Litman Gregory Masters Smaller Companies Fund Second Quarter 2017 Attribution

During the second quarter of 2017, the Litman Gregory Masters Smaller Companies Fund rose 2.78%, outperforming the Russell 2000 Index return of 2.46%. In addition, the fund outperformed the Morningstar Small Blend Category, which returned 1.49%.

Late in the quarter, we removed FPA as a sub-advisor after 13 years on the fund. We thank co-managers Dennis Bryan and Arik Ahitov for their long-term contributions. Replacing FPA as sub-advisor is Segall Bryant & Hamill, also a value-oriented manager. Mark Dickherber and Shaun Nicholson will co-manage that portfolio. Dickherber and Nicholson seek to identify companies that have the potential for significant improvement in return on invested capital (ROIC). We have been impressed with the co-managers for several years. We believe their edge lies in their focus on identifying the potential for significant improvement in a company’s ROIC, and more specifically, positive change with respect to company management’s capital allocation decisions, which is often a precursor to sustainably higher levels of profitability. Particularly, we are excited to have the team manage a very focused portfolio of only their highest-conviction stocks for the fund. See our full write-up of Segall Bryant & Hamill.

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.

Themes, Trends, and Observations from the Managers*

Jeffrey Bronchick, Cove Street Capital
As the year toils forward to the halfway mark, we reflect.

When you have a very concentrated portfolio, you will disconnect from the index, and this quarter it was to our benefit. We materially outperformed our benchmarks during a quarter when returns in the world of small cap have predictably ground to a halt after a torrid 2016. Strategies that include larger-cap companies—particularly those that have benefited from the scorching performance of the favored few tech stocks—have shown excellent returns, both absolutely and relative to common indexes, prevailing rates of inflation, fixed-income competition, and common sense. “Growth,” commonly abused as a categorization, continues to mulch “value.”

While we are also somewhat tired of the next topic, important things are always worth repeating and it is very relevant to our efforts to produce value for clients: the cascading rush of capital toward passive investing. Several things are crystal clear to us ... and shall be repeated. With an acute understanding of the long history of financial markets and burdened by 30-plus years of experience, we believe a massive move toward indexing from “faux” active management is an entirely rational idea that should be widely embraced. We don’t see it “going back” and recent graduates should consider that statement carefully. So, if this is to be the state of the world, what does it mean for Cove Street and our clients—current and prospective?

We sometimes frame the spectrum of investing to include U.S. Treasury bonds on one end and Botswanan private equity on the other. These are two asset classes that arguably represent distinctly different opportunities for an active investor to theoretically add value, the latter being a much higher probability bet if you can stand the heat and are a seswaa aficionado. While we frankly know little about either pole, we would argue that value and smaller-cap strategies represent something closer to the latter than the former. Cove Street was designed from the ground up to be able to invest in what others “fear” by limiting asset growth, limiting the number of positions, and focusing on old school things such as company fundamentals. The last category includes an analysis of whether management and the board are stealing for us or from us, and what a security is roughly worth under a variety of scenarios. In other words, while we strive to be a superb fisherman, we are at least fishing in the right pool.

And that is a crucial issue. There are a lot fewer public companies versus twenty years ago—as in, nearly half. The two obvious reasons are the massive explosion in money to invest in private deals that both fund private companies and take public companies private, and the ever-increasing regulatory and legal burden associated with being public. As a quick aside, what value is being derived for private equity investors who pay 2x to 10x the fees that most public managers charge in order to invest in companies that legitimately could be public? And “private equity” adds what management value if you are really paying attention? And asset allocators are saving how much in fees by moving from active to passive in public markets while still paying exorbitant rates for the privilege of investing in private companies?

But we digress. For the record, we calculate 2,284 stocks (at current count) with market caps between $100 million and $3.5 billion that are U.S.-based and trade on major U.S. exchanges, 262 more if you add non-U.S. domiciled firms to the same screen, and 4,397 if you include the farther reaches of over-the-counter. That is still plenty to choose from if you limit your asset size and concentrate your positions. We have 10 in this portfolio. You should have fewer the larger your target market-cap universe. The other point that is somewhat neglected is that while there are fewer stocks, there are arguably also fewer people paying attention.

