Portfolio Manager Commentary Q2 '17

Dividend

The Dividend SMA strategy kept pace with its benchmark during the second quarter and has now returned greater than 5% through the first half of the year (net of fees). As we usually remind you: We anticipate lagging the market during periods of very strong performance (like this one - the S&P 500 is up 9% this year!) but we expect the resilience of our businesses and strategy to shine during weaker markets. Overall, the portfolio is performing as we would hope.

Safety: Since the inception of this strategy in February 2016s, we have never suffered a dividend cut and we remain vigilant in protecting against this.

Significance: Our portfolio yield remains healthy at 3%, or 150% of the yield of our benchmark S&P 500, and higher than the 2.3% yield on Treasury bonds.

Growth: The businesses we own have the strength and commitment to grow their dividends. During the second quarter, we had three dividend announcements, each providing a raise. So far in 2017, our portfolio companies have increased their dividends by an average of 4.5%.

We didn't make any portfolio changes during the quarter. This doesn't mean we've been lazy! Instead, it's a signal that we're pleased with the positioning of the portfolio (and it means no transaction costs!).

Among the most challenging aspects of investing in dividend payers is finding businesses that have the possibility of being even better over the coming years than they have been in the past. Finding dividend payers that have a strong historical record is easy, but rarely do they have the business strength to support growing dividend payouts and attractive forward-looking total returns. Most dividend portfolios look great in the rear view, but through the windshield the horizon is challenged with disruptors, changing tastes, and a lack of profitable growth. In this light, we are very pleased with the view offered by our Dividend portfolio.

Our top five holdings all have the potential to get better over time. Microsoft and Paychex are businesses that have strong core technology franchises that have adopted the cloud as a delivery platform. Microsoft is a leader in business productivity tools and cloud infrastructure, and Paychex offers cloud-based payroll services to small businesses. The portfolio's third and fourth largest holdings are real estate companies with attractive end markets. Ventas has a portfolio of healthcare properties that range from biotechnology research campuses to senior housing facilities. Crown Castle owns towers across the U.S. and rents space to cell network operators so our mobile phones can access immense amounts of data. The fifth largest holding is Johnson & Johnson, a diversified healthcare company. The ageing of America and increasing data consumption are strong tailwinds that should provide the opportunity for years of profitable growth for Ventas, J&J, and Crown Castle. Additionally, these businesses possess the dividend safety and significance we prize.

During the quarter, industrial gas producer Praxair was the portfolio's strongest performer. Shares were up 12% as the company progressed toward the acquisition of a major competitor, Linde. Sometime in 2018 you'll see Praxair disappear from your account and Linde take its place. The combined business should be stronger than the individual ones and we are pleased Praxair's management will continue running the show.

Everlasting

The Everlasting strategy rose 3.5% during the second quarter of 2017, outperforming the S&P 500 Index by 0.4 percentage points (net of fees). Year-to-date, the portfolio has bested the market by 1.4 percentage points. The changes we've made recently continue to move the portfolio in the right direction relative to the benchmark.

Let's review some of the performance highlights for the quarter and discuss why we made the latest round of buys and sells.

PayPal was the top contributor during the second quarter and has now become the 6th largest position in the portfolio. It's nice to see the market coming around to what we've thought for some time -- that PayPal is a very strong franchise with an excellent leadership team who continue to make great investments to drive future growth. We believe cash-based payments will keep moving toward digital alternatives for many years to come, and PayPal is well-positioned to benefit from that trend.

Zillow, Facebook, Align Technology, and Cognizant Technology Solutions round out the five best performers for the portfolio during the quarter. Cognizant was a pleasant surprise. Activist investor Elliott Management targeted the company in late 2016, demanding that management concentrate more on profitability than sales growth. To date, the market has cheered company management responding to some of Elliott's recommendations. We continue to monitor this situation to make sure the business maintains the quality level we require.

As always, a few stocks fell short of the S&P 500 benchmark. Tractor Supply, TripAdvisor, National Oilwell Varco, and Nike all detracted from relative performance in the second quarter. One surprising name that also underperformed the benchmark was Middleby, our kitchen equipment maker and seller. The stock came off its highs, perhaps on fears that the restaurant sector will slow down their equipment purchases. CEO Selim Bassoul continues to communicate to investors that that's likely a short-term problem, since Middleby's equipment helps restaurants become more productive. We're maintaining our position (the second largest in the portfolio), as Selim knows the market and his customers better than anyone.

