During the third quarter of 2021, the iMGP Equity Fund fell -0.69%, modestly underperforming both its Russell 3000 Index benchmark (which lost -0.10%) and Morningstar Large Blend Category (down -0.22%). The Fund is ahead of both its index and Morningstar category so far in 2021. Since its December 1996 inception, the fund’s 9.14% annualized return slightly trails the Russell 3000 Index’s gain of 9.52%, and is ahead of the Morningstar category’s 7.90% 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
The market favored growth stocks in the latter part of the second quarter and for most of the third. Worries about the Delta variant and its effect on the economy turned investors toward the same forces that have prevailed since early 2020, when Covid first surfaced. The S&P 500, driven mostly by higher-multiple growth stocks, has performed strongly since the start of the pandemic (+38.9% from 2/1/2020 through September 28, 2021). Curiously, in a time of uncertainty and difficulty, many of the most speculative stocks have done even better. Bitcoin-sensitive stocks were up 277%, while the most liquid shorted stocks, popular with the Reddit/Robinhood crowd, were up 184%. Non-profitable technology stocks were up 158.9%. In fixed-income, speculative-grade issues have lapped Treasuries. New issues of money-losing companies are at a record level and ones that trade for greater than 20 times sales remain commonplace. In the U.S., currently there are over 800 companies with an enterprise value-to-sales multiple greater than 20 compared to approximately 300 at the peak of the 2000 market. This measures only companies with sales, so it excludes a significant number of development stage biopharma companies with sizeable market values. Historically, the five-year forward return for stocks with a price-to-sales ratio in excess of 15 has been negative 28%. We do not believe this is a “new era.” Given the speculative fervor and elevated valuation environment (10th decile), downside protection is paramount. We own a collection of high-quality companies with robust balance sheets, strong management, and that trade at discount valuations. We expect this to be a winning combination over the long-term.
Bill Nygren and Clyde McGregor, Harris Associates
Global equity prices were mixed in the third quarter as concerns mounted over how supply chain disruptions, inflation pressures and the lingering Delta variant may impact global growth. Several underlying positives are helping offset these concerns including continued global monetary stimulus, low interest rates, slowly rising employment, and improving consumer/corporate balance sheets. In addition, there are many who believe (as we do) that the headwinds cited above will become less significant over the next 12-24 months. As we enter the fourth quarter, we believe the underlying positives will eventually prevail and gradually improving economic conditions ought to create a positive backdrop for global equity prices.
There was limited activity in the portfolio this quarter and the companies we own continue to trade at discounts to our estimates of their intrinsic values. Since the beginning of the year, the companies we own have reported largely favorable earnings and cash flows as the global economy began to emerge from the pandemic. While the coming quarters may experience more mixed fundamental progress, due to supply chain disruptions and increasing inflationary pressures, we think the overall trend remains positive over the next 12-24 months.
Scott Moore and Chad Baumler, Nuance Investments
Our largest overweight, relative to the benchmark, remains the Consumer Staples sector. We continue to believe the COVID-19 pandemic has caused shifts in consumer spending behavior that we view as transitory. Within the sector, we continue to own stocks in the food products, Sanderson Farms and Cal Maine Foods, personal products, Beiersdorf AG, and household products, Henkel AG & Co. industries.
The health care sector remains our largest absolute exposure in the portfolio. We continue to believe that hospital patient volumes are still running below normal as the industry recovers from disruption associated with the COVID-19 pandemic. In our opinion, this has created opportunities within the healthcare equipment & supplies industry, and we were able to initiate a position in Zimmer Biomet Holdings Inc. during the quarter. We also continue to hold Smith & Nephew PLC, ICU Medical Inc., and Baxter International through the period.
While we continue to have an overweight position in the utilities sector, we have lowered our exposure as we exited our position in Pennon Group Plc after a period of outperformance. Though we lowered our exposure in the utilities sector, we continue to hold positions in United Utilities Group PLC, a leading water utility serving the northwestern part of England, and SJW Group, a leading water utility with operations largely in California and Connecticut. We believe these companies are under-earning as the base returns on equity awarded by regulators have been pressured by the historically low interest-rate environment.