One of the core functions of “markets” is to provide investors with a sense of the pricing of asset values so that they can make allocation decisions regarding their capital. For the moment, let’s ignore giant existential questions surrounding Adam Smith and the future of democracy and capitalism. Currently, investors are trying to answer simple questions such as: how on the margin are rational people pricing assets and estimating cost of capital and return on capital when exchange traded funds (ETFs) are collecting x dollars per day and simply buying what is in a stated asset class, regardless of value? How can we evaluate what the market is telling me about credit conditions if we cannot price credit within a barely functioning corporate bond market, especially when trading is down some 70% in the last few years due to the giant sucking sound of central banks and ETFs? How does a CFO price an acquisition opportunity? These are weird questions and the answers probably contain unpleasant implications.

What pricing we do see and try to make sense of tends to be … expensive. We are as driven as the next person to look for the next great investment, but trying not to do something stupid is a full-time job in financial markets that have had a mighty impressive run since 2009. We have adopted something of what we will attribute to infectious disease specialist Justin Graham: “Don’t just do something. Sit there.”

Cove Street Capital just celebrated its sixth-year anniversary. We have an enviable group of client-partners; a young, smart, and growing group of teammates who are increasing their equity ownership in our efforts; and as Warren Buffett would say, we continue to tap-dance on our way to work. “Delight Clients, Have Fun, Make Money” has been our mantra since day one and we thank you for our continued partnership.

Mark Dickherber and Shaun Nicholson, Segall Bryant & Hamill (SBH)
We continue to be more cautious with extended valuations in most of the market, which are not providing strong risk-adjusted return opportunities—thus why cash is higher. While over the remainder of this cycle we are a bit exposed to a late-cycle blow-off-top in the market, we believe this would be short lived and find ourselves (as always) more focused on providing capital-appreciation opportunities balanced with downside mitigation. We find energy not investable given the capital destruction and inability to better control corporate-level returns on capital. In addition, due to the massively changing complex within consumer discretionary, and the stage of the market cycle, we are more cautious—we do see pockets of opportunity, but the windows for investment here are rather tight and more balanced with regard to reward/risk. While we are not market timers, we are cognizant of the fragile nature of this market. The majority of market participants are either wholly unaware of, or are choosing to ignore this fragility, where investments lie in hands of machines or capital allocators that have a complete disregard for the precious nature of capital. Barring socialism taking hold and completely destroying capitalism, we are quite excited about the opportunities throughout the continuum of each cycle where investors are well rewarded for respecting capital and risk accordingly.

Dick Weiss, Wells Capital Management
Overall, U.S. equity markets held their gains for the quarter despite the Federal Reserve raising interest rates during the final month of the quarter. The Fed announced a quarter-point rate hike (mostly expected by Wall Street) with the new range of 1.00% to 1.25%. Additionally, more detail was provided by the Fed on how it will unwind its $4.5 trillion balance sheet, while expectations for inflation over the next 12 months “is expected to remain somewhat below 2% in the near term” but stabilize. While many point to higher interest rates as a potential burden for economic growth as lending standards become more stringent and borrowing costs rise, the economy continues to show resiliency with improving home prices, higher consumption, and stable employment. At a macro level, these factors are important, but we continue to be cognizant of company fundamentals as the main driver for equity returns. To that tune, more and more companies we speak with have been ramping up capital spending as they see increasing growth opportunities. For the past several years, companies deployed capital back to shareholders in the form of dividend increases and/or share buybacks. Now, as we hear more companies discuss increasing capital expenditures, this could be an additional driver for economic growth and company growth, which would help companies to expand their incremental margins and flow returns to the bottom line or invest further in their underlying operations.

For the portfolio, we continue to use our Private Market Value process when sourcing new investment ideas. We are seeing pockets of opportunity in the materials sector and other sub-sectors of the market. We have been overweight to the energy sector, which has impacted relative performance from an allocation standpoint. However, we feel oil is bottoming out here, and should we see a rebound, we believe the portfolio is well positioned to outperform versus the index.

