Litman Gregory Masters Smaller Companies Fund First Quarter 2019 Attribution

The Litman Gregory Masters Smaller Companies Fund gained 17.11% in the first quarter of 2019, outperforming both its Russell 2000 Index benchmark, which gained 14.58%, and the Morningstar Small Blend peer group, which gained 13.30%. For the trailing one-year period, the fund’s 4.63% return outperformed the Russell 2000 Index by 258 basis points (bps) and the peer group by 482 bps.

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 4/30/2019, the gross and net expense ratios for the Smaller Companies Fund were 1.80% and 1.38%, respectively. There are contractual fee waivers in effect through April 30, 2020.

Themes, Trends, and Observations from the Managers*

Jeffrey Bronchick, Cove Street Capital
We outperformed in the quarter relative to our benchmarks in a market that recovered with verve from a challenging second half of 2018. One of the benefits of running concentrated portfolios is that you don’t need a lot of things to go right in a quarter or a year to move the needle. This quarter, although the portfolio recovered broadly, the key was that some of our largest positions moved higher, driven at least partially by demonstrable fundamental improvement. Although a single quarter is a very short measurement period, any time we can keep pace—or even outperform—in a rapidly rising market is a minor victory in our eyes.

All of this brings us back to patience. It is true that we abhor frenetic activity and unnecessary turnover and therefore we are uniquely unsuited to jump in headfirst just because stocks are temporarily in a “bear market.” But, how do you know when to act? Perhaps the best way to gauge how active you should be—within the context of being a fiduciary of other people’s money—is to use valuation as your North Star. If you put the recent little stock hiccup into historical context, even with the drop, the Shiller P/E Ratio never fell below 28x—a number that is 10-plus turns above the long-term average and median. What we still see is an expensive market and generally rosy extrapolations that assume revenue growth and margin expansion will continue unabated. Down does not necessarily mean cheap. Similarly, a 20% drop in altitude when you are flying 30,000 feet above sea level doesn’t even get you to a place where humans can breathe normally (about 8,000 feet if memory serves). Our saving grace—or oxygen mask—is that we run concentrated portfolios and therefore we only need a few stocks to fall out of the sky per year.

So, we continue to fish in attractive ponds and to focus on simple ideas. There are plenty of ostensibly cheap stocks that will be multi-baggers if a sequence of unrelated but highly impactful events plays out exactly as management hopes. Of course, if the outside world doesn’t cooperate exactly the way the company’s PowerPoint presentation posits, you had better be prepared for turbulence. Those stocks are easy for us to throw in the “too hard bin.” On the contrary, we are looking for companies that have a clear line of sight to success and do not have to jump through lots of hoops. Additionally, we have a list of companies for which there may be a way to exploit a potential time arbitrage. These are businesses that are unequivocally getting more valuable every day, have the ability to re-invest internally at high rates of return, and are likely to be much larger in seven years. Companies with these characteristics often trade at nosebleed multiples but, at times, short-term noise that comes in the form of cyclical pressures and analyst downgrades provides us opportunities to pay a more reasonable price. The arbitrage opportunity arises when the market becomes maniacally obsessed with what the company will earn over the next 12 months and ignores the long-term opportunities that exist when great management is combined with secular tailwinds.

Although the drawdown in the fourth quarter was painful in the short term, we hoped for another two weeks of December. Several companies that we have followed closely approached our “hitting zone” but didn’t quite get there. We think we can all agree the world is odd enough that opportunities will present themselves and we will not hesitate to jump ... because that is how you make money over the long run.

Dick Weiss, Wells Capital Management
In the first quarter of 2019, U.S. equity markets saw a sharp recovery after the sell-off 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 industrials and energy holdings performed well. In particular, several of the portfolio’s industrials holdings reported strong quarterly earnings results and our energy holdings benefited from an improved commodity price.

Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
We have a materially higher weighting in consumer staples companies as we took advantage of weakness in the stock of Hain Celestial earlier in the quarter and the stock had a significant recovery into quarter-end. Market volatility is continuing to provide us with good reward/risk opportunities to find new management teams at companies that have the potential for positive inflection points in return on invested capital (ROIC) and improving franchise value. Capital preservation continues to be a stronger focus, though the risk of stagflation later in 2019 has us more concerned than we were at year-end. Getting exposure in resource plays will be more difficult in light of our ROIC framework, though good capital allocators lurk everywhere at times. We believe that the unwinding of global central bank balance sheets (or the lack of such unwinding) as well as the strength or weakness of the U.S. dollar will impact market performance for the remainder of 2019 and beyond. We have seen an uptick in management team turnover/retirements in the first quarter that could yield opportunities as we investigate whether these teams might make significant changes to their capital allocations. We think that 2019 will have no shortage of volatility and market stress, so we look forward to navigating the rougher waters through our holdings in companies with sound capital-allocating management teams. All of these factors keep us hesitant on the consumer discretionary sector in general, but we are open to investing in the sector if we find companies with the potential for significant ROIC improvement.