Our exposure to the financials sector still makes up a substantial portion of the portfolio, but we are underweight relative to the index. Within the sector, 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 also remain overweight the real estate sector due to our holding in Equity Commonwealth, which we believe offers an interesting risk-reward within the sector. We remain underweight the energy sector where we believe the sector continues to face a multi-year 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
In the year-to-date period through September, the S&P 500 Index advanced 15.92%. This occurred against a backdrop of ongoing challenges stemming from COVID-19, as well as uncertainty in the political and geopolitical spheres.
Negatives and challenges, while present, do not tell the whole story today. There are powerful forces and motivations in both the public and private sectors aimed at confronting the COVID-19 pandemic. To have vaccines designed, produced and distributed (however incomplete or uneven the process may still be) so swiftly is remarkable relative to historical experience. Corporate and household balance sheets appear fairly healthy, the U.S. economy has been resilient overall and fiscal and monetary stimulus have been aimed at providing further support over the last year. Significantly, as this year and 2020 have shown—roughly corresponding with the pandemic—there is no rule that holds stocks cannot appreciate in the face of headwinds on the ground, especially if the outlook for potential earnings power for businesses looks to be intact—or, better yet, poised for expansion from today’s starting point over the longer term. We see opportunities in leading financial services businesses, select semiconductor-related companies, e-commerce, healthcare, social media and cloud computing, among other areas, despite the near-term pressures described earlier.
Financials are an area we are excited about in the portfolio. In the decade following the financial crisis, financial companies demonstrated a powerful combination of resiliency, profitability, and growth while their share prices languished. This disconnect reached a stunning crescendo during the COVID-19 crisis when panicked sellers raced for the exits, making the financial sector one of the worst performing groups of that period. The sharp recovery from this overreaction is just the beginning of what we expect to be a decade of revaluations as investors come to appreciate the durability, steady growth, and low valuations of a carefully selected portfolio of financial leaders. Capital One Financial is a notable contributor to the portfolio and an example of the type of financial leaders we look for.
For the year-to-date period, the portfolio has delivered solid returns. The portfolio continues to represent a far more attractive set of businesses than the market as a whole. We own a portfolio of businesses that are by and large undervalued yet have grown earnings over the past five years at a much higher rate than the overall market. Together, we believe this set up results in a favorable risk/reward balance.
Michael Sramek, Sands Capital
The shift in market leadership over the course of 2021 illustrates how unpredictable markets can be in the short term. Exogenous factors and sentiment 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 companies. We’ve seen evidence of this in 2021, with dividends and earnings growth accounting for all of the MSCI ACWI’s year-to-date gain, amid a lower forward P/E multiple.
Therefore, we will continue to focus 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 digitization 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 9/30/2021 |
|---|---|---|
| Communication Services | 15.8% | 10.1% |
| Consumer Discretionary | 16.1% | 12.2% |
| Consumer Staples | 3.5% | 5.3% |
| Energy | 0.9% | 2.7% |
| Finance | 24.9% | 11.9% |
| Health Care & Pharmaceuticals | 11.6% | 13.6% |
| Industrials | 4.7% | 9.0% |
| Information Technology | 16.0% | 27.1% |
| Materials | 0.0% | 2.3% |
| Real Estate | 2.3% | 3.4% |
| Utilities | 1.4% | 2.4% |
| Cash | 2.9% | 0.0% |
| 100.00% | 100.00% |
- Sector allocation contributed to the fund’s performance in the quarter, however, stock selection detracted value during the three months.
- Stock selection within financials was among the largest detractors. GoHealth, a health care insurance company, accounted for nearly all the selection specific underperformance. The sector is by far the fund’s largest overweight versus its benchmark, which was positive from a sector allocation standpoint given it was the best-performing sector in the quarter.
- Positions within the consumer discretionary sector were the main detractors in the quarter. Five of the top-10 leading detractors reside in this sector. New Oriental Education & Technology, Alibaba, General Motors, Lear and Amazon.com were all a drag on returns.