Your team sold the following stocks during the quarter: TripAdvisor, Nike, National Oilwell Varco, and Tractor Supply. As always, we prefer not to sell our investments, and as long term investors, we try to practice what we preach when it comes to patience. But due to the weakness experienced by all four of those business over the past 12-18 months, we've been monitoring each of them very closely. Our most recent information points to that weakness continuing to persist, so in each case, we decided that selling was warranted.

We used the capital from those sales to purchase new positions in Salesforce.com, IPG Photonics, and American Tower. In addition, we added to our position in PayPal. We believe all of the new companies in the portfolio meet our goal of investing in strong companies with good growth prospects. Time will tell, but they're off to a good start already.

International

The future is here!

Or it's almost here.

At least that's the impression you'd get from looking at international stock markets over the past six months. Global indices have been driven by technology and healthcare stocks while falling oil prices have made energy stocks so yesterday.

While energy stocks make up only a small portion of your International SMA portfolio, their negative contribution has been felt even as our oversized position in Chinese tech giant Tencent continues to put up astounding numbers.

In the second quarter, your International SMA returned 4.1% (net of fees), which puts our 6-month performance at 12.4% (net of fees). Not a bad start to any investing year, but not good enough, since we trailed the benchmark for the second consecutive quarter.

2017 Returns

Company	Second Quarter	First Half
Tencent	24.6%	48.5%
MercadoLibre	18.6%	60.7%
HDFC Bank	15.6%	43.3%
Nestle	13.4%	21.6%
Medtronic	10.2%	24.6%
Chicago Bridge & Iron	(35.8%)	(37.9%)
Schlumberger	(15.7%)	(21.6%)
Core Labs	(12.3%)	(15.6%)
Sberbank	(9.9%)	(10.3%)
Fanuc	(6.1%)	15.9%
Int'l SMA	4.1%	12.4%
S&P Global Ex-US	6.1%	14.8%

Part of the reason for our underperformance is our skew towards emerging markets (29% vs 18% for the benchmark). Don't get us wrong -- it has been a good year for emerging markets, but they played second fiddle to developed markets, mostly Europe, in the second quarter.

This appears to mainly be a reaction to the French election results in late April. French voters handily elected Emmanuel Macron, a pro-EU, pro-business candidate. This eased everyone's concerns about the EU disintegrating and made Europe a safe place for money again.

Particularly popular were European banks and healthcare, two sectors in which our portfolio is underweight (banks because we don't feel they're fundamentally attractive and healthcare for valuation reasons), which left us on the outside looking in, for the time being.

The big disappointment, however, was Chicago Bridge & Iron, which suffered mainly from self-inflicted wounds. The most critical of these was poor capital allocation over the course of several years, which resulted in a precarious balance sheet. As a result, the shares have been abandoned by the market and the CEO has been shown the door.

New management might help the company find its footing, but concerns remain about the quality of the backlog of jobs accumulated under prior management and we just don't have faith in Chicago Bridge & Iron's stewards. We recognize that it took us too long to come to this conclusion, but we've now exited the position, which we believe improves the overall quality of our portfolio.

In addition to that subtraction, we made five other moves during the quarter.

First, we sold our position in NXP Semiconductors, as the share price nearly achieved the $110 offer price from Qualcomm. We used those funds to re-up our positions in Schlumberger and BRF S.A. Despite the current pain both these companies are facing, we believe they have promising medium- to long-term prospects.

We also added two new positions to the portfolio: Novo Nordisk and Softbank. Novo Nordisk is the global leader in diabetes treatments. The company is currently facing some pricing pressure from competitors and regulators, but we believe global health trends and its R&D capabilities position it well to respond.

We like to think of Softbank as a more tech-focused Berkshire Hathaway: founder Masayoshi Son has used the strong cash flows generated by the company's Japanese mobile telecom to invest in or acquire various other companies, including Sprint, ARM Holdings, Yahoo Japan, and Alibaba. Getting a grasp of conglomerates can be a bit tricky for outside investors, but we think we've got a winning combination of a visionary founder and a collection of companies with long runways in a tech-dominated future.

This quarter was far more active than most, but we think it leaves your International SMA in a stronger position and better prepared for whatever the future may hold. Bring on the future!

Large Cap Core

The Large Cap Core Strategy outperformed the S&P 500 Index by 2.5 percentage points, net of fees, during the second quarter of 2017, gaining 5.6%. Year-to-date, the portfolio is 4.9 percentage points ahead of the market, a welcome reversal of 2016's underperformance.