* 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 sectors posted strong gains in the first quarter of 2019, ranging from the mid-single-digits to the low-20% range.
  • The fund’s outperformance in the period stemmed from stock selection, with sector allocation having a negligible effect overall.
  • Contribution from stock selection was strongest in consumer staples and industrials. The Hain Celestial Group and TreeHouse Foods, two consumer staples names, added late last year by SBH managers Mark Dickherber and Shaun Nicholson, gained over 45% and 27%, respectively, in the period. Within industrials, Avis Budget Group, owned by Dick Weiss of Wells Capital Management, gained over 55%. Hain Celestial and Avis are discussed in more detail below.
  • The weakest sectors for stock selection were communication services and consumer discretionary, each of which cost around 100 bps in relative performance. Millicom International, the portfolio’s sole communication services name and held by Cove Street’s Jeffrey Bronchick, was down modestly for the quarter. However, the stock is a top position in the portfolio at about 4% of assets, so it was a leading individual detractor. The most significant detractor in the period was Qurate Retail, owned by Weiss, which fell 18.14%. Millicom and Qurate are discussed in further detail below.
  • From a sector allocation standpoint, financials and information technology had the most positive effect on relative performance. The fund had a material underweight to financials (see chart above) of over 12 percentage points, something that proved advantageous as financials underperformed the broader benchmark in the quarter. Conversely, the fund benefited by being significantly overweight to the outperforming information technology sector by over seven percentage points in the quarter.
  • The leading individual contributor during the period was Avid Technology. This information technology position, owned by Bronchick, is one of the 10 biggest weightings in the fund. It gained 56.84% in the quarter and is discussed in detail below.
  • Cash averaged over 10% in the quarter and was a meaningful detractor to relative performance amid the advance in the small-cap market.
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
Innophos Holdings Inc. 5.69 0.03 24.79 1.45 Materials
Compass Minerals International Inc. 3.41 0.09 32.21 1.01 Materials
Treehouse Foods Inc. 2.07 0 27.29 0.59 Consumer Staples
Heritage-Crystal Clean Inc. 3.01 0.02 19.3 0.58 Industrials
Avid Technology Inc. 3.3 0.01 56.84 1.97 Information Technology
Viasat Inc. 6.11 0.19 31.47 1.83 Information Technology
The Hain Celestial Group Inc. 3.36 0 45.78 1.72 Consumer Staples
Avis Budget Group Inc. 1.89 0.1 55.07 0.91 Industrials
Gardner Denver Holdings Inc. 2.03 0 35.99 0.68 Industrials
Great Lakes Dredge + Dock Co. 1.88 0.02 34.59 0.67 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 Contributors

Avid Technology (Jeffrey Bronchick, Cove Street Capital)

Avid Technology is the leading provider of professional software for video and audio production through its Media Composer and Pro Tools product lines. The company has struggled in recent years to show any pickup in demand for its core products, and the stock has suffered accordingly. However, a new management team, as well as new bookings, have created a turning point in the company's fundamentals. This quarter the company achieved its highest level of cash flow generation in seven years and produced organic growth for the first time in recent memory. Our research points to improved cash flows in 2019, respectable revenue growth and increased profitability—with significant upside in stock value from these levels.

The Hain Celestial Group (Mark Dickherber and Shaun Nicholson, SBH)

Our thesis on Hain was supported by a new CEO, who had a strong tenure at Pinnacle Foods, where he helped put in place a strong ROIC framework that created significant value for shareholders. Given the historical mismanagement of capital at Hain, we believe there is significant opportunity for ROIC improvement for years to come. We were a little early in our initial position; however, our confidence grew over the last several months and we took advantage of the weakness in the stock price (in the mid to upper teens) to materially increase the position size early in the quarter. The stock subsequently dropped, resetting expectations early in the quarter; however, following an analyst day later in the quarter, the market became more constructive on the new management team and the opportunities for value creation and the stock rallied. The combination of our aggressive buying on weakness early in the quarter and the stock’s subsequent rebound later in the quarter helped the strategy’s performance. The current valuation continues to underestimate the significant ROIC improvement we see for Hain; we expect ROICs to grow substantially from the current mid-single digits. level over the next several years. Assuming we see ROICs at 15% through the company’s reduction of bad assets and leveraging of good assets, along with an eventual return to appropriate asset growth in the next few years, we believe Hain’s stock price can double from here. This assumes that management executes its strategy properly (in a market backdrop that currently reflects limited ROIC expansion and no growth), though at a minimum, we believe Hain has 50% upside left based on market multiples in the 10x–12x EBITDA (earnings before interest, taxes, depreciation, and amortization) range (whereas growthier concepts trade at high teens multiples of EBITDA).