* 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

  • The second quarter was marked by strong stock selection within the portfolio, which more than offset the negative effect of sector allocation.
  • Industrials was the leading sector contributor in the portfolio during the period, almost entirely due to stock selection. Two stock picks in particular stand out: Wesco Aircraft Holdings and Heritage-Crystal Clean, both owned by Jeffrey Bronchick and discussed below. These positions are among the largest weights in the industrials portion of the portfolio. Wesco was up over 13% in the quarter, while Heritage was up over 16%.
  • The second-biggest contributing sector was consumer discretionary, again due primarily to stock selection. Online retail operator Etsy, owned by Dick Weiss and discussed in greater detail below, was the leading individual contributor with a return of over 41% in the three-month period. Etsy and other successful consumer stock picks were able to offset a disappointing quarter from apparel company Cherokee, owned by Bronchick and discussed below, which fell more than 19% in the quarter.
  • The most significant detractor (by far) from a sector perspective was energy, where positive stock selection was unable to offset the large negative effect of being meaningfully overweight to this sharply declining sector (energy stocks in the benchmark were down over 19% for the quarter). Two individual detractors were Cimarex (down over 21%) and Range Resources (down over 26%), both owned by Weiss and discussed below. Cimarex was a top holding with a 3.66% average weight in the portfolio, so its decline caused it to be the single-largest relative detractor in the period. Note that much of the fund’s recent energy exposure was held by FPA. Exposure to the energy sector declined meaningfully with the late June addition of SBH. At the end of the quarter, the fund was underweight to the energy sector.
  • Health care also detracted from performance. This was mainly due to the fund’s near 9% underweight position to this strong-performing sector, which returned just over 9% during the quarter.
  • The fund’s cash allocation—which increased relative to the prior quarter to slightly under 14%, on average—was a drag on relative performance during the period, given the positive return of the Russell 2000 benchmark.
Top 10 Contributors as of the Quarter Ended June 30, 2017
Company Name Fund Wt. (%) Benchmark Wt. (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Wesco Aircraft Holdings Inc. 2.29 0.03 13.02 0.75 Industrials
Etsy Inc. 2.02 0.07 41.11 0.72 Consumer Discretionary
Heritage-Crystal Clean Inc. 3.68 0.01 16.06 0.57 Industrials
Millicom International Cellular SA 4.96 0.00 11.68 0.50 Telecommunications
Aaron's Inc. 1.51 0.12 30.73 0.49 Consumer Discretionary
Babcock & Wilcox Enterprises Inc. 1.95 0.02 22.48 0.48 Industrials
Houghton Mifflin Harcourt Co. 1.42 0.08 30.54 0.44 Consumer Discretionary
Delta Air Lines Inc. 2.45 0.00 17.42 0.42 Industrials
Arris International PLC 3.14 0.00 9.75 0.36 Information Technology
Avid Technology Inc. 2.52 0.01 12.88 0.30 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

Wesco Aircraft Holdings (Jeffrey Bronchick, Cove Street Capital)
Wesco Aircraft was a recent addition to the portfolio and contributed positively to performance. Regular readers might remember Wesco as a position exited with a small loss several years ago. The long version of the story begins with a guy sweeping up a factory floor for an aerospace company (actually not far from our offices), picking up any variety of bolts and widgets that were deemed to be trash, and reselling them to neighboring companies. This is now known as “supply chain management for the aerospace industry,” which is the Wesco of today—one of the largest in the industry.

The company was bought by the private equity firm Carlyle from the son of the founder, and let’s just say, one did little and the other almost nothing of consequence for the benefit of shareholders from then on. They went public in 2013 at $16, hit a high of $24, sold shares along the way … and then the wheels began to come off. The veneer suggested a sophisticated distributor tied into its big clients through deep system integration, which would produce high margins, returns, and free cash flow. An acquisition was made with debt. The reality was that the company had antiquated systems, an antiquated warehouse with scattered B-52 parts, little in the way of financial systems appropriate for a public company, and “light” management. Thanks again, Carlyle—the alleged dean of the private equity business. Roll forward and they missed every forecast made; took inventory write-offs; replaced the CEO, the CFO, and a variety of others; and generally wasted what most would consider to be the biggest commercial aerospace build since World War II.