We crafted the Large Cap Core strategy to have a good balance of value, growth, and dividend/income stocks, because we believe that style diversity will result in a portfolio that has less volatility than the market over time. In addition, we tried to position the portfolio to do a bit better than the market as it rises, and to do much better than the market when it goes down. Year-to-date, our theory has proven to be correct, leading to strong relative performance.

Looking deeper into the portfolio, Align Technology, PayPal, IPG Photonics, Panera Bread, and American Tower delivered 4.7 points of performance, or about 80% of the portfolio's returns. At the same time, the worst five performers only contributed 1.5 points of underperformance. Those bottom five were TripAdvisor, Fastenal, National Oilwell Varco, Nike, and Splunk.

We made a number of buys and sells in June. We want the Large Cap Core portfolio to maintain its style diversity and we remain committed to owning the best businesses. We sold our stakes in Panera, General Electric, National Oilwell Varco, TripAdvisor, and Nike. A private equity firm acquired Panera, so we were unfortunately forced to sell that very good business. The rest of the sells occurred because we believe the companies in question are having business problems that are likely to take a long time to fix.

Although we prefer to buy and hold stock for long periods of time, our job as portfolio managers is to make sure we allocate your capital to the best possible investments, every day. That typically means selling one investment in order to reallocate that capital to a better one, which is what we did during the second quarter. We added to our positions in Splunk, Facebook, Amgen, Alphabet, Berkshire Hathaway, and Starbucks, and purchased new allocations of Priceline and Ionis Pharmaceuticals, two outstanding companies from our perspective at very different stages in their lifecycles.

Priceline is the leading global online travel agent, and it has an advantage in the marketplace that will be difficult to erode over time. The company continues to expand its huge inventory of rooms available to travelers all over the world, successfully converting them to sustainable revenue and cash flow growth. Ionis Pharmaceuticals is an on-the-rise biotechnology company producing drugs that serve the rare disease and cancer markets. It has a novel drug delivery technology as well as a large pipeline of future drugs, which we believe will translate into future revenue and cash flow growth. And by paying reasonable prices for these new stocks in the portfolio, your team is confident they should be better uses of capital over the long term.

Hedged Equity

The Hedged Equity strategy continued its strong start to the first half of 2017. The strategy modestly underperformed its benchmark during the quarter, but is up 8% this year (net of fees), nicely ahead of its benchmark.

Seven investments returned in excess of 10% during the second quarter. Unfortunately, the strongest performers were smaller holdings, so their impact on overall performance was muted. Longtime holdings Oracle, Broadridge, and Medtronic (together around 16% of assets) had a greater positive impact on results. All three companies had strong quarterly earnings reports that were well-received by the market and bolstered our confidence in their long-term prospects.

The most notable performance came from software provider Oracle. A decade ago the company set out to rebuild its entire software suite for delivery via the cloud. Several years ago, it rebuilt its sales force. Finally, bookings and sales are beginning to bear the fruit of these long-laid plans. Oracle is already a dominant player in on-premise enterprise software, but cloud deployment opens its products up to smaller and smaller companies. With a larger addressable market, a complete cloud-enabled product suite, and a focused sales organization, this mature tech giant appears to be entering a new phase of growth.

The strategy had several notable poor performers. Industrial distributor Fastenal, auto parts retailer O'Reilly, and rural retailer Tractor Supply fell -15%, -19%, and -21% respectively. The thread that connects these three businesses is the threat of increased competition from Amazon. In the case of O'Reilly and Tractor Supply, store traffic and sales have been weaker than expected and investors fear the business challenges are just beginning. Fastenal has reaccelerated sales growth by deepening relationships with large enterprises, but has done so at modestly lower profitability. Investors fear Amazon will continue to pressure profitability and steal customers at the margins. These fears are legitimate, but in each case we believe the businesses we own are well suited to defend their turf. Fastenal and O'Reilly benefit from immediacy of need. When replacing a critical fastener or engine part, every minute matters - waiting a day or two is unacceptable. Tractor Supply sells many items that aren't easy to ship cost effectively. In all cases, we believe the people working the stores and unique relationships they have with their customers are differentiators that make these businesses special. However, all three stocks have been weak this year and we are monitoring the situations.