Avis Budget Group (Dick Weiss, Wells Capital Management)

Avis Budget, a vehicle rental company, outperformed the market by 35% during the quarter as well as its primary competitor Hertz by 25%, largely driven by multiple expansion as the next fiscal year P/E went from 6x to 8x. The main driver of the multiple expansion was the belief that the core underlying backdrop for travel and rental car demand remained solid in the fourth quarter of 2018 and continued into 2019, against a backdrop of very low expectations by the market. Rental pricing, one of the primary metrics we track, began to show sequential improvements late in 2018, which gave the market confidence that the technology investments Avis had previously made were beginning to show the intended results. This was catalyzed by the fourth quarter 2018 earnings results, which showed pricing in the Americas strengthened sequentially and better than expectations. The company’s international operations also saw improvement, which was a change from the prior quarter. Beyond the fourth quarter 2018 print, the market is taking a more positive view on the company’s ability to enhance cost efficiency and implement its connected vehicle strategy based on management meetings. We entered the year with a full position and have been trimming back the holding on recent strength as we still recognize the cyclicality of the business.

Top 10 Detractors as of the Quarter Ended March 31, 2019
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Millicom International Cellular SA 4.06 0 -4.45 -0.2 Communication Services
MDC Partners Inc. Class A 0.5 0.01 -13.79 -0.04 Communication Services
Qurate Retail Inc. 1.96 0 -18.14 -0.42 Consumer Discretionary
Shutterfly Inc. A 1.35 0.07 0.94 -0.01 Consumer Discretionary
Urban Outfitters Inc. 0.48 0 -1.27 -0.03 Consumer Discretionary
Integer Holdings Corp. 1.65 0.13 -1.1 -0.01 Health Care
Ryder System Inc. 0 0 -1.37 0 Industrials
Sensata Technologies 1.56 0 0.4 0 Industrials
Steelcase Inc. Class A 0.01 0.07 -3.09 -0.01 Industrials
Sabre Corp. 0.12 0 6.38 0.03 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 Selected Detractors

Qurate Retail (Dick Weiss, Wells Capital Management)

Qurate Retail, which owns QVC, HSN, and Zulily, among other brands, underperformed the market by 28% during the quarter and the broader retail universe by 24%, driven by both multiple contraction and estimate reductions. The company reported a fourth quarter 2018 miss on the top and bottom lines with the market focusing primarily on the operating margins. The margin pressures in the quarter emanated from (1) mix (higher percentage of consumer electronics and lower-margin products within electronics) and (2) a slowdown in the last two weeks of December, which hurt sales and had an exaggerated impact on margins. However, the market latched onto the bear narrative around a gradual margin erosion due to the need to target new customers by enticing them with commoditized consumer electronics. However, after speaking with the company, the margin issue was due to assortment and more easily remedied, a view not yet appreciated by the market. While we have lowered the private value by a few percentage points on account of the miss, the stock clearly overreacted. Recognizing this fact and the fact that there are a number of ways to win as an equity holder by virtue of the free cash flow generation (debt paydown and buybacks), we have been adding to the position meaningfully in recent weeks.

Millicom International Cellular (Jeffrey Bronchick, Cove Street Capital)

Millicom International Cellular 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 under the direction of a CEO who hails from Liberty Global. This past quarter’s results were in line with expectations. Millicom’s stock rose during the quarter due to rumors that Liberty Latin America was looking to buy the company. However, when Millicom emphatically stated its desire for independence, the stock came back down to earth. Looking past short-term noise, we still see a company that is continuing to develop into a premier Latin American cable/telecom player, which now includes a cable/mobile bundled offering in each of their markets, and a stock that trades at a valuation reserved for declining telephone-focused entities, not growing cable-centric organizations with excellent returns.

Integer (Dick Weiss, Wells Capital Management)

Integer, a medical device manufacturer, underperformed the market by 13%, all on multiple contraction and almost all of the underperformance occurring in the last week of the quarter. A third-party research firm published a negative article on the company discussing how adjusted EBITDA at Integer exceeds “economic earnings.” After reviewing the article and supporting calculations, we believe that the assertions are misguided. The article ignores the large divestiture that the company recently made and transacted at a multiple above where the stock was trading at the time of the announcement, despite having lower-than-company average margins. While this would normally suggest a buying opportunity, the risk/reward was not compelling enough as the stock has been very strong over the past two years and we have been trimming the position to better align with that expected risk/reward profile. However, we still view the stock as a core health care holding given that the business continues to perform well and our positive interactions with the relatively new management team. All of the key themes to the story remain intact—above-market growth combined with operational leverage to drive healthy free cash flow, which is being used to pay down debt and create flexibility to make tuck-in acquisitions.