During the first quarter of 2021, the iMGP Equity Fund gained 8.65%, outperforming its Russell 3000 Index benchmark (which gained 6.35%) and the Morningstar Large Blend Category (up 6.74%). Since its December 1996 inception, the fund’s 9.05% annualized return is in line with the Russell 3000 Index’s gain of 9.37%, and ahead of the Morningstar category’s 7.75% return.
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.imgpfunds.com.
Quarterly Portfolio Commentary
Pat English and Jonathan Bloom, FMI
Vaccines are helping to drive COVID-19 into the background, economies are generally improving, and the outlook is brightening for revenue growth. This should favor value-oriented shares. The absence of generalized growth helped drive a high premium for those relatively few companies that were growing rapidly. There are still nearly 10 million Americans out of work, and once all the stimulus winds down, the expectation is that many people will rejoin the workforce. There is pent-up demand, and this should drive good GDP growth. As the economy gains speed and dormant money starts to get deployed within the banking system, inflation concerns may start to surface. We are already seeing anecdotal evidence of inflation in several places. Perhaps this sets the stage for the long-awaited “normalization” of interest rates. As previously mentioned, growth stocks have been the prime beneficiary of low inflation and unprecedented interest rates, coronavirus lockdowns, and massive financial market speculation. Stock prices remain elevated by historical standards, as most valuations are higher than at any time we have studied. We remain optimistic that high-quality businesses, which are reasonably-valued and have solid balance sheets will prevail over the long run. We have populated the iMGP portfolio with such companies, in out-of-favor sectors/industries that include financials, industrials, retail, and travel.
Bill Nygren and Clyde McGregor, Harris Associates
Continued optimism around a growing global economy driven by increasing COVID-19 vaccinations lifted global equities in the first quarter and provided greater optimism that the global pandemic may be closer to an end. Equity markets responded favorably to accommodative central bank policies: U.S. Federal Reserve Chairman Jerome Powell’s forecast for near-zero interest rates through at least 2023. In the U.K., investors pondered if the country would implement negative interest rates. Much like the U.S., the Bank of England also held its rates steady and kept its level of asset purchases intact. Bank of Japan Governor Haruhiko Kuroda projected the country’s economic growth would be “clearly positive” for the fiscal year beginning in April. In terms of projected global growth, the International Monetary Fund increased its guidance for 2021 and now expects 5.5%–6% global growth for the year as well as 4.2% growth in 2022. As we enter the second quarter, global monetary and fiscal stimulus and greater consumer demand ought to create a positive backdrop for global equities.
Scott Moore and Chad Baumler, Nuance Investments
Our largest overweight to the benchmark remains the consumer staples sector. As the COVID-19 pandemic has caused shifts in consumer spending behavior that we believe are transitory, it has created several interesting opportunities, in our view. The primary opportunities are in food products (Sanderson Farms and Cal Maine Foods), personal products (Beiersdorf AG), and beverages (Diageo plc) sub-industries, in our opinion.
The health care sector is now the second-largest overweight position as we continue to see opportunities primarily in the equipment and services industry. We believe many of these risk/rewards are attractive as the market generally believes that elective procedures will be delayed and that the health care system will be hampered by the need to have capacity available for COVID-19 patients. During the quarter, we were able to add a position in Baxter International, a leading supplier of kidney dialysis supplies and equipment along with intravenous fluids, pumps, bags, nutritional compounds, pharmaceutical compounding supplies, and pre-filled pharmaceutical bags.
While financials remain a large portion of the portfolio, we are now slightly underweight to the sector as the risk/reward shifted within the sector, in our view. We exited our positions in both MetLife, Inc. and Charles Schwab Corporation and we were able to deploy that capital within the utilities sector. We added positions in what we believe are leading water utility companies, SJW Group and United Utilities Group PLC. We believe both companies are underearning due to regulatory lag and historically low allowed returns on equity due to interest rates.
We also remain overweight to the real estate sector due to our holding in Equity Commonwealth (EQC), which we believe is an interesting risk/reward in the sector. While we remain underweight to the industrials sector, we are now void any exposure as we exited our only position in the sector. We sold 3M Company in favor of better risk/reward opportunities in other market sectors, in our view. We continue to avoid the energy sector where we believe the sector is facing a multiyear period of competitive transition. Additionally, we remain underweight to the consumer discretionary, communication services, industrials, information technology, and materials sectors primarily due to valuation concerns.
