Litman Gregory Masters Smaller Companies Fund Fourth Quarter 2017 Attribution

The Litman Gregory Masters Smaller Companies Fund gained 6.95% in the fourth quarter, soundly outperforming its benchmark, the Russell 2000 Index, which rose 3.34%.i The fund also outperformed the Morningstar Small Blend peer group’s gain of 3.52%. For the full year, the fund was up 14.44%. This is roughly in line with the 14.65% gain for the Russell 2000 Index and above the 12.40% return for the Morningstar peer group.

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

Themes, Trends, and Observations from the Managers*

Jeffrey Bronchick, Cove Street Capital
Spoiler alert—we did not own Bitcoin, cannabis-related stocks, or large-cap tech stocks, and we weren’t up 20% in 2017. You are forgiven for moving onto another Twitter feed.

As opposed to yet another outlook piece cluttering your inbox—and life—in 2018, we would prefer to spend some time on more of an inward look. As such, we will discuss our views on what is happening in our portfolio as well as on some of the more conceptually seismic issues that could really mean something to a client rather than the annual coin flipping or pontificating about our rhetorical other hand. Our annual forecast, for whatever it’s worth, remains unchanged. We think the long-term nominal average expected return for U.S. stocks is somewhere in the 7% to 8% range. It’s never 7.5% in any one year. You can temper that view based on a personal gauge of where we are in an economic cycle and the relative state of valuation. We think late and high.

“The market has never done better” was a quote from the Financial Times recently and the reference was in regard to the 2017 production of a 20% return in the S&P 500 with exceptionally low volatility. That is the classic financial free lunch that we apparently were educated, through practical and historical experience, not to expect. The stock market behaved as if the results were scripted by the Board of Federal Reserve academics … hmmm.

The apparent suspension of the Herbert Stein’s “if it can’t go on forever, it won’t” rule—which we would postulate as still being as inviolable as are the basic rules of thermodynamics—simply makes life on a relative basis more difficult for us. As a firm that seeks to buy a legitimate dollar of future cash flow, we require some combination of obfuscation, confusion, and price volatility that comes about due to issues ranging from short-term fundamental disappointment to sheer panic-selling. It is within this murky fog that we can formulate a differentiated viewpoint with a large enough margin of safety to be convinced to commit someone else’s money in sufficient size to make a difference. There was not a lot of that over the last year, as the S&P 500 put up 12 months of consecutive gains—the longest streak since 1959/1960. So, thorn in our side number one in 2017 was erring on the side of caution in any number of security-specific instances when, in retrospect, we should have stepped up and been rewarded by the short-term direction of the tide. This has been a perennial mistake of this portfolio manager in his career, a fact that his colleagues regularly point out with disdain. In fact, the post-Trump election period has mostly been a fantastic time to just shut up and buy stocks and stick with them. And if you had been willing to “pay up a little” in 2017, you would have been rewarded.

There is a major difference—as we have become painfully aware over the last 33 years—between the investment management “business” and the act of investing. The latter values patience and understands the unpredictability of the timing of return realization, a result that has a very low R-squared to the calendar year. The former wants to know “what have you done for me lately,” and the answer is simply not as much as we would have liked. Being competitive in up markets and outperforming in down markets pencils out marvelously on paper. It’s just less fun in practice in a very strong upcycle.

Being annoyed with the short-term is quite different from a number of behaviors we typically see during times such as these: quitting outright; throwing in the towel on longer-term value-based investing; changing stripes to play catch-up with the prior year; or believing that the game is now “rigged” against careful, concentrated, fundamental, value investing. 2017 was not the first year when things “seemed” very different than they have in the past. “This time is different” is a very important statement to consider before full implementation. We are always re-underwriting what we own at marked-to-market prices, just as we regularly reconsider ideas and values that we don’t own.

