States Consumer Staples
EasyJet PLC 0.29 0.00 6.16 0.06 United Kingdom Industrials
Coca Cola European Partners 1.27 0.00 2.25 0.02 United Kingdom Consumer Staples
Nexon Co. Ltd. 0.77 0.03 -1.49 0.01 Japan Communication Services
CAE Inc. 0.66 0.00 1.12 0.01 Canada Industrials
Diageo PLC 0.38 0.47 0.39 0.00 United Kingdom Consumer Staples
Bollore NV 0.01 0.00 -3.74 0.00 France 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 Contributors

Willis Towers Watson (David Herro, Harris Associates)

  • When formed in 2016, Willis Towers Watson was the third-largest insurance broker in the world. We find that insurance brokerage is an attractive industry, as it does not bear underwriting risk, requires little capital, is highly free cash flow generative, and traditionally earns high operating profit margins.
  • We think that Willis Towers Watson’s current focus on growth initiatives and investments will prove advantageous in the medium term.  
  • By our measure, the company’s current valuation does not reflect the earnings potential from the company’s growth and cost savings initiatives, and we expect that Willis Towers Watson will benefit considerably from higher interest rates and a tightening insurance market.
Willis Towers Watson delivered strong third quarter earnings results, in our view, as organic growth reached 5% after totaling 3% in the second quarter. Management now believes full-year organic growth will be closer to 4% after originally projecting a range of 3%–4%. In addition, the company lowered its fiscal-year tax rate guidance from 22%–23% to 20%–21%, which was lower than our estimates and drove increases to earnings-per-share estimates for the full-year period as well. We believe that Willis possesses several inherent strengths. The company is one of the largest brokers in the world and operates in the attractive insurance brokerage industry. In our view, the industry does not bear underwriting risk, requires little capital, is highly free cash flow generative, and traditionally earns high operating profit margins. We continue to believe that Willis is significantly undervalued relative to its normalized earnings power.

Coca Cola European Partners (Mark Little, Lazard Asset Management)

The European bottling business of Coca Cola, CCEP, held up well in the fourth quarter as investors rewarded its defensive characteristics and a strong set of results. While aided by the warm summer weather, these indicated the business improvement thesis—sales and margin—was well on track, exposing its attractive valuation.

Bolloré (David Marcus, Evermore Global Advisors)

Bolloré is a €10.2 billion market cap conglomerate based in France that is involved in international transportation and logistics businesses, port concessions in Africa, and communication and electricity storage solutions. The company also controls media assets including a 25% stake in Vivendi, a listed French media and telecom powerhouse, which in turn owns Universal Music Group, Canal+, and Havas. This 200-year-old holding company is controlled by Vincent Bolloré, an aggressive value creator with a proven track record (e.g., net asset value has achieved an 18% compound annual growth rate over the last 15 years).

Despite concerns of a trade war and a slower-than-expected growth trajectory in the transport and logistics segment, Bolloré’s business in Africa generated strong cash flows (which accounts for 50% of total net asset value). During the quarter, Bolloré has been slowly increasing its stake in Vivendi by reinvesting the proceeds from the sale of Havas to Vivendi). Despite strong operational results during the quarter, Bolloré was not spared from the global drawdown during the fourth quarter. We believe Bolloré has become cheaper and more compelling at current levels, trading at over a 50% discount to our estimate of intrinsic value.

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

Company Name

Fund Weight (%)

Benchmark Weight (%)

Three-month Return (%)

Contribution to Return (%)

Country

Economic Sector

OCI NV 3.32 0.00 -36.33 -1.35 Netherlands Materials
Codere SA 1.71 0.00 -55.45 -1.10 Spain Consumer Discretionary
Teekay Lng Partners LP MLP 2.76 0.00 -33.39 -1.00 Bermuda Energy
CNH Industrial NV 3.37 0.07 -25.37 -0.85 Netherlands Industrials
Anheuser Busch Inbev SA/NV 2.66 0.30 -23.61 -0.66 Belgium Consumer Staples
BNP Paribas 1.97 0.28 -26.29 -0.52 France Financials
CK Hutchison Holdings Ltd. 3.18 0.13 -16.68 -0.51 Hong Kong Industrials
Baidu Inc. 1.48 0.26 -30.65 -0.49 China Communication Services
Informa PLC 2.59 0.06 -19.25 -0.49 United Kingdom Communication Services
Bombardier Inc. B 0.56 0.00 -58.23 -0.49 Canada 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