Chris Davis and Danton Goei, Davis Advisors
The portfolio is invested in durable businesses with strong competitive advantages, which are trading at reasonable multiples overall. The major sectors represented include financials, communication services, consumer discretionary, and industrials. We believe that our portfolio trades at a far more attractive valuation than the S&P 500 Index, yet has the potential, based on our analysis, to grow significantly faster than the broader market. Finally, and importantly, each holding is handpicked based on our evaluation of management, business model, and the sustainability of competitive advantages.
Michael Sramek, Sands Capital
Our approach is not going to work in all market environments, and we expected a reversal as vaccines are broadly distributed, the global economy cyclically recovers, and fiscal stimulus increases. The speed with which interest rates have adjusted to all this change spooked the market, but we expect this to settle down before too much longer.
The first quarter’s noise has not distracted our focus on seeking the select few companies that we believe can generate above-average earnings growth over the next five years. We have long owned businesses that are driving and/or benefiting from digitalization, and the pandemic has accelerated this shift. We expect digitization will proliferate faster than pervious technology-driven shifts (e.g., the telephone, electricity, personal computers), and with unprecedented scale, touching nearly every aspect of commerce and daily life. Businesses can reach more customers faster than ever, a dynamic that we expect will lead to quicker margin expansion for the select few businesses driving and/or benefiting from the digital shift.
*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 six 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.
iMGP Equity Fund Sector Attribution
| Sector Weights | Fund | Russell 3000 as of 3/31/2021 |
|---|---|---|
| Communication Services | 12.8% | 10.0% |
| Consumer Discretionary | 17.6% | 12.3% |
| Consumer Staples | 3.8% | 5.6% |
| Energy | 0.8% | 2.6% |
| Finance | 23.8% | 11.7% |
| Health Care & Pharmaceuticals | 10.9% | 13.6% |
| Industrials | 7.9% | 9.8% |
| Information Technology | 14.2% | 25.7% |
| Materials | 0.0% | 2.9% |
| Real Estate | 2.4% | 3.2% |
| Utilities | 1.2% | 2.6% |
| Cash | 4.6% | 0.0% |
| 100.00% | 100.00% |
- All 11 sectors comprising the Russell 3000 Index saw gains in the quarter, ranging from 1.4% for the information technology sector to 31.6% for the energy sector.
- Both stock selection and sector allocation contributed to the fund’s outperformance in the quarter.
- The fund’s overweight to the financials sector, as well as its specific holdings, had the biggest contribution to outperformance. The sector was the second-highest performing sector within the benchmark in the first quarter—trailing only the energy sector. A number of financial stocks populate the top-10 contributor list in the quarter, including Capital One, Well Fargo, Ally Financial, and Charles Schwab.
- The information technology sector was the lowest-returning sector within the benchmark in the first quarter. The fund benefited from its underweight. ServiceNow was a leading detractor within the information technology sector and the portfolio as a whole in the quarter. This stock, owned by the Sands team and discussed below, fell over 9%.
- Stock selection within the consumer discretionary sector added the most value from a selection standpoint in the quarter. Value-add came from positions in General Motors, Thor Industries, and Lear Corp.
Top 10 Contributors as of the Quarter Ended March 31, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Economic Sector |
|---|---|---|---|---|---|
| Capital One Financial Corp | 4.43 | 0.13 | 29.14 | 1.16 | Financials |
| General Motors Co | 2.17 | 0.17 | 37.99 | 0.69 | Consumer Discretionary |
| Thor Industries Inc | 1.29 | 0.02 | 45.34 | 0.48 | Consumer Discretionary |
| Wells Fargo & Co | 1.74 | 0.33 | 29.85 | 0.48 | Financials |
| Alphabet Inc A | 2.64 | 1.5 | 17.68 | 0.44 | Communication Services |
| Ally Financial Inc | 1.46 | 0.04 | 27.42 | 0.36 | Financials |
| Lear Corp | 2.38 | 0.03 | 14.14 | 0.34 | Consumer Discretionary |
| Sea Ltd ADR | 2.83 | 0 | 12.15 | 0.33 | Communication Services |
| Charles Schwab Corp | 1.42 | 0.21 | 23.28 | 0.33 | Financials |
| CBRE Group Inc Class A | 1.32 | 0.06 | 26.13 | 0.33 | Real Estate |
Edited Commentary from the Respective Managers on Selected Contributors
Capital One Financial (Chris Davis and Danton Goei, Davis Advisors)
Capital One Financial is one of the top 10 banks in the United States by deposits, with a strong leading position in consumer finance and credit products, though it is best known for its credit card business. Capital One has been a strong contributor to results since mid-2020, rebounding from a low of close to $40 per share to a current level of $130 per share. We believe this appropriately reflects an improving outlook for the business, especially in light of economic expansion restarting already. This fact dramatically reduces the likely credit costs that Capital One and a number of other banks must absorb ultimately due to the COVID-19 recession.