The Large Cap Core strategy is about 75% net long. The overall strength of the market has made the strategy's hedge and short positions detract from performance. We continue to view these positions as central to downside protection and search for opportunities to play the unglamorous role of "insurance" against a market downturn. As a reminder, the goal of the Large Cap Core strategy is to grow your capital over rolling three-year periods with modest co-movement to other asset classes and a smoother ride along the way. To achieve this, hedges and shorts will be necessary, even though during strong markets like this one, they will be a drag. Of course, the backdrop won't always be as sunny, and the Large Cap Core strategy will be prepared.

Large Cap Aggressive Growth

The Large Cap Aggressive Growth SMA strategy gained 9.4% during the second quarter of the year, beating the S&P 500 by 6.3 percentage points, net of fees. Year-to-date, it has outperformed the benchmark by 9.6 points. So far, it's been an incredible year. But there's still a bit more work to be done to completely close the performance gap from 2016.

Your team continues to make investing decisions that improve the quality of the Large Cap Aggressive Growth strategy. We have been selling companies that no longer meet our standards and buying ones that do. As a reminder, we expect a company to have: a strong business model, durable competitive advantage, incredible long-term growth prospects, and a top-notch management team. We try to pay a reasonable (preferably attractive) price for its stock, too. And while we've had a bit of luck at the start of 2017, the changes we've made over the past six months have played an important role in generating those returns.

Align Technology, Ionis Pharmaceuticals, PayPal, IPG Photonics, and Mercadolibre were, in order, the five largest contributors to the portfolio's outperformance during the second quarter. They delivered 6.7 percentage points, or almost 70%, of the returns for the portfolio. The largest detractors of performance relative to Large Cap Aggressive Growth's benchmark, the S&P 500 index, were TripAdvisor, Splunk, Middleby, Nike. Together, that contributed 1.5 percentage points of underperformance. All in all, many of our largest holdings delivered the best returns, which is exactly what we want from the portfolio.

Your team continues to actively manage the portfolio to make sure you own the best companies with the most attractive growth opportunities. As such, we made a few changes. We sold all shares of TripAdvisor, Middleby, Panera, and Nike. We then used that capital to purchase additional shares of Facebook, PayPal, Splunk, Salesforce.com, and IPG Photonics. We believe those companies better fit the mold we prefer to use.

Let's quickly review the sales. A private equity firm acquired Panera. So we were, unfortunately, forced to sell that very good business. We sold shares of Middleby, not because it's a poor business (it's not), but because it no longer fits the Large Cap Aggressive Growth model. It has a great manager in Selim Bassoul and a decent acquisition-based business model. It just doesn't have as much growth potential as, say, IPG Photonics, which also has a great management team and a stronger business model. As long term investors, we try to practice what we preach when it comes to patience. But we've been monitoring Trip Advisor and Nike closely as they've experienced weakness over the past 12-18 months, and our most recent information points to that weakness continuing to persist. So, we decided it was better to reallocate that capital to better situations.

As we said last quarter, "The lesson coming out of 2016 can be best summed up as 'invest in your winners and sell your losers quickly'". That continues to be a prudent model halfway through 2017, especially when those "winners" are great businesses that have the ability to grow for a long time.

U.S. Small & Mid-Cap

During the second quarter, the SMID SMA strategy had a net return of 5.0% (net of fees), compared to a gain of 2.0% for the benchmark index, S&P MidCap 400. Year to date, the SMID strategy has gained 6.5% (net of fees) versus 6.0% for the benchmark. For the quarter, our industrial stocks led the way and were the biggest contributors to performance.

Two of our industrial holdings, Proto Labs and XPO Logistics, were on fire in the second quarter, notching gains in excess of 30%. Proto Labs' gains came after its Q1 earnings report in April, where revenue and earnings per share came in better than expectations, and management's guidance for Q2 was well received. XPO's shares have done very well over the past year as management has followed through on improving the company's profitability after a flurry of acquisition activity.

The second quarter was an active one on the trading front. We sold out of four holdings: Infinera, Polaris, TowneBank, and Varex Imaging. We used the proceeds from those sales to add a handful of new companies to the portfolio: Access National, GrubHub, Lakeland Financial, McCormick & Co., and Paycom Software.

We acquired Varex Imaging as a spin-out from Varian Medical Services, and while both stocks have done remarkably well since the separation, Varex was a largely commoditized business, highly susceptible to exchange rate movements, with comparatively little to be excited about over the long term. TowneBank had also been a highly successful holding in the portfolio, but in our opinion the market had more than fully rewarded the stock for a job well done, and future gains in the position were not worth the risk.