OCI (Vinson Walden, Thornburg Investment Management)

OCI is a global producer of nitrogen fertilizers and methanol with assets in North America, Europe, and Africa. In recent years, OCI invested heavily in North America to take advantage of the ample supply of cheap natural gas, building a world-scale nitrogen fertilizer plant in Iowa and a world-class methanol production facility in Texas. The buildout coincided with a period of oversupply for both nitrogen fertilizers and methanol globally. The multi-billion-dollar investment required for these plants left OCI with a high debt load, as the plants were not yet operational. OCI has begun to bring the new plants online, which is helping drive a period of strong growth. The medium-term supply/demand outlook for nitrogen fertilizers and methanol are much improved, as excess supply has exited the markets and little new supply is scheduled to come online. The combination of these elements will drive significant earnings and cash flow growth at OCI and repair its balance sheet.

OCI shares were a strong performer for most of the year but suffered a sharp correction in the fourth quarter of 2018, driven by a collection of shorter-term factors. We believe that the medium to long-term outlook remains intact. During the quarter, OCI was impacted by a spike in U.S. natural gas prices due to colder than normal weather across parts of the United States. Higher gas prices raise the input costs to manufacture nitrogen-based fertilizers and the industrial chemical methanol. The pricing for the key commodities that OCI is exposed to were simultaneously pressured by a falling oil price, which partially helps set the market price for nitrogen fertilizers and methanol. In recent weeks, U.S. natural gas prices have begun to normalize and oil prices have begun to rebound, negating these pressures.

Full-year 2018 results have confirmed our thesis for OCI. The new facilities have ramped up nicely (though not fully yet) and commodity prices have been supportive. OCI has seen substantial earnings growth this year (>70%) and is on pace to reach investment-grade metrics no later than 2020. OCI has controlled what it can control and executed well throughout the year.

The valuation remains compelling with the new assets reaching full utilization, supportive commodity prices, and minimal capex given that all of OCI’s major projects are complete. Free cash flow generation will be meaningful. We believe that the market is not yet giving OCI credit for its improved earnings power and financial metrics. We have recently added to our position.

OCI (Fabio Paolini and Benjamin Beneche, Pictet Asset Management)

OCI declined sharply during the fourth quarter following a very strong run up since it was acquired for the portfolio in the first quarter. Aside from being in a cyclical industry that fell out of favor in the general market turmoil, OCI also hit a confusing period for shorter-term-focused investors. During the fourth quarter of 2017, the group was ramping up production at its major new fertilizer plant in Iowa. This and the seasonality of manufacturing volumes mean that period does not really represent a useful “base” to inform likely production (and earnings) forecasts for the fourth quarter of 2018. Added to this, local U.S. natural gas prices rose sharply in November as a result of production bottlenecks in U.S. shale oil infrastructure. Given that gas constitutes 70% of the input cost for nitrogen fertilizer production, sentiment has turned against the fertilizer stocks. On both counts we believe the concerns will be short-lived. First, our view on OCI is based on the long-term future, not on how accurate current quarter forecasts will be (this issue will go away in a couple of months!). Second, the shale oil pipeline issues will be fixed relatively quickly and well inside the period of 12 months for which OCI has hedged its gas price at levels way below current spot prices (75% of its gas requirements are also hedged for a five-year period). Longer term, and somewhat ironically, higher gas prices would be positive for OCI’s competitive position given its status as the lowest-cost nitrogen fertilizer producer in the region. We remain holders.