General Motors (Clyde McGregor, Harris Associates)
- GM holds a dominant and highly profitable market position in North American pick-up trucks and has built what we consider to be strong market positions in emerging economies.
- We think that an improving auto industry in general and solid secular growth in the emerging world (which now accounts for more vehicles sold than either the U.S. or Europe) will drive increased sales.
- In our assessment, CEO Mary Barra is a strong leader who took action early in her tenure to correct both vehicle defect issues and management problems that she inherited; we are also pleased that she is accessible and communicates with us when requested.
In January, GM launched its BrightDrop brand that is focused on electric delivery vehicles. Later, the company announced a new strategic relationship with Microsoft in an effort to help accelerate the commercialization of self-driving vehicles. As part of the agreement, Microsoft will partner with GM, Honda and others to make a new investment of more than $2 billion in Cruise (GM’s self-driving car company). In our view, GM will benefit not only from the investment, but also from a closer working relationship with Microsoft, which it hopes will accelerate digital transformation efforts and artificial intelligence capabilities.
GM issued fourth-quarter results including adjusted earnings that reached $3.71 billion and led to earnings per share of $1.93, which exceeded market forecasts by 24% and 21%, respectively. More importantly, total adjusted earnings advanced 15% year over year. Results in North America were especially robust as earnings margins exceeded 12% (excluding vehicle recall impacts), owing to benefits from an attractive product mix and strong pricing aided by solid demand and effective inventory management. Likewise, high used car prices, lower credit costs and lower interest expenses prompted record-level results in GM’s financial segment where adjusted earnings rose 29% from last year. We later spoke with CFO Paul Jacobson and discussed the company’s outlook for 2021. He stated that while GM will encounter some unique pressures in the current year, including a global semiconductor chip shortage that has disrupted new vehicle production, the company anticipates plentiful free cash flow and many exciting new business opportunities available to pursue. In March, Cruise acquired Voyage, an autonomous vehicle technology startup.
Ally Financial (Bill Nygren, Harris Associates)
- We like that Ally is no longer captive to one auto lender, but rather serves a wide variety of auto dealers including General Motors, Ford, Chrysler and Toyota. Ally is carefully building a consumer franchise online at an advantaged funding cost versus traditional lenders, which more than offsets any cyclicality from the auto business.
- We appreciate that Ally Financial is a secured lender with a history of strong credit management.
- In our view, an improvement in funding costs is helping to drive continued net interest margin expansion at the company.
- We like that Ally Financial trades at a discount to its tangible book value, making it an attractive investment.
As management predicted and we expected, Ally Financial released good fourth-quarter results. Total net revenue rose 21% from a year earlier while earnings per share advanced 68% and both exceeded market forecasts. In addition, total deposits grew 13% and average total earning assets (including auto loans and mortgages) rose 3% year over year. Notably, the company’s provision for credit losses decreased materially from $998 million in the fourth quarter of last year to $102 million in the current fourth quarter. This decline combined with net interest income growth of 13% led to an annualized return on average tangible common equity (ROTCE) that increased from the prior quarter to 18.7%. Full-year 2020 ROTCE reached 9.1%. Management is targeting an ROTCE of 12% for 2021 followed by 15% for 2022–2023, which we believe is achievable based on recent trends. Lastly, Ally announced a new $1.60 billion share repurchase authorization in January following favorable results from the most recent Federal Reserve Board stress test.