Polaris and Infinera are companies which we have respect for, but in both cases management has made tactical mistakes that have punished shareholders over the last two years. We wish both companies and their shareholders well, but felt there were better places to be invested.

Access National and Lakeland Financial replaced TowneBank in the portfolio, as they are similarly well-run small banks, but with more attractive valuations in our estimation. We like the opportunities provided by small banks as a group, but valuation matters. McCormick & Co., the dominant spices and seasoning maker in the world, gives us some exposure to consumer staples. For a long-time we've been admirers of the company, waiting for an attractive entry point. Our patience was rewarded when the market reacted negatively to their recent acquisition of UK-based Reckitt Benckiser's food business at what appears to be a steep $4.2 billion price tag, but we are confident in management's capital allocation acumen for this acquisition, and over the long-run.

When we make a trade, we are always looking to make the portfolio as a whole better than it was prior to the trade. Our transactions this quarter reduced our consumer discretionary exposure, where we were significantly overweight relative to the benchmark, and increased our exposure to financials and tech, where we were underweight. More importantly than just balancing out our sector exposure, we also seek to continually improve the business quality of the companies we own. One indicator of business quality is profit margins, so we're pleased to report that at the end of Q2, the weighted average operating profit margin of the portfolio was 10.2% (compared to 9.5% at the end of Q1).

While we won't make a prediction as to how the market, or our portfolio, will perform over the second half of the year, we do have high expectations for the business performance of each of the companies we own. As Q2 and Q3 earnings reports are released, it is important to us to see the results we are looking for. It is our preference to increase our stakes in companies that are doing well and, on the other hand, exit our positions in those that are not.

U.S. Small & Mid-Cap Dividend

During the second quarter the SMID Dividend strategy returned 2.67% versus a gain of 1.97% for the benchmark index, the S&P MidCap 400. Year to date, the SMID Dividend portfolio has gained 5.30% compared to 5.99% for the benchmark.

On an individual stock basis, the top three performers in the quarter were (new addition) Jones Lang LaSalle (up 19.3%), Texas Roadhouse (up 14.9%), and Quest Diagnostics (up 13.7%).

It was an uncharacteristically busy trading quarter for us, swapping out 10 of the 37 companies in the portfolio as of March 31, and topping up another seven positions. In alignment with the Foolish investing philosophy, we look to hold our investments for the long term, but we will, and did, sell for a few reasons.

One reason for selling is if our investment thesis breaks down - our theses necessarily involve making certain assumptions, and when these assumptions are proven wrong, we need to re-evaluate and respond appropriately.

The sales of DSW, Polaris, Schweitzer-Mauduit International (SMI from here on out), Tanger Factory Outlet Centers, and Towne Bank fall into this category.

• We lost confidence in SMI because its CEO left in the middle of significant transition in the company's business model.
• A combination of self-inflicted pain and increased competition has soured us on Polaris's ability to stand out in the crowded off-road toy industry.
• We initially believed Tanger Factory Outlet Centers and DSW could withstand the onslaught of Amazon, but recent evidence has us reviewing this stance.
• We sold Towne Bank after management made a questionable acquisition, raising doubts about their capital allocation skills and priorities.

Because we believe in paying a reasonable price for the companies we own, a second reason for selling is if the price becomes too rich for us to justify. This is actually a pretty good problem to have, assuming you've got other companies in which to invest. The winners we sent packing were Donaldson, MSA Safety, Nordson, and Healthcare Realty Trust. Finally, we sold Weyerhaeuser simply because acquisitions have made it too big to fit in our small-cap universe.

With the cash raised from those sales, we went SHOPPING!

We bought: DC-area bank Access National, fellow asset managers Diamond Hill, know-it-all information provider FactSet Research Systems, real estate services company Jones Lang LaSalle, RV component manufacturer LCI Industries, spice traders McCormick, fancy paper maker Neenah Paper, pizza provider Papa John's, West Coast strip mall owner Retail Opportunity Investment Corp., specialty retailer Tractor Supply, and plastic cookware party thrower Tupperware.

Earnings growth is the engine that drives dividend growth. At the end of Q2, the portfolio had a weighted average earnings per share growth of 9.1% over the past three years, compared to 6.1% at the end of Q1. The impact of all of the trades made during the quarter is that we have upgraded the earnings growth, and potentially the future dividend growth, of the portfolio. That is supported by looking back on a trailing three year basis, where dividend growth of the portfolio was 12.5% per year versus 10.5% at the end of Q1. The current dividend yield of the portfolio is 2.3% compared to 1.6% for the benchmark.