CNH Industrial (Vinson Walden, Thornburg Investment Management)

Case New Holland Industrial (CNH) is an Italian-based manufacturer of agricultural equipment, construction equipment, commercial vehicles, and powertrains. CNH has a diverse set of end markets and operates globally. Its most important end market is agricultural equipment, particularly in North and South America. The demand for new agricultural equipment in these markets drives the bulk of CNH’s group earnings. We believe a steadily growing North American agricultural equipment market, coupled with a recovering Latin American agricultural equipment market, should be a positive driver of earnings growth at CNH. At current valuations, shares are attractively valued, with CNH trading at a discount to its relevant peers.

We purchased the shares over the summer months after a meaningful correction from the share price highs seen during the first quarter of the year. A weakening outlook for global growth reduced the outlook for CNH’s commercial vehicle and construction equipment end markets. Trade tensions between the United States and China clouded the outlook for U.S. soybean crops, and in turn U.S. soybean farmer profits. Intensification of the trade dispute between the two nations mainly occurred during the post-harvest season, but the forward-looking uncertainty led to a de-rating in the shares, despite solid financial execution throughout the year and a relatively robust backlog for its North American agricultural equipment business.

CK Hutchison (David Marcus, Evermore Global Advisors)

CK Hutchison Holdings is a HK$290 billion market cap conglomerate based in Hong Kong. It has market-leading listed and private investments in telecom, retail, energy, infrastructure, ports, and property development. This holding company is the main investment vehicle for one of Asia’s wealthiest billionaires and well-respected value creators, Li Ka-Shing. Earlier in the year, the leadership baton was passed to his elder son, Victor Li, who has been groomed by his father starting at an early age.

The company continues to generate strong cash flows and to further simplify its cumbersome structure. However, investors have been myopically focused on asset dispositions. In the past, CK Hutchison completed lucrative dispositions in maturing businesses, including a telecom business in India and ports in Hong Kong. The company also successfully consolidated telecom assets in Italy, Austria, and Ireland in order to benefit from scale and improve efficiencies. Further, the company sold 25% of its retail business to Temasek, Singapore’s sovereign fund for 20x earnings in 2014. With limited visibility for potential near-term asset sales, we believe investors have been wrongfully dismissing this stock, which presents an opportunity to strategically add to this investment. CK Hutchison continues to trade at a steep discount to our sum-of-the-parts valuation, and we believe that new company leadership will narrow the gap between trading price and value in the coming months and years.

Informa (Mark Little, Lazard Asset Management)

Informa, the business information, academic publishing, and exhibitions group, was weak in the fourth quarter of 2018. In part this was a result of a slightly disappointing margin performance and outlook in its results, though it also fell on cyclical concerns around its exhibitions, especially those in China, which we feel is less warranted given its mix of business and attractive valuation.

Baidu (Vinson Walden, Thornburg Investment Management)

Baidu is the dominant search engine in China. Search is a winner-take-most business in every geography. The leading search engine sees more queries, which enables it to improve future search results and thus the user experience, resulting in a virtuous self-reinforcing cycle.

In mid-2018, news reports indicated that Alphabet (Google) wanted to launch a search business in China. We appraised the probability of Google entry as remote. Even if Google does enter, Baidu has had experience successfully competing against Google when it was last active in China. News reports in late 2018 indicated that Google was de-emphasizing its China plans in light of employee push-back and regulatory scrutiny, as we expected, although we remain mindful of the risk.

The share price undervalues Baidu’s core search business. Baidu owns a majority stake in iQiyi, a leading online video business in China, and a minority stake in Ctrip.com, a leading online travel agent in China. Backing out the value of these investments from Baidu’s market cap suggests that the core search business is trading at a low-teens price-to-earnings multiple. This undervalues Baidu’s search business and ascribes no value to its long-term investments in artificial intelligence and autonomous driving, which are free options.

Baidu disappointed investors with conservative guidance for the fourth quarter, citing a slowing domestic economy and regulatory changes to discourage certain online activities, including gaming. Nevertheless, Baidu’s core business continues to grow at a healthy rate and provide funding for investment in emerging businesses. We retain our position in Baidu.