Charles Schwab (Pat English and Jonathan Bloom, FMI)
Our initial thesis on Schwab was that the revenue mix shifting toward cash monetization would cause the business to be less cyclical while also driving lower competitive intensity. We saw this play out in early 2020 as rates declined but investors swiftly moved to more cash to protect their portfolios, helping to buffer the earnings hit. This helped confirm our thesis while the shares sold off dramatically over fear of the earnings decline from lower rates. Quarter after quarter, the company is working through the impact of lower rates and should be at trough net interest margins over the coming quarters. More recently, interest rates have begun to move higher as the impacts of an economic recovery and significant stimulus/infrastructure spending become apparent. Just a return to 2019’s net interest margins have the potential to increase earnings per share by over 70%. This, combined with steady progress on the TD Ameritrade merger, caused the stock to perform well during the quarter. Despite the strong performance, we still believe the shares are reasonably valued at 22x trough earnings, well within the historical range despite what we believe will be accelerating earnings growth over the coming years.
Top 10 Detractors as of the Quarter Ending March 31, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Economic Sector |
|---|---|---|---|---|---|
| Servicenow Inc | 2.53 | 0.26 | -9.14 | -0.24 | Information Technology |
| Amazon.com Inc | 3.66 | 3.42 | -5 | -0.2 | Consumer Discretionary |
| Smith & Nephew PLC ADR | 1.11 | 0 | -10.13 | -0.13 | Health Care |
| Atlassian Corporation PLC A | 1.31 | 0.08 | -9.88 | -0.13 | Information Technology |
| Beiersdorf AG ADR | 1.07 | 0 | -9.85 | -0.11 | Consumer Staples |
| Visa Inc Class A | 3.5 | 0.9 | -3.05 | -0.11 | Information Technology |
| Netflix Inc | 2.7 | 0.57 | -3.53 | -0.1 | Communication Services |
| Edwards Lifesciences Corp | 0.78 | 0.13 | -8.32 | -0.07 | Health Care |
| Alibaba Group Holding SP ADR | 2.19 | 0 | -2.58 | -0.05 | Consumer Discretionary |
| Charter Communications Inc A | 0.79 | 0.23 | -6.73 | -0.04 | Communication Services |
Edited Commentary from the Respective Managers on Selected Detractors
ServiceNow (Mike Sramek, Sands Capital)
ServiceNow is the leading provider of enterprise workflow automation software, based on market share. Enterprise digital transformation is a powerful secular tailwind that should drive demand for ServiceNow’s offerings over the next decade. The business’s extensible workflow automation platform is a key enabler of the digital transformation efforts necessary for companies to remain competitive in the modern world, driving cost savings and functionality improvements for ServiceNow’s customers. After building a leading position addressing IT department workflows, ServiceNow has gained strong momentum for its solutions addressing other enterprise workflows, including customer service, HR management, and facilities management. The business’s easy-to-customize platform has resulted in high organic growth rates and best-in-class margins at its scale, in addition to consistently compelling product releases. We believe that the durability of ServiceNow’s above-average growth potential is underappreciated, given its ability to address multiple use cases across enterprises.
ServiceNow continues to meet our sixth criterion, rational valuation relative to the market and business prospects. We expect mid-20s annualized revenue growth and low-30s annualized free cash flow growth over our investment horizon.
ServiceNow shares traded lower despite strong fourth-quarter 2020 results and better-than-expected first-quarter and full-year 2021 guidance. The business continues to become a more strategic partner to its customers, signing larger deals across more products. Excluding foreign exchange effects, subscription revenue grew 29 percent year over year and subscription billings growth accelerated eight percentage points to 32 percent, despite a difficult comp. For the full year, ServiceNow delivered 32 percent free cash flow margins and 25 percent operating margins, both up 400 basis points year over year as they benefited from operating leverage and lower travel and expense spend. For 2021, management guided to an acceleration in net new annual contract value, and healthy billings and subscription revenue growth. Ultimately, we believe that ServiceNow is becoming an increasingly strategic enabler of digital transformation for large enterprises.
Smith & Nephew (Scott Moore and Chad Baumler, Nuance Investments)
Smith & Nephew PLC is a leading manufacturer of advanced medical devices and a long-time Nuance holding. The company holds leading market-share positions in sports medicine, advanced wound care, knee replacement, hip replacement, and trauma devices. We view these as advantaged product categories, with high barriers to entry and a customer base that values quality and innovation, and we believe Smith & Nephew is well positioned to maintain or gain market share across most of these categories.
