Litman Gregory Masters Smaller Companies Fund Fourth Quarter 2018 Attribution

In what was a challenging period for stocks, the Litman Gregory Masters Smaller Companies Fund declined 16.92% in the fourth quarter of 2018. While down sharply, the fund fell less than its Russell 2000 Index benchmark, which declined 20.20%, and the Morningstar Small Blend peer group, which fell 19.40%. The fund also outperformed these benchmarks over the calendar-year period; the fund’s 10.51% decline compares to a decline of 11.01% for the Russell 2000 and a decline of 12.73% for the Morningstar category.

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 Smaller Companies Fund were 1.74% and 1.32%, respectively. There are contractual fee waivers in effect through April 30, 2019.

Themes, Trends, and Observations from the Managers*

Jeffrey Bronchick, Cove Street Capital
Losing money is not any fun for anyone. Losing less “relative” money than we might have is somewhat better.

Clearly, the perception of financial and market risk has moved from a Star Trek-esque distance probability to something more tangible and current. Which, again, is how it usually is: gradually and then suddenly things change. Us? Not so much. The mixed metaphor du jour for clients has been: when you are standing on your tippy toes on a 10-foot ladder, it doesn’t take much of a push to knock you down, and the fall could be very unpleasant. But when you tend to buy pancakes, there is simply less distance to the ground.

As is becoming needless to say, credit conditions are the thing to watch in 2019. LIBOR rates going up 150 basis points is not the driving factor in the creation of miserable environments—losing access to credit is what really hurts. We abstain from interest rate forecasting other than to reiterate that we continue to believe the bottom was made in the summer of 2016 and rates will move irregularly higher over a long time. But we have seen credit spreads widen, we have recently seen deals changed or dropped at the last minute on both sides of the ocean, and we have seen the first peeps of protest at what has arguably been the most lenient and largest availability of credit offered to some of the shrewdest and most undeserving people in the history of financial markets. The willingness to extend credit is a fickle thing and difficult to model. And it is another “thing” that tends to change gradually—and then hard—all of a sudden. The tide will go (or maybe is going) out one day. One can and should be wary of areas and entities that have definitely benefited from nearly free credit for a lot longer than at least we would have thought. And small-cap stocks in general are particularly sensitive to the availability of credit.

We operate on the basis that posting on Facebook has not eliminated the concept of a business cycle, and we have had a big and favorable economic cycle for a long time. While no one calls tops and bottoms consistently, it pays to think about generally where one stands in a cycle, and we certainly ain’t at the bottom of one. As value investors, we have often dismissed macro as something that doesn’t matter “a lot” as it relates to our Buffett and Graham paradigm and our focus on Business, Value, and People. But we are acutely aware that we have spent much of the last nine years with generally decent macro, and the unprecedented benefit of lower rates and low cost of capital. And thus, it is not easy to stand in the mirror and say “bad macro” won’t matter. And bad macro once again has proven itself to be independent of political party.

But … cue music … stocks fluctuate. And they do so well in excess of their underlying fundamentals. Not surprisingly, this is because of people and their behavioral problems—and the often dysfunctional environment in which they work and for whom they work. For reasons that must originate in the deep, reptilian origins of man’s conscious/self-conscious internal babble—because I remain dazedly confused as to why—stocks remain ensconced as Giffen goods in that they are more highly prized when they are priced high, and they take on scales and sulfurous qualities when they drop. This is the old normal and it is what one should expect a lot more of in the years to come. And to restate the painfully obvious, a “Value Restoration Project” like the one we are now at least partially in, is good—to a point, of course—for the long-term investor.

Greed is changing to fear, and opportunities are being created for future gains. While not in any way immune to near-term pain, we are reasonably positioned to profit from it over the longer run. The easiest “edge” for any investor is the time arbitrage of accepting other people’s near-term fear and investing with a long-term time horizon.

We would suggest that the time to worry about a fundamental downturn is when things are going great. When a stock goes from $55 to $23, someone else has done a lot of worrying for you and that’s when it pays to start looking. Headlines declaring that a stock or market is in a “bear market”—mysteriously defined by someone probably long dead, or if not, something that should be immediately put out to intellectual pasture—is arguably the dumbest idea that “finance” can come up with. Why does “down 20%” constitute something important? Annoying and unwanted for sure, but completely irrelevant. If anything—it is probably a clue to start looking at a stock, not the beginning of the time to start worrying.

What we will reiterate is an interesting value proposition, pun intended. Thoughtful and active value investing is evergreen, and the fewer people professing to do it, or actually doing it, the better the opportunity for those that remain. The fewer the sell-side firms and the larger the size of asset managers, the more opportunities abound in the small-cap space. Idiotic compliance rules like “we will not even custody stocks with a market cap less than $300 million” further enhances the opportunity set. Asset management industry consolidation means larger asset pools—which is simply death in the small-cap performance derby and creates continued opportunities for us. I think we can all agree that a low(er) cost basis is a good thing, and better than a high(er) cost basis. And the recent weakness in the market provides an opportunity for new capital to enter at prices that are more favorable than even a few months ago. The recent market conditions could be a return to the “old normal” where volatility has a role and there is at least an element of fear, which is a healthy development for the long run.

