During the second quarter of 2021, the iMGP Equity Fund gained 7.32%, underperforming its Russell 3000 Index benchmark (which gained 8.24%) and performing in line with the Morningstar Large Blend Category (up 7.53%). The fund is ahead of both its index and Morningstar category so far in 2021. Since its December 1996 inception, the fund’s 9.27% annualized return is in line with the Russell 3000 Index’s gain of 9.62%, and ahead of the Morningstar category’s 7.99% 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
Global stock markets have continued to climb, as vaccines were administered, economies reopened, and growth prospects brightened. A strong rebound in cyclical/recovery sectors in recent quarters led to an attractive relative valuation case for both Facebook and Alphabet. Both stocks were trading at a meaningful discount to the market, with better balance sheets, growth prospects, and return on invested capital (ROIC). In fact, they were trading near their widest relative discount to the market in five years. We have always considered them to be great businesses, but valuations and concerns around competitive threats, management and capital allocation had previously kept us on the sidelines. Our key reservations have either faded to the background or seen significant improvements in recent years. As a result, we added Facebook and Alphabet to the portfolio in May, while selling more cyclical, slower-growing businesses in Eaton and TJX Companies, which traded at similar or higher valuation multiples.
Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices continued to move higher in the second quarter, despite the impact of the COVID-19 Delta variant in certain parts of the world. Continued optimism around the efficacy of the vaccine and steady vaccination efforts have convinced market participants that the global pandemic is closer to an end. Equity markets also continued to respond favorably to accommodative central bank policies, increased consumer spending, and low interest rates. As we enter the third quarter, global monetary and fiscal stimulus and greater consumer demand ought to create a positive backdrop for global equities.
Since the beginning of the year, the companies we own have reported largely favorable earnings and cash flows. We think this trend will continue as the world continues to emerge from the pandemic. We believe the portfolio contains some of the highest quality, U.S.-domiciled businesses that currently trade at attractive prices.
Scott Moore and Chad Baumler, Nuance Investments
While our overweight and underweight sector exposures were unchanged during the quarter, we did make changes to the composition of the portfolio as risk reward opportunities shifted. In the consumer staples sector, our largest overweight position relative to the benchmark, we initiated a position in Henkel AG & CO, a leading supplier in adhesives and sealants, and we exited our position in Diageo as we believe the risk reward in Henkel is more attractive. Also, within the sector, we continue to own stocks in both the food products, Sanderson Farms and Cal Maine Foods, and personal products, Beiersdorf AG, sub-industries.
We remain overweight the health care sector and continue to see what we believe are attractive risk rewards in several select leaders, primarily in the equipment and supplies industry. We believe that hospital patient volumes are still running below normal as the industry continues to recover from disruption associated with the COVID-19 pandemic. While some businesses and sub-industries are taking longer to return to our view of their normal returns on capital than others, we were able to exit our position in Dentsply Sirona as we believe the stock was approaching our view of normal returns on capital and fair value. In turn, we were able to add to other positions with what we view as more attractive risk rewards in underperformers like ICU Medical and Smith & Nephew.
While financials remain a large portion of the portfolio, we are slightly underweight the sector as we are overweight the insurance industry but underweight the banks and diversified financials industries. In our opinion, we continue to see attractive risk rewards within both the property & casualty and reinsurance sub-industries.
We continued to add to our positions in the utilities sector, specifically the water utilities industry. We added to our position in United Utilities Group PLC, a leading water utility serving the northwestern part of England, and we initiated a position in Pennon Group Plc, a leading water and wastewater utility based in the southwest region of England.
We also remain overweight the real estate sector due to our holding in Equity Commonwealth, which we believe is an interesting risk reward inside the sector. We remain underweight the energy sector where we believe the sector is facing a multiyear period of competitive transition. Additionally, we remain underweight the consumer discretionary, communication services, industrials, information technology, and materials sectors primarily due to competitive uncertainty and valuation concerns.
Chris Davis and Danton Goei, Davis Advisors
We are invested across a wide range of businesses and industries as distinct from one another as financial services, technology, industrials, health care and consumer-oriented businesses. The drivers of performance this year include many businesses that had negative stock price trends just a year or so ago, as the effects of COVID-19 were being felt much more. The portfolio’s largest sector allocation—a byproduct of individually chosen stocks that each have their own merits, in our analysis—is financial services, which saw performance hurt in 2020, but has been a tailwind this year.
We see a significant opportunity in select well-capitalized financial leaders, such as Wells Fargo, which currently sell at distressed prices, despite being explicitly prepared for today’s turmoil. Yet, even though our banks are far more conservatively capitalized, with almost twice the capital they held before the financial crisis, and are carrying far less risk in their credit portfolios, a huge gap has developed between their price and value.
