During the second quarter of 2022, the iMGP Equity Fund fell 19.17%, underperforming both its Russell 3000 Index benchmark (down 16.70%) and Morningstar Large Blend Category (down 14.91%). Since its December 1996 inception, the fund’s 7.59% annualized return trails the Russell 3000 Index’s gain of 8.59% and is ahead of the Morningstar category’s 7.13% 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
Quality companies, the earmark of the FMI investment philosophy, have trailed deeper value names and sectors. We do not believe most energy, commodity, and utility companies fit the definition of a good, growing business even though from time to time they can be wonderful trading stocks. Our focus remains on durable franchises that earn a return above their cost of capital, have modest financial leverage, and trade at a discount. It appears that a highly speculative phase of the market is ending, and we are encouraged by what this might mean for the next several years. If businesses are sound and the balance sheets are strong, bear markets are an opportunity to buy or add to stocks you love at a discount. These companies gain market share and grow their advantages in tough times. Good managements of good businesses are able to adjust to the environment. For years, as markets traded in the clouds, the refrain from us has been “attractive relative valuations,” but today, we own excellent businesses trading at attractive absolute valuations, many for less than 15 times next year’s earnings. From top to bottom we believe we have one of the strongest line-ups we’ve ever fielded. Yes, it is painful that the quality and discount valuation hasn’t held up a bit better, but it is a long game and we have not been this confident about the future trajectory in years. We believe patience will ultimately be rewarded, as the next five-to-ten years will look a lot different than the last five-to-ten years.
Bill Nygren and Clyde McGregor, Harris Associates
It was a difficult quarter for equity markets as inflation remained at elevated levels, which caused central banks around the world to raise—or express their intentions to soon raise—interest rates. This situation was made even more challenging by continued lockdowns in China (and the negative impact this had on global supply chains and economic growth in China) and the continued hostilities in Ukraine. Despite this difficult macroeconomic backdrop, our portfolio companies have mostly continued to report acceptable operating results to date. Although some consumer discretionary categories (e.g., apparel) are exhibiting signs of weakening demand, overall, the business environment remains favorable. We remain vigilant for signs of noticeable weaknesses to business conditions but are enthusiastic about our portfolio’s mid- to long-term return potential.
While the coming quarters may experience more mixed fundamental progress, due to tighter financial conditions and ongoing supply chain disruptions, we think the long-term fundamental trend across portfolio companies remains positive over the next 12-24 months and should lead to higher equity prices.
Scott Moore and Chad Baumler, Nuance Investments
While the volatility in the quarter created opportunities that we believe allowed us to take advantage of the changing risk rewards in the portfolio, our sector weightings have not shifted significantly. The largest overweight positions, relative to the index, remain the consumer staples and healthcare sectors. Within the consumer staples sector, we exited our position in Sanderson Farms after a period of outperformance, and we increased our exposure in Henkel AG & Co. KGaA and Clorox Company. Additionally in the consumer staples sector, we continue to own Beiersdorf AG, Cal-Maine Foods, and Kimberly Clark. Our view is that earnings from these companies have been negatively impacted by rising raw material costs. We believe these costs can ultimately be mostly offset by price increases which generally lag the raw material price increases.
We retain our significant overweight position to the healthcare sector as we wait patiently for elective procedures to normalize following a prolonged disruption. We continue to believe there is a meaningful backlog of deferred procedures to be worked through and under-earnings continue across many of our favored Health Care leaders. We currently have positions in several healthcare stocks, primarily in the equipment & supplies industry.
We also remain overweight in the real estate sector as we hold a position in Equity Commonwealth (EQC), a one-off stock that we believe offers an attractive risk reward. Our largest relative underweight position in the portfolio is within the financials sector. While we were overweight the financials space heading into 2021, we believe that many of the opportunities we were seeing have played out, and we have been reducing our exposure over the past eighteen months.
In the utilities sector, while we continue to hold United Utilities Group, a leading water utility serving the northwestern part of England, we have reduced our position following a period of relative outperformance and are now underweight the sector.
While we are underweight the industrial sector, we did initiate a position with Knorr Bremse, a German based global leader in braking systems and safety critical sub-systems for rail and commercial vehicles.
We remain underweight in the energy sector where we believe the sector continues to face a multi-year period of competitive transition. Finally, we remain underweight in the consumer discretionary, Communication services, information technology, and materials sectors primarily due to competitive uncertainty and valuation concerns.
Chris Davis and Danton Goei, Davis Advisors
During this period, the Federal Reserve explicitly guided towards and instituted a series of interest rate increases in response to signs of inflation in the U.S. The key concerns in our conversations with clients include inflation and interest rates, the war in Ukraine and the potential for a near-term recession, among other topics.