But, our continuing bet is that people don’t change nearly as much as markets normally vacillate. To suggest that one should simply extrapolate recent trends as the proper expectation for the future has a material non-zero probability of being very wrong, and therein lies our own mean reversion. In the meantime, we have lots of interesting things going on in the portfolio that have their own engine of growth or change and don’t require much help from the overall state of the equity market to produce very satisfactory returns. Although, I am not sure if that will add up to 20% compounded in the intermediate run.

Dick Weiss, Wells Capital Management
The final quarter of the year was undoubtedly kind to investors and put the final note on a strong 2017 for the equity markets. Several sectors, including cyclical ones, performed well in the quarter as energy, industrials, and consumer stocks were among the better-performing groups. The portfolio was well represented in these sectors, which acted as a nice tailwind to performance. In particular, several of the portfolio’s energy holdings outperformed the benchmark return on the heels of improving global demand and a rising commodity price. Further, within the industrials sector, performance was strong and broad based across several holdings. On the other hand, lack of exposure to the consumer staples sector proved to be a relative detractor, as we do not have exposure to this “bond proxy” sector.

Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
The portfolio has experienced very little turnover over the last quarter as we continue to see significant return on invested capital (ROIC) improvement opportunities developing over the next several years for our holdings; however, we are always measuring the reward-to-risk ratio of our holdings and aim to size positions accordingly. We added one holding during the quarter: Great Lakes Dredge & Dock. The thesis on Great Lakes centers around the new CEO’s aggressive focus on proper capital allocation and implementing a returns-based culture, which had not been present in this company in the past. It is early, but as we gain confidence in the company’s ability to execute on these initiatives, this position will likely increase in the portfolio if the reward-to-risk ratio continues to appear favorable. We continue to look for new ideas for the portfolio; however, each name must meet certain criteria, particularly around improving ROIC tailwinds. We continue to see many companies being rewarded by the market even as they appear to destroy capital when looking at capital decision-making through an ROIC lens. As cost of capital shows signs of rising for the first time in many years, we believe that these poor capital allocation decisions are unlikely to be rewarded if trends continue. In terms of overall portfolio positioning, we have kept a larger cash balance as our fundamental bottom-up analysis has not resulted in favorable reward-to-risk ratios in many cases, in tandem with a general lack of significant ROIC catalysts due to continued appreciation within the market. The continued rise in the market seemingly ignores the many risks that still remain both from a company-specific perspective and at the market level. We have not managed the portfolio to avoid sectors, industries, or geographic regions and instead are completely focused on finding companies with what we believe are underappreciated ROIC catalysts and high reward-to-risk ratios.

* 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 Smaller Companies Fund Attribution

Smaller Companies Fund Attribution Chart

  • While both sector allocation and stock selection contributed to relative outperformance in the quarter, stock selection was by far the primary driver of strong relative performance versus the Russell 2000 Index benchmark.
  • Stock selection within the information technology sector was particularly strong, where portfolio holdings gained 19.3% (on average) compared to less than 1% for the index’s technology holdings. Jeffrey Bronchick’s positions in GTT Communications (up 49.5% in the period) and Viasat (up 17.7%, and the fund’s largest holding as of 12/31/2017) were the largest contributors within this sector. See below for the sub-advisor’s comments on GTT Communications.
  • The health care sector also saw strong stock picking in the period, mostly due to the performance of Haemonetics. This company’s stock price gained just over 29% in the quarter and is among the top holdings in the fund as it is owned by both Weiss and SBH. Each of these managers discusses the position in greater detail below.
  • Stock selection within the materials sector detracted mildly from relative performance. This was primarily due to the 5.2% decline of Innophos Holdings, owned by SBH and by far the largest holding (nearly 17%) of their portfolio.
  • The portfolio’s largest sector overweight—industrials—was beneficial in the quarter as this sector outperformed the broad benchmark. Stock selection, however, was mixed within the sector. Two industrials positions discussed below are Spartan Motors (owned by SBH and which gained 46.3% in the quarter) and Wesco Aircraft Holdings (owned by Bronchick and which declined 23.0%).
  • The fund’s average cash position during the quarter was 13.4%, which detracted slightly from relative performance as the small-cap market moved slightly higher.
Top 10 Contributors as of the Quarter Ended December 31, 2017
Company Name Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Haemonetics Corp. 3.37 0.13 29.12 1.00 Health Care
Spartan Motors Inc. 2.53 0.03 46.28 0.90 Industrials
Viasat Inc. 5.07 0.18 17.68 0.89 Technology
GTT Communications Inc. 2.01 0.06 49.46 0.89 Technology
Buffalo Wild Wings Inc. 1.75 0.10 48.20 0.74 Consumer Discretionary
Foot Locker Inc. 1.63 0.00 36.11 0.60 Consumer Discretionary
Avid Technology Inc. 3.15 0.01 10.58 0.58 Technology
Orthofix International NV 2.24 0.04 17.80 0.39 Health Care
Axon Enterprise Inc. 2.01 0.06 16.49 0.35 Industrials
Gardner Denver Holdings Inc. 1.37 0.00 24.45 0.33 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