Naturally, we have to execute for you. Going forward … the future remains uncertain. Which is what we said last year. And probably last quarter. We have been at this for a long time with a solid long-term track record. What you will see from us is something that rhymes with what you have seen in the past: a focus on carefully researched investment ideas; better combinations of Business, Value, and People; people working very hard to make fewer mistakes; and thoughtful patience. It remains a very simple process: work tirelessly to position yourself to “see” the good idea, have the intellectual and financial fortitude to buy as much of it as you can prudently stomach … and then just be right. Our goal remains simple: delight clients, have fun, make people money.

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 Federal Reserve 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, a 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.

Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
We have not materially changed the portfolio’s sector positioning despite recent turnover given how we have reinvested. At the margin in 2018, we reduced our industrial/cyclical exposure, but otherwise there was no specific attempt to reposition the portfolio.

We are sifting through the growing rubble of 2018 pullbacks hoping to find new management teams with positive inflection points in return on invested capital (ROIC) to provide visibility into improving franchise value. Capital preservation currently remains a stronger focus, though the risk of stagflation later in 2019 has us examining the potential for changes—either headwinds or tailwinds—in the ROIC frameworks of our holdings to determine if any shifts are needed. 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 in 2019 and beyond. For us, we haven’t seen as many new management teams as compared with a year ago. While the last two to three years have produced a large pool of candidates for management teams to execute on ROIC improvements, we are waiting for the better visibility of those catalysts coming to fruition.

We think that 2019 will have no shortage of volatility and market stress, so we look forward to trying to navigate the rougher waters with the ROIC and sound capital-allocating management teams we hold. All of these factors leave us hesitant on the consumer discretionary sector in general, but we would be open-minded if we saw a 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 losses in the fourth quarter of 2018.
  • The fund’s relative outperformance was driven roughly equally from the effects of sector allocation and stock selection.
  • The bulk of contributions from sector allocation came from the health care and energy sectors. The fund was meaningfully underweight to both underperforming sectors in the period. Health care holdings in the index declined over 25% in the quarter, while the benchmark energy stocks fell 41.08%.
  • Sector exposure to financials was the biggest detractor from an allocation perspective. As seen in the sector weights chart above, the fund’s roughly 12.5-percentage-point underweight to financials is the largest deviation from the benchmark. This exposure hurt relative performance since the benchmark’s financial holdings were down less than the benchmark. Stock selection within financials was also an overall detractor in the quarter. In particular, Bank of N.T. Butterfield & Son, held by Dick Weiss of Wells Capital and discussed below, declined 39.0%.
  • Stock selection in the materials sector was the most costly to relative performance. This was almost exclusively due to the performance of Innophos Holdings, which declined over 43% in the quarter. This non-benchmark name is the fund’s second-largest individual holding, held at a weight of over 5% in the portfolio. Mark Dickherber and Shaun Nicholson from Segall Bryant & Hamill (SBH) discuss this position in detail below.
  • Stock selection was beneficial within the communications services sector. Millicom International, a leading cable and wireless provider in Colombia and Central America, was the fund’s leading individual contributor in the quarter. The stock, owned by Jeffrey Bronchick of Cove Street Capital, gained nearly 14% in the period and is discussed below. At nearly 4% of the portfolio, it was the fourth-largest individual holding.
  • At the individual stock level, Lancaster Colony gained 19.43% and was the second-largest contributor in the period. The stock was sold by SBH after its price appreciated and is discussed below.
  • Cash averaged over 10% in the quarter and was the most meaningful overall contributor to relative performance amid a sharp small-cap market decline.
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
Millicom International Cellular SA 3.80 0.00 13.88 0.46 Communication Services
The E W Scripps Co Class A 0.61 0.04 4.18 0.06 Communication Services
Foot Locker Inc 1.50 0.00 5.09 0.08 Consumer Discretionary
Lancaster Colony Corp 0.53 0.16 19.43 0.21 Consumer Staples
Treehouse Foods Inc 2.06 0.00 5.98 0.12 Consumer Staples
Great Lakes Dredge & Dock Co. 2.16 0.02 6.77 0.19 Industrials
Heritage-Crystal Clean Inc 2.83 0.02 7.78 0.18 Industrials
Sensata Technologies Holding 0.20 0.00 5.66 0.08 Industrials
FLIR Systems Inc. 0.20 0.00 -1.52 0.03 Information Technology
MAM Software Group Inc 3.52 0.00 2.60 0.09 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 Contributors

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 but thanks to the company’s expected listing on the NASDAQ, many U.S.-based investors have finally started to take notice. Looking past short-term noise, we still see a company that is continuing to develop into a premier Latin American cable/telecom player and a stock that trades at a valuation reserved for declining telephone-focused entities—not growing cable-centric organizations with excellent returns.