Last year around this time, the share prices for many of our holdings declined dramatically in the face of the COVID-19 outbreak. After some significant investment of time studying the direct and indirect implications of COVID-19, we took a few notable actions. The first was to compare the relative opportunities, since prices had changed significantly in virtually every group in the market, with some being buoyed by investors favoring so-called COVID-19 trades (i.e., Internet-related businesses and food delivery, by and large). We pared some of our larger technology-related holdings (including, for this purpose, the e-commerce and broader online space), some of which had held up better than other parts of the portfolio.
We also exited energy entirely. Despite the rebound that has occurred in oil and gas since our sale, our view was that the longer-term outlook for the fossil fuel industry could become far more difficult both operationally and, even more, financially over the coming decade and perhaps beyond. Between regulation, taxation and changing social and political attitudes towards drilling, it is yet to be seen whether the recent run in this sector has a sustainable path looking out years, and we have decided for now to avoid the area for fundamental reasons, rather than any outlook on the commodity price.
Michael Sramek, Sands Capital
The shift in market leadership from the first to second quarter of 2021 illustrates how unpredictable markets can be in the short term. Exogenous factors can have an outsized influence in short-term price movements, and these factors are impossible to correctly predict, we believe, with any repeatable process.
Over longer time periods, history shows us that stock prices tend to follow compounded earnings growth, and that most value creation accrues to a select group of winners. Therefore, we will continue to focus our efforts on finding the select few companies that we believe can generate above-average growth over the next five or more years.
We have long owned businesses that are driving and/or benefiting from digitalization, and the pandemic has accelerated this shift. We expect digitalization will proliferate faster than previous 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 6/30/2021 |
|---|---|---|
| Communication Services | 16.5% | 10.1% |
| Consumer Discretionary | 16.7% | 12.2% |
| Consumer Staples | 3.5% | 5.3% |
| Energy | 0.9% | 2.8% |
| Finance | 24.4% | 11.6% |
| Health Care & Pharmaceuticals | 11.0% | 13.6% |
| Industrials | 4.9% | 9.5% |
| Information Technology | 13.8% | 26.6% |
| Materials | 0.0% | 2.5% |
| Real Estate | 2.2% | 3.3% |
| Utilities | 1.9% | 2.4% |
| Cash | 4.2% | 0.0% |
| 100.00% | 100.00% |
- All but the utilities sector in the Russell 3000 Index were positive in the quarter. Communication services, energy, information technology, and real estate sectors led the way with low double-digit gains.
- Both stock selection and sector allocation detracted modestly from the fund’s performance in the quarter.
- Stock selection was positive in financials, where the fund has the largest overweight versus its benchmark (25.3% vs. 11.9%). The fund’s largest position, Capital One, gained 21.9% in the second quarter—easily outpacing the 7.3% average return for financial stocks in the index. Wells Fargo also contributed to returns with a 16.2% gain.
- Positions within the consumer discretionary sector were the main detractors in the quarter. Four of the leading detractors reside in this sector. New Oriental Education & Technology, Thor Industries, Booking Holdings, and Prosus were all a drag on returns.
- Strong returns from Sea Ltd., Alphabet, and Facebook drove gains in the communication sector.
Top 10 Contributors as of the Quarter Ended June 30, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Economic Sector |
|---|---|---|---|---|---|
| Capital One Financial Corp | 5.16 | 0.16 | 21.89 | 1.02 | Financials |
| Alphabet Inc A | 3.44 | 1.65 | 18.39 | 0.55 | Communication Services |
| Amazon.com Inc | 3.46 | 3.32 | 11.19 | 0.38 | Consumer Discretionary |
| Visa Inc | 3.27 | 0.91 | 10.59 | 0.35 | Information Technology |
| Wells Fargo & Co | 2.07 | 0.40 | 16.17 | 0.31 | Financials |
| Alphabet Inc. C | 1.40 | 1.63 | 21.16 | 0.27 | Communication Services |
| LivaNova PLC | 1.94 | 0.01 | 14.08 | 0.27 | Health Care |
| Intuit Inc. | 1.02 | 0.26 | 27.96 | 0.27 | Information Technology |
| Facebook Inc | 1.50 | 1.82 | 18.06 | 0.26 | Communication Services |
| Sea Ltd | 2.76 | 0.00 | 23.01 | 0.60 | Communication Services |
Edited Commentary from the Respective Managers on Selected Contributors
Alphabet (Pat English and Jonathan Bloom, FMI)
Alphabet is a company we have followed and admired for many years. In spite of that, we had a number of concerns that caused us not to invest. These concerns included the impact of increasing mobile app usage, competitive concerns like Bing or white-label search engines, the fact that the business was unproven in a weak economy, a lack of discipline on expenses, and a seemingly hubristic founder-led management team. We’ve seen improvements on all fronts. At the same time, we have also increasingly gained an appreciation for how much the company has reinvented itself and grown in ways we never could have reasonably predicted a priori (e.g., Cloud, YouTube).