- Strong returns from Sea Ltd., Netflix, and Alphabet drove positive stock selection in the communication sector.
- The industrials and materials sectors were the two worst-performing sectors for the index during the quarter. The fund’s underweight to both sectors was a positive.
- Stock selection within the technology sector was positive in the quarter thanks to strong returns from Atlassian and ServiceNow.
Top 10 Contributors as of the Quarter Ended September 30, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Economic Sector |
|---|---|---|---|---|---|
| Atlassian Corporation PLC A | 1.54 | 0.1 | 52.39 | 0.64 | Information Technology |
| Sea Ltd ADR | 2.85 | 0 | 16.07 | 0.42 | Communication Services |
| Netflix Inc | 2.63 | 0.53 | 15.55 | 0.39 | Communication Services |
| Alphabet Inc Class A | 4.33 | 1.81 | 9.49 | 0.37 | Communication Services |
| DexCom Inc | 1.21 | 0.11 | 28.07 | 0.3 | Health Care |
| Servicenow Inc | 2.39 | 0.26 | 13.23 | 0.3 | Information Technology |
| Capital One Financial Corp | 5.21 | 0.16 | 5.46 | 0.29 | Financials |
| CBRE Group Inc Class A | 1.44 | 0.07 | 13.57 | 0.18 | Real Estate |
| Booking Hldgs Inc | 2.02 | 0.2 | 8.49 | 0.17 | Consumer Discretionary |
| Thor Industries Inc | 1.58 | 0.01 | 9.02 | 0.14 | Consumer Discretionary |
Edited Commentary from the Respective Managers on Selected Contributors
Atlassian (Mike Sramek, Sands Capital)
Atlassian is a leading software-application vendor that creates tools to enhance team productivity. The company is best known for its Jira tool, which enables developers to plan, track, and release software. Jira is specifically designed for a software-development method known as agile development, which involves frequent small deployments of code updates. Among its developer user base, Atlassian employs a “land and expand” cross-selling approach, in which most Jira users adopt additional tools aimed at both specific tasks and general team collaboration. All cross-selling is automated and built into the products, which not only reduces friction, but improves the company’s margin profile. Moreover, Atlassian offers transparent and low pricing, despite its position as a mission-critical application for its users. For this reason, we believe Atlassian has strong long-term pricing power. Beyond software development, expansion potential for broader business use cases is the primary upside driver to our investment case.
Atlassian 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 30 percent annualized revenue growth and 40 percent annualized earnings growth.
Atlassian reported strong fourth-quarter results for fiscal year 2021 (ended June 30, 2021), headlined by a significant acceleration in subscription revenue growth, which expanded 50%year-over-year. Notably, it was the fastest year-over-year growth since Atlassian began focusing on transitioning from a server-based to a cloud-based software offering in fiscal 2020. Expectations were muted heading into the quarter, with the cloud transition expected to weigh on topline growth. However, the underlying business continued to execute well, with cloud and data center revenues (the two main components of subscription revenue) growing 47%and 63%, respectively. Total customer count grew 32%year-over-year to 230,000, driven by a record 22,000 new additions—more new customers than Atlassian added in all of fiscal year 2019. We believe that the company’s decision one year ago to replace starter licenses with a free tier has made a meaningful difference in expanding the funnel for new customer acquisition. Management said it’s working on more ways to better monetize the growing base of free users. Looking ahead, we continue to see Atlassian as a category leader with significant pricing power and an expanding product set that should enable above-average growth over the next several years.
Alphabet (Pat English and Jonathan Bloom, FMI)
Google Search may be one of the best businesses ever created. We believe digital advertising has expanded the market size rather than being a pure substitution for traditional advertising. Given this, we believe the growth runway for Google is longer than the market appreciates. The company 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 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-19. There continues to be strength in COVID-19 beneficiary areas like ecommerce, while at the same time seeing a recovery in depressed areas like travel. Although the shares have rerated modestly, the earnings estimates are up over 15% since our purchase, the 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.
