Portfolio Manager Commentary Q4 '17

Dividend

The Dividend strategy had a strong fourth quarter, edging out the steadily rising S&P 500. For the year, the strategy trailed its benchmark (which posted returns of 21.8%), but still returned about 16.2%, net of fees. We expect the resilience of our businesses and strategy to shine during weaker periods, but there were no such periods in 2017. The S&P 500 advanced every month during the year! We are pleased with our strong absolute returns, but as you know, we grade ourselves on how well we implement our quality dividend strategy.

Safety: During the life of the strategy (since its inception on 2/25/16) we have never suffered a dividend cut and we remain vigilant in protecting against this.

Significance: Our portfolio yield remains healthy at 2.7%, but is at its lowest level since inception, while our cash position has grown to more than 5%. Our portfolio yield remains above our benchmark and higher than the 2.4% yield on Treasury bonds.

Growth: During 2017, 22 of our portfolio companies announced dividend increases. On average, our dividends were raised +7.6%.

In our third quarter commentary we wrote about the continuing troubles at General Electric. The company had become a complicated mix of businesses that was hard to manage. Ultimately, we sold because we believed the ongoing business transformation would jeopardize the company's ability to pay a significant and growing dividend. A few days after our sell, GE cut its dividend in half and the stock dropped considerably. Selling when we did saved us some pain, but we did not escape it all. GE was a drag on the portfolio up until the time we sold.

During the last quarter of 2017, the best performing holding in this strategy was Walmart (+23%). The team at Walmart has been working hard to improve its e-commerce capabilities, make shopping in its stores more enjoyable, and treat its associates better. These efforts cost money and have temporarily depressed profits, but they are bearing fruit in the form of accelerating online sales growth and resurgent same store sales growth. Walmart remains the King of Retail and is successfully defending its throne from Amazon.

CVS Health, however, is having a tougher time with competition from Amazon. Shares of the retail pharmacy and benefit manager slid -11% during the quarter as rumors swirled that Amazon may enter into the pharmacy business. This move would pressure pharmacy profits and weaken the position of its front of store retail franchise (if Amazon will deliver your prescriptions, will you still buy candy and makeup from a brick and mortar CVS location?). In response, CVS announced it intends to purchase health insurer Aetna. This move would make CVS a more holistic provider of health services and retain scale in its benefit management business, but introduces significant integration risk (assuming the deal would be allowed by regulators).

Finally, we'd like to call out that the portfolio yield of 2.7% is modestly understated, since financial exchange operator CME group (a top 10 position in this strategy) only reports a 1.6% dividend yield. However, the company announced a special dividend of $3.50 per share (up from $3.25 per share last year), which brings its total yield close to 5%. Management is committed to paying a reliable dividend (that's the 1.6%) and returns excess cash to shareholders in the form of a special dividend at the end of each year. Special dividends aren't included in our reported yield metric -- but the cash that hits your account spends just the same!

Everlasting

The Everlasting investing strategy finished the fourth quarter 0.7 percentage points ahead of its benchmark (7.3% vs. 6.6%) and ended the year up 5.8 percentage points (27.6% vs. 21.8%). All figures are net of fees.

All in all, it was a good quarter, an excellent year for the strategy, and a very welcome improvement over 2016. We made a number of changes at the end of 2016 and in the first half of 2017, swapping out what we considered lower-quality companies with declining prospects for higher-quality companies with strong current and expected growth opportunities. Below are the 3 biggest changes we made:

1. Buying Amazon in November 2016.

2. Selling Under Armour and buying Align Technologies in February 2017.
3. Selling TripAdvisor and buying more PayPal in June 2017.

PayPal, Amazon, and Align Technologies were 3 of the top 5 largest contributors to the portfolio's results. (Facebook and Mastercard were the other big contributors.) Under Armour and TripAdvisor continued to decline after we sold them (unfortunately, for a loss). Together, the aforementioned buys and sells delivered about 3 points of the portfolio's outperformance in 2017. Let's look at the 5 largest contributors and detractors to the portfolio's results to gauge the impact of the changes. (Note that contribution is the product of a stock's allocation and its return.)