Haemonetics (Dick Weiss, Wells Capital Management)

Haemonetics designs, manufactures, markets, and services blood processing systems. Its products are divided into four categories: Plasma, Blood Center, Hospital, and Software Solutions. The company’s long-term goal is to double operating income and quadruple free cash flow by fiscal year 2021. The turnaround potential is primarily levered to the NexSys product, the company’s next-generation plasma apheresis system. The company plans for a limited market release this winter leading to a full-scale launch near the middle of 2018. Optimism around new products and potential earnings power have led the stock to perform well for the quarter and much of the year. The company reported strong quarterly results during the quarter, which helped propel its share price higher. Specifically, revenue of $225 million topped consensus of $219 million while earnings per share of $0.48 came in $0.07 ahead of consensus. Further, management raised its full-year guidance calling for earnings per share of $1.70 at the midpoint versus $1.60 prior and free cash flow of $100 million versus $35–$55 million prior. Currently, we have a private market value (PMV) on the company near $80.

Haemonetics (Mark Dickherber and Shaun Nicholson, SBH)

The thesis on Haemonetics is centered around the company’s new management continuing to employ its ROIC-focused turnaround, which has been showing solid results, an improving ROIC profile, and a new product strategy that could prove to be a significant revenue and ROIC driver over the next several years. The new product strategy focuses on more efficient plasma methods and data-rich software inclusion in order to better manage demands as well as provide information for customers to improve their own ROIC. The thesis has not changed over the last three months; however, with share prices starting to reflect more execution in operations and future product success, we are likely to trim from our position in the near term. The stock performed well in the quarter, returning approximately 29%, and we did trim our position slightly during the quarter.

Spartan Motors (Mark Dickherber and Shaun Nicholson, SBH)

The thesis for owning Spartan was the rapid change of focus on ROIC and working capital improvements that the new CEO and CFO have introduced to the company. In our view, these factors were entirely underappreciated by the market. The thesis has not changed over the last three months; however, as the company has executed upon the ROIC and working capital improvements, it has opened them up to take advantage of the tremendous tailwinds in their end markets, which is anchored by the e-commerce boom. At this point, we still believe that Spartan is in the very early innings of creating value, while the operational improvements are still only about halfway to being fully realized. The stock trades at what we would consider fair value today based on what they have accomplished, but it is being given no credit for the future improvements we expect over the next two to three years. Upon successful execution of the remaining catalysts in front of this management team, and achieving their 2020 goals, we believe that the stock still has significant upside from current levels.

The stock performed well in the fourth quarter 2017, returning 43%, as the company announced its three-year profitability objectives at a very well-received investor day, while at the same time announcing a very large order from a major customer. We did not take any action from the positive response during the quarter as we continue to see the catalyst and ROIC improvement firmly in place for the next several years.