We do not have a precise expectation or view relative to how long above-historical inflation can continue nor when prices will stabilize. We believe, therefore, that we should be prepared for a range of scenarios. We are focused on balance sheet strength, product longevity, valuation, and competitive advantages—each of which can be an indicator of durability under a wide range of conditions. From a high level, two attractive sectors represented in the portfolio and that demonstrate the breadth and contrast between individual business types are healthcare and financials—two of the market’s most well-established, enduring sectors. We also own a number of information technology leaders in the semiconductor space, in technology-centric communications services and in consumer discretionary enterprises engaged in e-commerce and cloud computing primarily.
Michael Sramek, Sands Capital
The shift in market leadership over the course of 2021 through the first quarter of 2022 illustrates how unpredictable markets can be in the short term. Exogenous factors and sentiment can have an outsized influence on short-term price movements, and these factors are impossible to correctly predict, we believe, with any repeatable process.
We have no differentiated insights into the market’s short-term gyrations. We do have insights into our businesses’ potential long-term growth trajectory, and nothing that we’ve seen over the past quarter has changed our views. Enterprises remain early in their digital transformation efforts, new technological offerings are enabling access to commerce and financial services, and life sciences innovations continue to change how we define, diagnose, and treat disease. We believe we will be successful in identifying businesses that will extract most of the value created by these trends.
Just as sentiment drove equities sharply lower, a stabilizing macro picture and lengthening investor time horizon could lead to an equally sudden upward move. As we’ve seen following previous bear markets, those businesses with strong fundamentals will likely lead the way higher. Our job, in our view, is to use the market’s indiscriminate selling as an opportunity to seek high-quality assets at discounts to long-term potential value.
Below is what we shared with clients in the depths of the Great Financial Crisis in 2008, and again following the first quarter of 2020. We believe it rings true in today’s environment, as well.
History suggests that stock market recoveries occur well before economic recoveries. As we like to say at Sands Capital, you have to “be there,” not “getting there.” In other words, investors need to be positioned in the right companies before the market turns, not after. Having adhered assiduously to our investment philosophy and strategy, we believe our strategies are already “there” and positioned to benefit from this recovery. We also think there is a case to be made that this recovery could be dramatic given the current compelling valuations.
The market at this moment is gripped by fear, panic, and severe risk aversion. This too shall pass. Looking forward, we believe that patience will be rewarded.
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
| By Sector | Fund | Russell 3000 | +/- |
|---|---|---|---|
| Finance | 20.3% | 11.6% | 8.7% |
| Consumer Discretionary | 20.3% | 10.6% | 9.7% |
| Information Technology | 15.7% | 25.5% | -9.8% |
| Communication Services | 12.4% | 8.1% | 4.3% |
| Health Care & Pharmaceuticals | 13.4% | 14.9% | -1.5% |
| Industrials | 7.6% | 8.9% | -1.2% |
| Consumer Staples | 4.5% | 6.4% | -1.9% |
| Real Estate | 2.7% | 3.7% | -1.0% |
| Utilities | 0.3% | 3.0% | -2.8% |
| Energy | 1.2% | 4.4% | -3.2% |
| Materials | 0.0% | 2.9% | -2.9% |
| Cash | 1.6% | 0.0% | 1.6% |
- Stock selection detracted from the fund’s second quarter relative performance, while sector allocation had a more meaningful negative impact.
- Stock selection in technology sector was a significant detractor in the quarter. An overall underweight (13.13% vs. 26.14%) to the sector was a positive, however, as tech stocks fell in-excess of those in the index. Block was the biggest detractor within this sector during the second quarter, falling nearly 47%.
- Health-care stock picks was another main detractor. Dexcom and LivaNova both underperformed significantly.
- The fund’s underweight to energy stocks was a drag on returns. The energy sector outperformed the broader index in the second quarter. The fund’s sole energy stock—EOG Resources—has a loss similar to that of the energy sector.
- Stock selection in the consumer discretionary sector was strong. The top contributor in the quarter was Dollar General. Positions tied to China also added value in the quarter, with Alibaba, JD.com and Prosus each posting positive returns in the period.