The core Google search business may be one of the best businesses ever created, and it has now proven its mettle against competitive threats and a weak economy only to come out stronger. The continued strong growth in core search also gave us higher conviction that the advertising market size has expanded rather than it being a pure substitution of traditional advertising. In short, our views and understanding of the business have evolved after years of studying it.
The sum of all these changes, combined with multiyear low relative valuations led us to make an investment in Alphabet. Today Alphabet is a highly profitable business with a great balance sheet and significant optionality that has one of the largest moats we’ve ever seen. All of this is trading for a below market multiple and well below the prices you have to pay for numerous GDP-type growers in industrials, staples, luxury, and many other industries. Throughout the quarter, the
shares performed well likely due to an increased appreciation for digital advertising’s role in fulfilling exceptional customer demand post-COVID. Although the shares have re-rated since our initial purchase, our thesis is intact and we still find the shares to be relatively attractive compared to an expensive market. Given that, we have maintained our initial position size.
Intuit (Mike Sramek, Sands Capital)
Intuit is a leading provider of financial software for small businesses, individuals, and tax professionals. The company sells two core products: QuickBooks (accounting software for small businesses) and TurboTax (personal tax preparation software). Both are leaders within their respective categories, with approximately 90 percent market share for QuickBooks and 60 percent of U.S. tax filings for TurboTax. Intuit also provides payroll and payment processing software for small businesses. We expect these offerings will be important growth drivers going forward, as small businesses continue to replace manual, paper-based processes with digital solutions. QuickBooks is also in the midst of transitioning from desktop software to a cloud-based, software-as-a-service (SaaS) model, which we should enable the company to further penetrate and improve monetization in existing markets, as well as open new growth channels and geographies. Furthermore, we expect the transition to a SaaS model will lead to strong recurring revenue streams, greater pricing power, and higher margins over time, as software businesses tend to have low incremental costs.
Intuit 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-teens annualized revenue growth and 20% annualized earnings growth.
Intuit reported strong third-quarter fiscal 2021 results (quarter ending April 30, 2021). On a year-over-year basis, TurboTax sustained low-teens growth, the small business/QuickBooks segment accelerated to 20% growth amid abating pandemic pressure, recently acquired Credit Karma outperformed initial consensus expectations, and operating margins expanded by 100 basis points. We believe that Intuit remains a high-quality business with growth drivers that remain underappreciated by the market. While Intuit has always been a blend of standard software and fintech services, it is increasingly leaning into the latter opportunity, which we believe should be larger in an era of Internet-connected software vs. Intuit’s prior era of desktop software. Over time these fintech revenues could overtake subscription software as the majority of the business.
Top 10 Detractors as of the Quarter Ending June 30, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Economic Sector |
|---|---|---|---|---|---|
| New Oriental Education & Technology Group Inc | 0.54 | 0.00 | -42.69 | -0.40 | Consumer Discretionary |
| Thor Industries Inc | 1.41 | 0.02 | -16.13 | -0.25 | Consumer Discretionary |
| Booking Holdings Inc. | 2.09 | 0.23 | -6.08 | -0.14 | Consumer Discretionary |
| Koninklijke Philips NV | 1.04 | 0.00 | -12.03 | -0.14 | Health Care |
| Reinsurance Group of America | 1.17 | 0.02 | -9.06 | -0.11 | Financials |
| GoHealth Inc | 0.89 | 0.00 | -5.08 | -0.06 | Financials |
| Equity Commonwealth REIT | 0.94 | 0.01 | -5.76 | -0.06 | Real Estate |
| Tencent Holdings Ltd | 0.92 | 0.00 | -3.89 | -0.04 | Communication Services |
| Tencent Holdings Ltd ADR | 0.72 | 0.00 | -5.41 | -0.04 | Communication Services |
| Prosus NV | 0.32 | 0.00 | -11.83 | -0.04 | Consumer Discretionary |
Edited Commentary from the Respective Managers on Selected Detractors
New Oriental Education & Technology (Chris Davis and Danton Goei, Davis Advisors)
Following strong performance in 2020, New Oriental Education & Technology was a detractor to performance this period due to heightened regulatory concerns. The Chinese government embarked on a comprehensive antitrust review of the consumer technology sector starting in earnest in November 2020. However, it also clearly communicated what its long-term goals are. In 2015, the government proclaimed the Made in China 2025 strategy, which was a policy roadmap to transform the Chinese economy from a powerhouse in labor-intensive industries into a powerhouse of technology-intensive products and services. As such, we believe the ongoing technology industry antitrust review is designed to strengthen the industry, rather than weaken or nationalize it.
