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Commentary iMGP SBH Focused Small Value Second Quarter 2023 Commentary

For the second quarter of 2023, the iMGP SBH Focused Small Value portfolio (the “Fund”) gained 8.11%, outperforming the 3.18% return for the Russell 2000 Value Index (the “Benchmark”). The Fund also outperformed the Morningstar Small Value Category’s 3.80% gain.

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. Short term performance is not a good indication of the fund’s future performance and should not be the sole basis for investing in the fund.To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit Returns less than one year are not annualized.  The Advisor has contractually agreed to limit the expenses of the fund through April 30, 2024.  Without this limit the fund’s net expenses would be higher the return would be lower.

Market Overview and Strategy Performance

The second quarter was a bit less volatile than the first quarter as we moved further past the banking failures and investors shifted their focus towards the Federal Reserve’s (Fed) interest-rate decisions related to driving down inflation. Excitement around Artificial Intelligence (AI) and the potential applications and benefits of this technology over the coming years and decades emerged as a theme. This was the primary reason that Information Technology was the best-performing sector during the quarter followed by Industrials. We have maintained an underweight position in regional banks and the Financials sector in the portfolio and currently do not plan to increase those exposures. The Fund is underweight the Energy sector post the reconstitution of the Benchmark in late June. Energy now represents close to 9% of the Benchmark. This is an area we are keenly focused on in terms of unearthing solid capital allocators that could benefit the Fund.

As we stated last quarter and based on historical precedent, we still believe the ingredients are in place for a recession to occur within the next several quarters; however, we believe that if one does occur, it might be quite shallow in terms of economic damage. We also believe the Fund is in a position of strength due to the focus we have always had on return on invested capital (ROIC) relative to the cost of capital. We have always held the Fund’s companies to a capital allocation standard where management is focused on ROIC well above recent historical weighted-average cost of capital (WACC) levels once assets are managed for optimal returns.

Contributors to Return

The three sectors that contributed most to the Fund’s performance relative to its Benchmark in the quarter were Industrials (driven by selection and allocation), Consumer Discretionary (driven by selection), and Utilities (driven by allocation). Within Industrials, CIRCOR International (CIR) (holding weight: [insert] %) was the top performer in the quarter. CIR, under a new leadership team, has taken an aggressive approach to driving margin improvement by capitalizing on its product portfolio pricing structure which was aided by deploying an 80/20 strategy across the organization. The CIR board announced a process in which it was undertaking strategic alternatives to extract maximum value for shareholders. During the quarter, the board received two offers to buy the company for a significant premium.

Within Consumer Discretionary, Modine Manufacturing (MOD) (holding weight: [insert] %) was the top performer. MOD has seen significant success in deploying an 80/20 culture which has allowed for a less complex, higher margin, and higher growth business, which we believe has significant potential in the next several years. We always seek to identify those stocks that have the leadership and culture in place to drive an inflection point in ROIC and, in our experience, those companies adopting an 80/20 focus throughout the organization can create a pathway for value creation.

Detractors from Return

The three sectors that detracted most from the Fund’s performance relative to its Benchmark in the quarter were Information Technology (driven by selection), Financials (driven by selection), and Real Estate (driven by selection). Cash was also a detractor from relative results. Informa􀆟on Technology holding Lumentum Holdings (LITE) (holding weight: [insert] %) was the top detractor within the sector. We underestimated the inventory overhang the business would be facing from its major telecom customers and though LITE has a strong balance sheet and solid prospects going forward, we now realize it will take a couple of quarters for the business to get back on track. Glacier Bancorp (GBCI) (holding weight: [insert] %) was the top detractor within Financials. After reporting its first quarter earnings, GBCI suffered as its net interest margin (NIM) contracted more than expected. GBCI has one of the most resilient deposit models; however, as a safety measure, it took on higher cost borrowing due to the bank failures and uncertainty on deposit pricing dynamics. Looking ahead, GBCI expects its NIM to bottom sometime in the third quarter as it pays down those higher cost borrowing and loan yields reprice at much higher levels. The area we are watching closely for all the Fund’s bank exposure is credit issues that might become more prevalent as the year progresses. GBCI has a reputation as one of the most disciplined credit underwriters based on past loss rates. Therefore, in a period of broader credit stress, we believe GBCI will be a positive standout.

Market Outlook

What an exciting time to be an active investor! As we continue into the second half of 2023, there are a lot of moving parts including a monetary policy that is trying to slow the broad economy and quell wage inflation and fiscal stimuli (Highway Bill, Inflation Reduction Act, CHIPS and Science Act, etc.) that are continuing to fuel growth in focused areas of our economy. In addition, we have the continued shift toward reshoring, renewed trade restrictions between China and the U.S., potential peace attempts starting with Russia and Ukraine, and an AI-driven productivity boon for machines.

Importantly, rising real interest rates are having an impact on the cost of capital—increasing it—for all companies. In turn, this demands a shift in thinking by company managements regarding how much debt to maintain longer term. In our opinion, we see a challenging market backdrop going forward primarily due to the significant increase in the cost of capital that is not likely to reverse any􀆟me soon; however, the impact of this higher cost will likely be felt over months and years rather than in just a single quarter. Our investment approach has always used a high cost of capital hurdle (10%+), coupled with our work toward keeping our Fund populated with ROIC change agents. ROIC change agents are management and incentive driven focus on how to optimize capital allocation via asset purchase and sales, facility rationalization, and continuous programs with improving returns as the goal. We remain comfortable with our philosophy and process over cycles regardless of the economic backdrop. We do see volatility increasing as real rates continue to rise, particularly for loss makers and zombie companies. In recent years, due to easy money policies, we have seen many companies misallocating capital (i.e., investing in too many low return businesses), while simultaneously not allowing for creative destruction. Hopefully, we can return to an appropriate balance of appropriate capitalism for the benefit of companies and citizens alike. While we cannot know exactly when a soft landing or hard landing will occur, we think we are nearing that juncture over the next two-three quarters. Our focus is on management teams that cannot just weather a broad variety of storms but can become stronger organizations, financially and culturally, via continuous improvement programs. We are excited to invest in a difficult investment backdrop that even Stanley Druckenmiller calls the most difficult of his career. Thank you for your continued interest and support.

Portfolio Breakdown as of 6/30/2023

By SectorFund
Consumer Discretionary11.6%
Information Technology5.1%
Communication Services0.0%
Health Care & Pharmaceuticals3.9%
Industrials 37.3%
Consumer Staples 3.4%
Real Estate 7.0%
Summary Statistics
Market Cap Median (bn)$3.38
Weighted Average Market Cap (bn)$3.62
# of Holdings42
By Region
US Equities98.3%
Developed International Equities1.7%
Emerging Market Equities0.0%

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Mutual fund investing involves risk. Principal loss is possible. Past performance does not guarantee future results. 

Investing in small companies subjects investors to additional risks, including security price volatility and less liquidity than investing in larger companies. Though not an international fund, the fund may invest in foreign securities. Investing in foreign securities exposes investors to economic, political and market risks and fluctuations in foreign currencies. These risks are greater for investments in emerging markets. 

basis point (bps) is a value equalling one one-hundredth of a percent (1/100 of 1%)

Return on Invested Capital (ROIC) is a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments. Return on invested capital gives a sense of how well a company is using its money to generate returns.

The Russell 2000 Value Index measures the performance of small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

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Index performance is not illustrative of fund performance.  An investment cannot be made directly in an index. 

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The iMGP Funds are Distributed by ALPS Distributors, Inc.  LGM001321 exp. 7/31/2023