Top 10 Contributors as of the Quarter Ended June 30, 2022
| Holding | Weight (%) | Return (%) | Contribution (%) | Benchmark Weight (%) | Sector |
|---|---|---|---|---|---|
| Dollar General Corp | 2.00 | 10.51 | 0.18 | 0.13 | Consumer Discretionary |
| Kimberly Clark | 1.00 | 10.73 | 0.11 | 0.11 | Consumer Staples |
| Cigna Corp | 1.33 | 10.45 | 0.11 | 0.20 | Health Care |
| Reinsurance Group of America | 1.30 | 7.81 | 0.10 | 0.02 | Finance |
| JD.com Inc ADR | 0.70 | 13.58 | 0.08 | 0.00 | Consumer Discretionary |
| Constellation Brands Inc Class A | 0.60 | 6.91 | 0.07 | 0.09 | Consumer Staples |
| Humana Inc | 0.21 | 5.40 | 0.05 | 0.14 | Health Care |
| Prosus NV ADR | 0.23 | 20.20 | 0.05 | 0.00 | Consumer Discretionary |
| Alibaba Group Holdings ADR | 0.88 | 4.49 | 0.04 | 0.00 | Consumer Discretionary |
| Clorox Co | 0.62 | 2.21 | 0.03 | 0.04 | Consumer Staples |
Edited Commentary from the Respective Managers on Selected Contributors
Dollar General (Pat English and Jonathan Bloom, FMI)
Dollar General is a defensive business that performs well in most economic environments. For example, the company has grown its same store sales in 31 out of the past 32 years. We expect that over the next few years, same store sales will keep growing, and the company will also continue to expand its store base. This should drive steady and reliable sales growth over our investment time horizon. When including stock buybacks, earnings per share are expected to grow at a double-digit compound annual rate. The company also pays a 1% dividend. We believe the stock is reasonably valued trading at ~20x 2023 earnings per share estimates in an expensive market. Our thesis has not changed over the past quarter. The current macro environment, which consists of high inflation and weakening consumer spending, has created a difficult operating environment for most retail businesses. However, Dollar General, with its conveniently located stores, consumables-heavy offering and low prices is resonating with customers and has been gaining share in the market. Dollar General is seeing strong growth from its core lower income customer base who are relying on the retailer more than ever, as well as from higher income consumers that are trading down into the channel to take advantage of Dollar General’s lower prices. That combined with strong management execution and excellent capital allocation drove the outperformance in the stock versus the benchmark in the second quarter. Dollar General’s resilient business model has been standing out so far in 2022.
Kimberly-Clark (Scott Moore and Chad Baumler, Nuance Investments)
Kimberly-Clark is a leading global manufacturer of a variety of staple household products, including diapers, wipes, feminine care products, adult incontinence products, and toilet paper. Their portfolio includes many recognizable brands including Huggies®, Pull-ups®, Depends®, Cottonelle®, and Scott®. The household products sub-industry has long been a favorite sub-industry, given its stable demand profile, steady organic revenue growth rate, and limited risk of major technological disruption given the incumbents’ scale, branding, and innovation.
Kimberly-Clark has leading market shares in the geographies where it competes and is generally ranked #1 or #2 in its product categories according to our research. Additionally, over the last few economic cycles, the company has exhibited a high level of return on capital consistency with predictable peaks and troughs, has maintained reasonable leverage on its S&P A-rated balance sheet, and has displayed rational capital allocation policies, including its current 60% dividend payout ratio, which on today’s stock price yields over 3%. This combination of product leadership and consistency with regards to its returns on capital, balance sheet and capital allocation policies has led our team to conclude that Kimberly-Clark has a solid competitive position and is well positioned for the future.
Kimberly-Clark is expected to earn around $5.75 per share in 2022 per Wall Street consensus estimates and we believe the company is under-earning its long-term potential. The company has faced numerous headwinds in 2021 and 2022, including higher labor and transportation costs. However, the largest issue facing Kimberly-Clark’s reported earnings has been rising raw material costs, in our opinion. Key raw materials for its products and packaging include pulp, which is made from timber and has been buoyed by above trend housing demand for lumber, and to a lesser extent resin, which is a hydrocarbon derivative. The price of both commodities has been increasing rapidly and has created a near-term transitory headwind for the company and its cost of goods sold. Kimberly-Clark has already implemented price increases to help offset these raw material costs increases. Yet, much like in previous cycles including the commodity inflation cycle that happened between 2006 and 2008, the price increases have lagged the commodity increases and we believe it will likely take a year or two for pricing to catch up with costs and margins to normalize higher. If organic revenues were to continue to grow in the low single digits, commodity inflation was to stabilize lower, and Kimberly-Clark was able to pass along price increases similar to prior cycles, then we believe earnings per share could reset higher.