Dexcom (Mike Sramek, Sands Capital)
Dexcom is a leading producer of medical devices treating diabetes. We expect the company’s next-gen continuous glucose monitoring (CGM) platform—known as the G7—to reshape the market as the new standard of care in diabetes. CGM provides continuous, predictive data that can monitor blood glucose levels and inform treatment decisions. The G7 will be the thinnest, most accurate, most algorithmically advanced, and most consumer-friendly CGM on the market. We believe it addresses the three largest barriers to adoption: cost, physical discretion, and insurance coverage/availability. Over time, we expect Dexcom to leverage its data and further differentiate the G7 platform via future software and data analytics capabilities. Beyond insulin-intensive diabetics, who are the primary users of CGM today, but are still underpenetrated, we expect the G7 to address the massive and largely unaddressed population of non-insulin-intensive Type 2 patients. CGM sensors enable recurring revenues due to their replacement frequency. As G7 adoption inflects, we expect margin leverage, given the low production cost and distribution via higher-margin channels (e.g., pharmacies).
Dexcom 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-twenties annualized revenue growth and 50 percent annualized earnings growth.
Dexcom reported strong second-quarter 2021 results in July, with record patient adds and robust year-over-year global volume growth. We believe this growth was attributable to Dexcom’s investment in its U.S. sales force—which has nearly doubled year-over-year—and its expanded digital marketing efforts. Additionally, Dexcom reported a prescribing doctor base that has also doubled in the last 18 months. Margins came in significantly above our expectations, largely due to the relief of manufacturing and supply constraints. At this year’s American Diabetes Association Scientific Sessions conference, the benefits of continuous glucose monitoring in Type 2 diabetes were featured prominently and should drive continued reimbursement expansion. This, we believe, is the key remaining barrier to patient adoption. We continue to believe that Dexcom will reshape the industry with its G7 platform, which could create a new standard of care for diabetes. We expect the G7 to launch in the United States in the coming quarters.
Top 10 Detractors as of the Quarter Ending September 30, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Economic Sector |
|---|---|---|---|---|---|
| GoHealth Inc | 1.4 | 0 | -55.13 | -0.97 | Financials |
| New Oriental Education & Technology Group Inc | 0.19 | 0 | -73.5 | -0.61 | Consumer Discretionary |
| Alibaba Group Holding ADR | 1.39 | 0 | -34.72 | -0.6 | Consumer Discretionary |
| Smith & Nephew PLC ADR | 1.21 | 0 | -20.31 | -0.27 | Health Care |
| General Motors Co | 1.78 | 0.16 | -10.92 | -0.22 | Consumer Discretionary |
| Twilio Inc Class A | 1.09 | 0.13 | -19.06 | -0.22 | Information Technology |
| Lear Corp | 1.65 | 0.02 | -10.44 | -0.19 | Consumer Discretionary |
| Amazon.com Inc | 3.49 | 3.32 | -4.51 | -0.16 | Consumer Discretionary |
| Tencent Holdings Ltd | 0.26 | 0 | -18.04 | -0.15 | Communication Services |
| CK Hutchison Holdings Ltd | 1.08 | 0 | -13.12 | -0.15 | Industrials |
Edited Commentary from the Respective Managers on Selected Detractors
GoHealth (Clyde McGregor, Harris Associates)
We like that GoHealth and other Medicare Advantage e-brokers are disrupting traditional brokers with a lower-cost model that also benefits seniors. In particular, the company’s digital model allows it to acquire customers at a cost far below traditional brokers while its remote agents enroll seniors at a faster rate than independent brokers. Moreover, GoHealth possesses meaningful scale and is nearly 50% larger than the second-, third- and fourth-largest e-brokers in an industry with large barriers to entry and an attractive baseline growth rate with a long runway for market share gains, in our estimation. Furthermore, the largest brokers have the deepest and richest data to make customer value predictions, making them even more favorable in the eyes of the carriers.