Our in-depth research several years ago picked up much of this, and we sold the stock in the mid-teens with minor damage. After what appeared to be the right management changes and a walk that looked like it was following the right talk, we began repurchasing shares just under $11 several years later. The core business properly managed is a good business with solid returns and high free cash flow. That worked to a point. The flaw in the ointment turned out to be that the new CEO Dave Castagnola was a “manufacturing guy,” and distribution even on the highest scale still required a softer touch. While there was a tremendous amount of improvement in many financial areas, Wesco still was not “in the zone” and did not create what we would consider to be acceptable cash flow given the level of new business they were signing.

We built our position after Dave got the boot this quarter and took his overly optimistic projections with him. The company is being led by Todd Renehan, who we think has the right set of skills to match new business with free cash flow. We would also note that Carlyle still owns 23% of the stock in a fund that is long closed, and they received a two-year extension to keep the investment that ends this December. The Snyder family still owns 10%. Good value, large, unhappy shareholders with a quiet clock ticking in a consolidating industry. We see either outcome—fundamental improvement from a cheap stock or a takeover—as satisfactory for us. After we built Wesco into one of our largest positions, the stock rebounded. We are playing the long game here and maintain our position.

Etsy (Dick Weiss, Wells Capital Management)
Etsy is an online retail operator for specialized goods. The stock performed well over the quarter as the company provided an update on their strategic review in which it was announced the company will reduce headcount by 20% from 2016 levels and place an emphasis on marketing tools to drive buyer frequency. Shares reacted positively to the update, driving outperformance. We originally bought the company feeling Etsy was well positioned to take share in a growing market.

Heritage-Crystal Clean (Jeffrey Bronchick, Cove Street Capital)
Heritage-Crystal Clean (HCCI) is a provider of environmental services as well as a provider of the re-refining of used motor oil. Its performance this quarter was driven by the upward move of base oil prices over those realized last year. This positive trend helped produce good free cash flow generation and increased margins. HCCI’s environmental services business returned to growth after a down year in 2016, helping drive overall corporate margins higher. We continue to see the normalization of margins within the re-refined oil segment in addition to the continued long-term growth of environmental services as the two future drivers for earnings and therefore returns in the stock.

Top 10 Detractors as of the Quarter Ended June 30, 2017
Company Name Fund Weight (%) Benchmark Weight (%) Three-month Return (%) Contribution to Return (%) Economic Sector
Cimarex Energy Co. 3.66 0.00 -21.27 -0.94 Energy
Cherokee Inc. 2.87 0.00 -19.19 -0.60 Consumer Discretionary
Avnet Inc 1.99 0.00 -15.96 -0.43 Information Technology
Patterson-UTI Energy Inc. 1.23 0.00 -17.64 -0.29 Energy
Rowan Companies PLC 0.88 0.00 -22.21 -0.27 Energy
Noble Energy Inc. 1.40 0.00 -13.17 -0.23 Energy
Helmerich & Payne Inc. 1.01 0.00 -18.41 -0.23 Energy
Range Resources Corp. 0.70 0.00 -26.30 -0.21 Energy
Tegna Inc. 1.61 0.00 -12.59 -0.20 Consumer Discretionary
Goldcorp Inc. 1.31 0.00 -11.38 -0.15 Materials

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

Cimarex Energy (Dick Weiss, Wells Capital Management)
Cimarex Energy is an independent oil & gas exploration & production company. Its activities include drilling, completing, and operating wells. Its projects cover the Permian Basin and the Cana-Woodford in Oklahoma, Texas, and New Mexico. The company has been impacted by falling oil prices but is well positioned longer term with improving drill techniques, while it has one of the lower oil price breakeven points within the industry as well. Our original thesis for owning the name revolved around the company’s improving technology for drilling wells, which should lead to higher returns in a flat oil market.