As of June 30, 2022, the stock was trading at roughly $135 which equated to approximately 17.5x our estimate of normalized earnings, a multiple that is below its historical average and a multiple that is significantly more attractive than our universe’s median multiple of roughly 25x. If Kimberly-Clark’s earnings per share were to reset higher and P/E multiple were to expand to levels in line with history, then meaningful absolute and relative upside could be generated, in our opinion. Additionally, we believe Kimberly-Clark’s stable and well positioned balance sheet, when combined with its attractive dividend yield, may provide reasonable downside support for the stock in a market downturn. The combination of a company with with what we believe is an excellent competitive position in a desirable household products sub-industry, transitory under-earnings, and an inexpensive valuation is what our team looks for in an investment and explains why Kimberly-Clark has been a top position for our strategy.
Cigna (Chris Davis and Danton Goei, Davis Advisors)
A notable contributor to performance this period is Cigna. Cigna has been benefiting from shareholder-friendly capital allocation decisions as well as outsized growth in a few select niches in their portfolio, e.g., specialty pharmacy (on the services side) and small employers (on the insurance side). The multiple has also expanded slightly, indicating that investors may be warming up to what we believe to be Cigna’s attractive valuation relative to a growing earnings/cash flow stream that should be relatively insulated from macro turmoil.
Top 10 Detractors as of the Quarter Ending June 30, 2022
| Holding | Weight (%) | Return (%) | Contribution (%) | Benchmark Weight (%) | Sector |
|---|---|---|---|---|---|
| Dexcom | 1.34 | -85.43 | -1.38 | 0.09 | Healthcare |
| Amazon.com Inc | 3.35 | -34.84 | -1.35 | 2.67 | Consumer Discretionary |
| Alphabet Inc Class A | 4.70 | -21.65 | -1.06 | 1.74 | Communication Services |
| Netflix Inc | 1.33 | -53.32 | -0.99 | 0.24 | Communication Services |
| Block Inc Class A | 1.17 | -54.68 | -0.84 | 0.11 | Information Technology |
| Berkshire Hathaway Inc Class A | 3.50 | -22.68 | -0.79 | 1.41 | Finance |
| Capital One Financial Group | 3.65 | -20.23 | -0.71 | 0,12 | Finance |
| Booking Holdings | 2.70 | -25.53 | -0.68 | 0.22 | Consumer Discretionary |
| Sea Ltd ADR | 1.04 | -44.19 | -0.56 | 0.00 | Industrials |
| Cloudflare | 0.57 | -63.45 | -0.54 | 0.00 | Information Technology |
Edited Commentary from the Respective Managers on Selected Detractors
Netflix (Mike Sramek, Sands Capital)
Netflix is the largest global video streaming content producer and distributor, based on content spend and subscribers, respectively. The business benefits, in our view, from powerful network effects: award-winning proprietary content leads to more subscriber growth, which in turn fuels more content development. The higher-quality content enables stronger pricing power, and the large subscriber base allows for high incremental margins. Following a period of hypergrowth that resulted in over 200 million global subscribers, we believe Netflix is evolving into a business that will continue to deliver strong topline results, but with rapid margin expansion and cash flow generation. Historically, Netflix’s pace of content development resulted in massive upfront cash costs. This trend is reversing as the pace of original content production moderates, given the large existing library and declining marginal benefit of incremental content. With slowing cash burn and growing revenue (from new subscribers and pricing increases), we expect free cash flow to expand rapidly, enabling Netflix to ultimately return excess cash to shareholders through buybacks.
Capital One (Bill Nygren, Harris Associates)
During the reporting period, Capital One delivered mixed first-quarter earnings results. On one hand, an elevated level of operating expenses caused concern for investors as marketing spend was up 83% year-over-year, reflecting the impact of generous sign-up bonuses for the recently launched Venture X card. Management believes todays spend will be rewarded with durable, profitable growth in customer accounts. The company is also grappling with wage and other input cost inflation, especially when it comes to attracting tech talent. However, first-quarter charge-offs and delinquencies remain well below historical averages and loan growth remains strong. Net interest margins expanded 50 basis points year-over-year and card purchase volume increased 23% year-over-year. Capital One also bought back 4% of its shares during the quarter and authorized a further $5 billion repurchase program, adding to our confidence in management’s commitment to adding value for its shareholders.
We like that Capital One possesses a strong capital position with a common equity tier 1 ratio that exceeds both regulators’ requirements as well as the company’s own internal target. We appreciate the company’s good underwriting track record with a history of lower loss rates than what we would expect given its business mix and yield. In our view, Capital One’s management team is focused on the long term with consistent reinvestment in technology development, and its online/branch bank provides a stable deposit base with decent funding cost.
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).