GTT Communications (Jeffrey Bronchick, Cove Street Capital)

GTT Communications is a provider of cloud networking services and broadband connectivity to multinational enterprises and government customers. We completed a thorough deep dive into the company following additional acquisitions of unique networking service assets, which brought a significant missing ability concentrated on SD-WAN into GTT’s asset base. Put simply, there is an enormous gap between newer and more nimble competitors versus the incumbent telcos, and the messy combination of Level 3 Communications and CenturyLink versus an organization like GTT in a world of ever-growing international interconnectedness. With management continuing to execute their acquisition and integration strategy, the company’s performance continues to outpace expectations, driving the stock higher. We see significant upside and feel that insiders’ nearly 20% ownership of the company properly aligns management’s incentives with our own.

Buffalo Wild Wings (Mark Dickherber and Shaun Nicholson, SBH)

During the fourth quarter, Buffalo Wild Wings received a $157 offer to be taken private. While the deal provided a positive impact on our strategy’s returns in the fourth quarter, we are disappointed by the timing of the deal, given we had expected chicken wing costs to drop dramatically (which happened subsequently following the announcement). We are still pleased that our reward-to-risk expectations ultimately provided a solid return. However, we are disappointed in what could have been, as we believe that the stock had the potential to move closer to $200 per share if the ROIC improvements in place had been allowed time to fully come to fruition.

Top 10 Detractors as of the Quarter Ended December 31, 2017
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Wesco Aircraft Holdings Inc. 3.23 0.02 -22.99 -0.79 Industrials
The E W Scripps Co Class A 2.85 0.05 -17.62 -0.60 Consumer Discretionary
Innophos Holdings, Inc. 5.38 0.04 -5.22 -0.28 Materials
Cherokee Inc. 0.79 0.00 -27.45 -0.26 Consumer Discretionary
Integer Holdings Corp. 2.00 0.07 -11.92 -0.26 Health Care
HNI Corp. 1.79 0.08 -7.69 -0.15 Industrials
CommVault Systems Inc. 0.35 0.11 -2.78 -0.04 Information Technology
MAM Software Group Inc. 0.10 0.00 -2.47 -0.02 Information Technology
MDC Partners Inc. A 3.22 0.03 -11.36 -0.01 Consumer Discretionary
Microsemi Corp. 1.12 0.00 -0.87 -0.01 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

Wesco Aircraft Holdings (Jeffrey Bronchick, Cove Street Capital)

Wesco Aircraft Holdings distributes aerospace bearing products and provides supply chain management services to the aerospace industry in North America and internationally. The company’s new CEO has had to unwind the previous CEO’s operational mistakes while attempting to solve poor execution issues on their ad hoc business. While already suffering from low expectations, the company’s margins surprised further to the downside, with the turnaround taking a heavy toll on what were previously respectable margins. In addition, negative growth in their core distribution business with apparent share loss to their major competitor created a washed-out environment for the stock. However, through additional due diligence, our research indicates that Wesco’s core business is intact and customers are still beholden to the services they provide. Several mentioned to us that they are just waiting for operational issues to be resolved before giving more work to Wesco. The ball is in management’s court and we see significant upside in the stock with very unassuming growth and margin targets.

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

The E.W. Scripps Company owns television broadcasters and a collection of digital assets. The U.S. broadcast television industry is currently in a state of flux. People are concerned about cable subscribers “cutting the cord” and about advertising dollars migrating to, ostensibly, greener digital pastures. While these are legitimate industry dynamics, our research suggests that the aforementioned industry trends are unlikely to undo the business models of companies such as E.W. Scripps. It remains a fact that 23 out of 25 of the top primetime shows on television are shown by one of the big four broadcast networks. As such, broadcast remains a very relevant advertising medium for companies who want to reach millions of people, all at once. Furthermore, recent Federal Communications Commission rule changes are likely to open up very accretive station swaps and station acquisitions for E.W. Scripps. Our valuation analyses indicate that the market is ascribing minimal value to their growing digital businesses and is underestimating the strength of the company’s political ad footprint. We also own a position in TEGNA, a broadcaster with the same theme.