During 2020, the company experienced a significant decline in revenues and profits as the COVID-19 pandemic led to the postponement of elective procedures. As of this writing, procedure volumes remain below normal levels, but we believe the decline is transitory and that procedure volumes will likely move back toward more normal levels during the next several years. That said, the drop in elective procedures is likely to cause Smith & Nephew to underearn during 2021, in our view. Specifically, Wall Street analysts expect the company to earn $1.74 per share for 2021, well below our estimate of $2.70-2.80 in normalized earnings per share (mid-cycle). We would note that Smith & Nephew maintains a solid balance sheet at 1.2x net debt to earnings before interest, taxes, depreciation, amortization, and rent expense (EBITDAR), which should allow the company to navigate this trough earnings period while continuing to pursue opportunistic tuck in acquisitions, according to our internal view. Trading at less than 15.0x what we consider normal earnings on March 31, 2021, Smith & Nephew offers what we consider a compelling risk/reward opportunity versus other stocks in the sector.
Alibaba (Mike Sramek, Sands Capital)
Alibaba operates the world’s largest e-commerce marketplace, based on gross merchandise volume (GMV). Alibaba accounts for approximately 70 percent of all e-commerce sales in China. Several characteristics make China an attractive ecommerce market, in our view, including its large and growing user base, rising middle-class incomes, and an underdeveloped traditional retail infrastructure. While overall e-commerce penetration is high in China relative to other large markets, significant segments—including packaged and fresh food—remain early. Over our investment horizon, we expect Alibaba’s earnings growth to be driven primarily by higher GMV and increasing monetization, which remains lower than global peers. Longer term, we see upside potential from several additional opportunities, including cloud computing and digital financial services. Alibaba’s cloud business is China’s clear leader, with twice the estimated market share of the next-closest competitor, and enterprise digital transformation remains early. Investee Ant Group is China’s market-share leader in digital payments and has a massive addressable market for other digital financial services, including credit, insurance, and investment management. (Ant Group is not a holding in the iMGP Equity Fund.)
Alibaba continues to meet our sixth criterion, rational valuation relative to the market and business prospects. Over the next five years, we expect the business to produce mid-20s annualized revenue growth and high-20s annualized earnings growth.
During the quarter, regulatory pressures weighed on Alibaba. While heightened regulation was originally one-sided with financial decoupling measures by the U.S. government, Chinese regulators also began to take action, as evidenced by the derailed Ant Group IPO and antitrust investigations.
The business received some positive news, in our view, shortly after the quarter ended. On April 10, the State Administration for Market Regulation (SAMR) announced a $2.8 billion fine on Alibaba for abusing its market dominance to force exclusivity on merchants. Alibaba is required to stop its forced-exclusivity behavior, self-monitor, and report compliance to SAMR over the next three years. The fine is equivalent to 11 percent of Alibaba’s calendar-year 2020 adjusted EBITDA and free cash flow.
This is a better-than-expected outcome and removes a major overhang on the business and stock, in our view. The investigation was concluded quickly—over approximately four months—which indicates to us the regulators didn’t intend to have the issue drag on. Management said this marks the conclusion of SAMR’s investigation into Alibaba’s forced-exclusivity practices. There are no other investigations related to the anti-monopoly law, other than change-of-control transactions review. That investigation is largely focused on reviewing merger transactions involving VIE structures and includes other Chinese Internet businesses.
The dollar amount of the fine, in our view, is immaterial to Alibaba’s long-term results. The fine is lighter than expected in two aspects: 1) the law calls for a fine equal to one to 10 percent of the prior-year revenues, and SAMR chose four percent of Alibaba’s 2019 revenues; 2) The fine has manageable profit impact, as only 11 percent of Alibaba’s calendar-year 2020 adjusted EBITDA and free cash flow.
This ruling indicates to us that the regulatory pressure on Alibaba is lighter than feared. The recent regulatory actions sparked fear among investors that the Chinese government might over-regulate and stifle the development of the Internet economy. The regulator’s punishment to Alibaba is more of a slap on the wrist, in our view, indicating that it does not intend to cause material damage to the businesses. We view the recent actions as bringing China more in line with the developed countries since the Chinese regulators had not previously exercised much oversight on the Internet companies.
Additionally, in SAMR’s 26-page write-up, it acknowledged Alibaba’s importance, saying 1) Alibaba’s e-commerce platform has a large base of affluent customers and retention rate is over 98 percent; 2) it is an important channel for brand-building: not operating on Alibaba’s platform results in less revenue and weaker brand power.