Although GoHealth’s second-quarter revenue figures bested analysts’ estimates, the company materially lowered its adjusted earnings guidance for the year from a range of $345-$385 million to a range of $300-$330 million. The change in outlook stems from $50 million in incremental costs related to higher-than-expected agent attrition and increased costs to recruit and train new agents. As a result, we lowered our estimate of GoHealth’s intrinsic value. Although customer churn and cash collections remain in line with expectations, we were disappointed with management’s inability to identify specific hiring and training process issues that they were rectifying. While we remain shareholders of GoHealth, we are monitoring the situation closely.
Alibaba (Mike Sramek, Sands Capital)
We sold Alibaba during the quarter. Our strategy seeks to own an extra-concentrated group of what we view as the strongest fits with our investment criteria. Alibaba continues to be a high-quality business, in our view, but is no longer a fit for the portfolio given its maturing growth profile, increasing competitive pressure, and uncertain regulatory environment.
Alibaba shares sold off, along with the broader Chinese internet sector, due to intensifying regulatory pressure. The government’s priority has shifted from economic growth to “common prosperity,” which aims to distribute wealth more equally and to even the playing field between large and small companies. To us, the major signal of this changing objective was the removal of GDP growth as a key performance indicator in the 14th Five-Year Plan, introduced in March 2021. Chinese internet businesses, which had previously been largely unregulated, will likely see slower revenue and earnings growth due to higher competitive intensity, wages for workers, and spending on core technology and data security. At this point, Alibaba’s major segments have already been regulated—which we believe reduces downside risks to its earnings power—but we also expect slower growth going forward as the business matures and competitive intensity increases.
Smith & Nephew (Scott Moore and Chad Baumler, Nuance Investments)
Smith & Nephew is a leading manufacturer of advanced medical devices and a long-time 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, SNN 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 remained below normal levels, but we believe the decline is transitory and that procedure volumes could revert back toward normal levels during the next several years. That said, the drop in elective procedures has caused the company to significantly underearn during 2021, in our view. Specifically, Wall Street analysts expect Smith & Nephew to earn approximately $1.75 per share for 2021, well below our estimate of $2.70-2.80 in normalized, mid-cycle earnings per share. As of September 30, the stock is trading at roughly 12-13x our view of normal earnings (mid-cycle). We would note that the company maintains a solid balance sheet at approximately 1.2x net debt to earnings before interest, taxes, depreciation, amortization, and rent expense (EBITDAR), which we believe should allow the company to navigate this trough earnings period while continuing to invest internally and pursue tuck-in acquisitions. Trading at less than 13.0x our view of normal earnings on September 30, 2021, Smith & Nephew offers what we consider a compelling risk reward opportunity versus other stocks in the sector.
CK Hutchison (Pat English and Jonathan Bloom, FMI)
CK Hutchison Holdings is a blue-chip holding company that owns relatively defensive, high-quality businesses (telecom, infrastructure, retail, etc.). The company has taken steps to unlock value over the past year, yet the stock price has barely budged. In November, CKH announced a favorable sale-and-leaseback of its European tower assets for €10 billion, equivalent to 43% of its market cap (while giving up ~5% of consolidated EBITDA). In addition, the company’s energy segment (~3% of normalized earnings from an equity investment in Husky Energy), which had been a drag on its sentiment in recent years, has recently been deconsolidated. Husky merged with Cenovus, which reduced CK Hutchison’s ownership of the combined entity to around 16%. These transactions demonstrate management’s willingness to take action to create shareholder value. Despite a strong balance sheet, based on our estimates, the stock trades at around a 60% discount to net asset value, which is more than a two standard deviation departure from its historical levels. On 2021 estimated earnings, the stock trades at only ~6x, and pays a healthy 4.8% dividend. Insiders have purchased $34 million of stock over the past couple years, which is encouraging. The current stock price severely undervalues the business. Sentiment has been weak, in part due to the company being less aggressive with shareholder returns (buying back stock, increasing the dividend) than investors had expected following the tower sale. We have written a letter to management and the board to encourage additional activity on this front.