Lancaster Colony (Mark Dickherber and Shaun Nicholson, SBH)

We owned Lancaster Colony (LANC) because we believed in the newer CEO who brought a more disciplined approach on lean initiatives and capital allocation to improve productivity and growth well above the cost of capital. The stock performed well through 2018 as the market chased safety in staples, while improving metrics at the company also helped. We sold the position when the reward-to-risk ratio shifted to neutral from the original 3:1 ratio. We will consider investing in LANC later in 2019 if the stock price pulls back enough.

Great Lakes Dredge & Dock (Mark Dickherber and Shaun Nicholson, SBH)

The thesis for owning Great Lakes Dredge & Dock was the significant improvement in capital discipline we are seeing under the new CEO as well as the strong demand backdrop. This thesis has not changed over the last three months. The current valuation continues to look attractive based on our belief that the market has not fully rewarded the improvement in returns we expect over the next few years. The stock performed well off a very strong third quarter, which started to show the significant operational leverage that is being created, leading to upside versus expectations in the third quarter of 2018. We did trim a small amount as the stock was moving higher.

Top 10 Detractors as of the Quarter Ended December 31, 2018
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Innophos Holdings Inc 5.58 0.03 -43.83 -3.08 Materials
GTT Communications Inc 1.88 0.07 -45.48 -1.01 Information Technology
GP Strategies Corp 2.98 0.01 -25.16 -0.93 Industrials
Spectrum Brands Holdings Inc 1.84 0.00 -42.99 -0.92 Consumer Staples
Bank of N.T Butterfield & Son Ltd 1.81 0.11 -39.00 -0.79 Financials
Avid Technology Inc 3.94 0.01 -19.90 -0.73 Information Technology
Shutterfly Inc A 1.48 0.09 -38.90 -0.66 Consumer Discretionary
Cimarex Energy Co 1.91 0.00 -33.53 -0.66 Energy
Axon Enterprise Inc 1.53 0.15 -36.07 -0.66 Industrials
The Hain Celestial Group Inc 1.15 0.00 -28.69 -0.65 Consumer Staples

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

Innophos (Mark Dickherber and Shaun Nicholson, SBH)

The thesis for owning Innophos the last few years was to capitalize on the change in management that was strategically going to redirect capital into higher-margin, higher-return areas. The thesis has not changed as management has continued down this path; however, the process has taken longer than we would have anticipated given the amount of work needed to be done to stabilize and de-risk the business. In our view, the current valuation is extremely compelling relative to what we expect this business to generate from an ROIC level. At the current valuation, the stock is not embedding any ROIC improvement. The stock sold off significantly on a weaker third quarter earnings report, which was impacted by equipment downtime and further culling of low- to no-margin business. Estimates fell about 10% to 15%; however, the stock declined more than 40%. We added to this position on the weakness.

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. Increasing margins, due to owning physical infrastructure assets combined with a low capital intensity service/integration business, create an interesting hybrid model that is poised to grow well in a world of ever-expanding international interconnectedness. A large purchase of European infrastructure gave the company new markets and fixed assets that are hard to replicate. Additionally, the deal was financed with a great deal of debt, creating a seemingly overleveraged company. As the market sold off any companies that appear to be heavily leveraged, GTT was thrown in with this move to bet against indebtedness. With their maturities not occurring for five years, we see no impending liquidity issues and thus remain holders of GTT. Our research indicates that post their deal integration activities, both EBITDA and cash flow to deleverage the company should increase value in the long term.

Bank of N.T. Butterfield (Dick Weiss, Wells Capital Management)

The Bank of N.T. Butterfield & Son (NTB), a Bermuda-based bank, underperformed both the market and regional bank peers during the quarter as the company reported quarterly results that were below expectations. The company missed expectations on net interest income and expenses, partially offset by higher fee income and a lower/negative provision. The bigger news was that the company disclosed that a pending acquisition is now expected to bring on fewer deposits than previously expected and will be only about 5% accretive compared to the 10% accretion expected at announcement. Following this disclosure, in late November various news sources reported that German authorities raided the Frankfurt headquarters of Deutsche Bank in a probe related to a money laundering investigation stemming from the Panama Papers. As part of its acquisition of Deutsche Bank’s Global Trust Solutions, NTB did acquire an unregulated entity called Regula Limited, which is mentioned as part of this probe. Following the earnings release, we conducted several calls with management and attended an investor event at the company’s headquarters and concluded that while the events that unfolded were disappointing, they did not represent a material deviation away from the thesis. The asset sensitivity story is still very much intact, the roll-up story is still very much intact, and there are no credit issues that would warrant such a pullback. We continue to expect the company to earn a mid-20% return on equity in 2019, which should facilitate an attractive capital return story. Since the third quarter release, earnings expectations for 2019 have fallen by 10% and our private value has come down by 13% compared with a stock down 37%, hence we have been adding to the position recently.