Over the 15+ years we have been investing in China, we have carefully monitored government and regulatory actions, and should we see a move away from the pragmatic long-term growth strategy of the past, we will take action. Today the Big Tech antitrust review in China seems driven by similar goals and circumstances to the reviews ongoing for many years in other countries. Yet the stock market moves in our Chinese Big Tech names are imputing a very dire scenario that neither the government’s track record nor long-term strategic plans support.
Thor Industries (Clyde McGregor, Harris Associates)
Thor Industries is the market leader for recreational vehicles, which is an industry that we see as very attractive. Thor possesses a solid reputation in terms of both products and management. Thor’s decentralized operating structure empowers subsidiaries to be responsible for their own success, and the company prides itself on both transparency in financial reporting and a simple pay-for-performance compensation philosophy. The company generates a high return on invested capital, produces substantial free cash flow, and has a strong balance sheet. We are impressed that Thor has been profitable every year since its founding in 1980, which adds to our confidence in management’s commitment to creating shareholder value.
Thor Industries reported fiscal third-quarter results that included revenue of $3.46 billion and earnings per share of $3.29, which were better than market forecasts by 14% and 41%, respectively. Furthermore, the company’s consolidated recreational vehicle order backlog increased 32% to $14.32 billion from $10.81 billion at the end of the second quarter, which we think bodes well for future positive performance. Consumer demand remains robust at the retail level, and inventory positions remain historically low at the dealer level. CEO Bob Martin commented that he sees “no signs of demand slowing even as the economy recovers from the pandemic.” Martin further remarked that this favorable scenario is not limited to the United States as he sees “lots of runway” for both organic and inorganic expansion in Europe. Despite these solid results and positive trends, the share price of Thor Industries fell for the quarter, possibly due to investor profit taking.
Koninklijke Philips (Pat English and Jonathan Bloom, FMI)
Phillips was once a do-everything conglomerate, and after years of transformation, it is now a top-10 global medical technology company. They have a strong position in diagnostic imaging (particularly image-guided therapy and cardiac ultrasound), patient monitoring and respiratory care. They also have an attractive consumer business with brands such as Norelco, Sonicare, and Avent. This is a business which should be able to drive the topline in the mid-single digits and has the potential to drive several hundred basis of margin improvement. A large percentage of the business is recurring in nature, which includes software, service, and support, often secured by long-term contracts. The company has a robust balance sheet, a solid track record of research & development (R&D) and innovation, and high incremental returns on capital.
The stock trades at a sizeable discount to medical technology peers, despite having a good chance of growing earnings faster than the sector. The stock came under pressure in the quarter due to a €500 million product recall (DreamStation1 product). While the recall was disappointing, we do not believe the roughly 19% (nearly €9 billion) pullback in the stock is warranted, so we used the correction as an opportunity to add to our position size.
Equity Commonwealth (Scott Moore and Chad Baumler, Nuance Investments)
Equity Commonwealth is an office REIT that historically was mismanaged, in our opinion. In 2014, new management took control of the company and began fixing up and selling the company’s office properties, taking the portfolio from over 150 properties to 4 properties. These asset sales generated significant capital, with most assets sold at gains and allowed the company to pay three special dividends over the last three years totaling $9.50 per share. Before announcing its recent Monmouth Real Estate Investment Corp acquisition, the company had more than $23 per share in net cash on their balance sheet, after paying off all gross debt. In the last month Equity Commonwealth announced the acquisition of Monmouth Real Estate Investment Corp in an all-stock transaction. Monmouth is a triple net leased industrial REIT, with assets in the portfolio including distribution and logistics facilities used by FedEx, Amazon, Home Depot, and others. In general, we hold a positive view of industrial logistics and distribution assets, and we like that the management team did not recklessly lever the balance sheet. In fact, the company is continuing to keep some powder dry with an updated $7 per share of net cash on the balance sheet, pro forma, following the acquisition. We believe the company is underearning its long-term potential primarily due to the excess cash that still remains on the balance sheet. As of June 30, 2021, Equity Commonwealth’s stock is trading around $26.50 or about 18x our view of normal funds from operation (FFO) per share, and this compares favorably versus most other industrial REITs, in our opinion. We estimate the stock’s fair value to be $29 per share.