Cherokee (Jeffrey Bronchick, Cove Street Capital)
Cherokee has unfortunately been caught up in the market’s concerns about all things retail (or at least those not named Amazon). However, many domestic investors are not familiar with the fact that the retail dynamics outside of the United States do not exactly mirror what we are witnessing here. As a result of the recent acquisition of Hi-Tec (headquartered in the Netherlands), Cherokee has become a much more international company. In reality, that is where most of the growth has come over the last few years and we expect that trend to continue. Also, the company is in the middle of replacing its largest U.S. customer— Target—with a slew of other wholesalers and retailers. The ramp up has been slow and the market has clearly become concerned about Cherokee’s ability to regain its domestic position. However, our research suggests that Cherokee has built a global platform into which it can drop new and existing brands and thus has built a growth engine for the future. The valuation remains undemanding and if Cherokee’s initiatives are successful over the next 12 months, it is very likely that the current stock price will have represented a very attractive entry point.

Range Resources (Dick Weiss, Wells Capital Management)
Range Resources is an independent natural gas and oil company, which engages in the exploration, development, and acquisition of natural gas and oil properties in the Appalachian and Midcontinent regions of the United States. It operates through a single segment, which is the exploration and production of natural gas, natural gas liquids, and oil in the United States. The company has been impacted by the fall in commodity prices but should be able to grow production by more than 15% annually for the foreseeable future. Our original thesis for owning the stock revolved around the company having robust topline growth potential and improved takeaway capacity, which should help support improved operating metrics.

Edited Commentary from SBH about Selected Initial Positions

Innophos Holdings
Innophos Holdings declined 19% in the second quarter of 2017. The company serves niche markets within specialty ingredients solutions for food, health, and nutrition as well as some industrial markets. Our thesis for owning the stock is driven off the significant shift higher in return on invested capital we expect to unfold over the next several years. Underpinning our confidence is the revamped management team led by CEO Kim Ann Mink, who joined after a successful career at Dow Chemical. She has led a significant effort to implement a lean manufacturing process and operational excellence culture and position the company toward higher-value-add ingredients within food, health, and nutrition markets. These are very niche markets that carry much higher margins than the traditional phosphate markets the company was built around. The market rewarded her early efforts at these initiatives; however, as the volume pressure has remained in the core business, investors have pressured the stock. Management is forecasting volume declines of 5% this year; however, some of this is self-inflicted as they have transitioned away from a significant amount of volumes that were commoditized and thus carried lower margins. We believe with the recent pullback in the stock, the market is not giving much, if any, credit for these value-enhancing initiatives, and our expectation is for them to continue their strong free cash flow from return-enhancing markets, which we believe will be rewarded once again by investors. We particularly like the fact that this new management team sets expectations that they can meet or beat and it pays a handsome 4% plus dividend yield. We added to our position on the pullback during the quarter.

SPX Corp.
SPX shares rose 3% in the second quarter of 2017. The company is a supplier of highly engineered products and technologies, holding leadership positions in the HVAC, detection and measurement, and engineered solutions markets. The company operates in three segments: Engineered Solutions (46% of revenues), HVAC (37% of revenues) and Detection & Measurement (17% of sales). Our thesis for owning the stock is the underappreciated niche market positions they maintain across their businesses and the renewed capital allocation discipline and culture change to following a return-on-invested-capital improvement path after being spun out from a larger enterprise in late 2015. The management team is well seasoned and disciplined in lean manufacturing and operational excellence and has taken a much more aggressive approach to implementing these tools post-spinoff. The company has significant optionality around deploying capital over the next several years, and we expect they will execute upon this optionality in a prudent manner that is not yet appreciated by investors. Another attractive attribute is the defensiveness of the business model as more than 60% of their revenues are replacement/repair, which is far more stable in tougher economic climates. We still believe the stock flies well below the radar, trading at a significant discount to other niche industrial companies, which in part is driven off of low Street coverage and lack of knowledge of the company post-spinoff. We continue to add on pullbacks to maintain this as one of our larger positions in the portfolio.