Our job as portfolios managers is to allocate capital from the least productive opportunities to the most productive opportunities. To that end, all 5 of the largest detractors were sold during the year, and the capital moved to stocks that delivered positive contribution. Every portfolio is going to have stocks that go up and stocks that go down. The key is to make sure that the positive contributions are higher than the negative contributions. From the table above, the Everlasting strategy did just that in 2017, and we will work hard to build on those results.

Now is a good time to address a question we get from time to time about selling stocks. As Foolish investors, we do believe in the importance of investing for the long term. Although we would always to prefer to hold our stocks for years or even decades, sometimes we need to make a sale. Your team will sell a stock if:

1. We made a mistake in our analysis. (Yes, it happens. Even to the best stock pickers.)
2. The company is undergoing a change that invalidates our previous investment thesis. (TripAdvisor, above, is a perfect example.)
3. We need the cash to invest in an even more promising investment opportunity.

One stock that we have no plans to sell right now is PayPal, which was an outstanding performer for the portfolio in 2017. The financial payments company has all the qualities we look for in a long-term investment. Management, led by CEO Dan Schulman, has been making all the right moves to make PayPal a stronger business following its spin off from eBay. The company makes a little bit of money off each transaction that it facilitates, and continues to attract more users and merchants to its platform, make it easier for them to execute transactions, and develop more products and services for them to use. With such a large following, PayPal has an advantage over the competition, which should drive continued sales and cash flow growth over the next decade. The price isn't as attractive as it was when we first purchased shares, but we don't believe it's overvalued.

We did not buy or sell any stocks during the last quarter of 2017. We've been looking at a few new ideas recently, and we'd love to find another investment like PayPal. But right now, we like the portfolio as it is.. As always, we value the trust you place with us to manage your money and look forward to communicating with you again next quarter.

International

As 2018 gets underway, it's that time again to pause and take stock (get it?) of what the past year did to your portfolio. In 2017, your International strategy delivered net-of-fee returns of 26.6% versus the benchmark's 28.5%. I'd also like to take this opportunity to remind everyone what a terrible forecaster I am. Here's my (appropriately couched) forward-looking commentary from a year ago:

We don't know exactly what 2017 has in store for us, but early indicators are that we may face another strong year for the dollar, which means further pain for emerging market companies that have relied on low rates to load up on dollar-denominated debt.

Sometimes it feels good to be wrong. In fact, 2017 was the worst year the dollar has seen since 2003: The dollar index (a comparison of the dollar against a basket of foreign currencies) dropped almost 10%, including a 15% drop against the euro and an 11% drop against the British pound. That was great news for international investing, providing a nice tailwind as the broad index for non-US companies rose 25% for the year and the broad emerging market index posted a whopping 32% gain.

Your International strategy started the year a bit slow, trailing the benchmark through the first six months, but the final two quarters delivered the types of returns we like to see and the fourth quarter turned in a strong 5.76% return, beating the benchmark by just under half a percentage point.

Of the 10 largest individual company positions (as opposed to ETFs, which make up 4 of the largest positions in the portfolio) at the start of the year, seven turned in double digit gains, four beat the benchmark, and three posted losses.

(Somewhat) Unfortunately, as you'll see in the table below, three of our top five performers were well outside our ten largest positions to start the year.

One of the regrets I have about 2017 was selling Sberbank in August and missing out on the bulk of the gains th e stock posted last year. Of course, this year's gains were on top of the 100% returns we saw in 2016, so it wasn't all missed opportunity.

While I regret leaving money on the table, I still agree with our decision to remove the political risk from the portfolio (to recap, the latest round of sanctions against Russia may prohibit US investors from holding stock in Russian companies, and we decided that was an unattractive risk).

Of the 17 individual company positions we held for the entire year, 9 failed to beat the benchmark, and the largest drags on our performance were Brazilian chicken producer BRF SA, oil services providers Schlumberger and Core Labs. Our performance was also hurt by holding on to Chicago Bridge & Iron for too long. It dropped 55% before we sold in late June.

During 2017 your portfolio was impacted by the wave of mergers and acquisitions taking place around the world. Syngenta, a pesticide and seed manufacturer, was acquired by ChemChina and we sold your position when the share price got close to the acquisition price. We took those proceeds and rolled them into NXP Semiconductor, one of the largest makers of semiconductors in automobiles, which was in the process of being acquired by Qualcomm for $110. When the share price got within a hair's breadth of the acquisition price, we sold that holding as well.

To replace the technology exposure we lost with the departure of NXP, we purchased SoftBank, superficially a Japanese telecom, but the company's CEO has been using the hefty cash flows produced by the telecom to invest in tech-related companies around the world. We also put new money into Novo Nordisk, the leading manufacturer of diabetes-related treatments, as fears about drug pricing gave us an attractive entry point.

Then, just before year-end we recycled some capital, trimming our position in Tencent, which had grown to over 6% of the portfolio, and reinvesting it into restaurant group, Yum China. We wanted to maintain our exposure to Chinese consumers, and felt Yum China, operator of KFC and Pizza Hut in China, provided a more stable alternative to the highly valued, tech-driven Tencent. So we spread our bet a little, still keeping an oversized position in Tencent.

We also trimmed our holdings of Taiwan Semiconductor and Fanuc as both had delivered great returns over the past year, but now look to be valued without regard for the ups and downs of their industries. We still think they are great companies positioned well for the future of technology and industry, but we just can't justify holding larger than average positions at the current valuations.

Like last year, I'm not going to claim to know what 2018 has in store for us, but broadly speaking it looks like economic growth is building around the world.

For the past couple of years, the US has been a lone bright spot in the global economy, but it now looks like Europe is finally on the mend, and rising commodity prices should help regions like Latin America post at least modest growth. This should generally be good for the companies we own as widespread growth will lift all boats and we won't have to get lucky owning companies with exposure to certain hot markets.

Regardless, I'm comfortable with how your International SMA is positioned - we've got high quality companies with solid balance sheets that should be able to continue to innovate and grow regardless of what economies and stock markets do.

As always, we'd like to express our humble thanks for the trust you place in us, and we promise to do all we can to continue earning that trust as we work to deliver market-beating returns for your portfolio in 2018 and beyond.

Large Cap Core

The Large Cap Core investing strategy finished the 4th quarter of 2017 2.6 percentage points ahead of the S&P 500 (9.2% vs. 6.6%) and bested the benchmark by 12.3 percentage points for the full year (34.6% vs. 21.8%). All figures are net of fees.

2017 was a fantastic year for the portfolio and, looking back, it was a busy one, too. Your team made 10 changes to the portfolio during the year, which is significantly more turnover than we expected. Even with all the activity, the portfolio continues to do what it's designed to do: perform a bit better than the market on up days as well as a little better on down days. That's because the Large Cap Core strategy has more balance across investing styles (growth, value, income, etc.) and business sectors, making it a little less volatile than Motley Fool Wealth Management's other large-cap portfolios.

It always helps when your 4 largest positions are also your best performing stocks. IPG Photonics, PayPal, Amazon, and Align Technology delivered incredible returns in 2017, powering the portfolio well beyond its benchmark. Those 4 stocks more than made up for the poor returns posted by General Electric, TripAdvisor, Under Armour, and Devon Energy, all of which we sold during the year.

As has been a theme of previous quarterly letters, we made a very conscious effort to improve the quality of the portfolio by selling troubled businesses and reallocating that capital to stronger ones with more promising long-term prospects. As such, we started positions in Priceline, Ionis Pharmaceutical, Crown Castle, Microsoft, and Amgen, and we bought additional shares of Facebook, Alphabet, Starbucks, and Splunk. The aforementioned companies also delivered solid contributions to the strategy's outperformance in 2017. In fact, we're so happy with the makeup of the portfolio right now that we haven't made any transactions since June.

Quality means different things to different people. So to illustrate what we mean by a "high-quality company," let's take a closer look at Align Technologies. We use 4 criteria to assess the quality of a business: management, the economics of the business model, its competitive advantage, and the sustainability of its growth.

Align's management team deserves tremendous credit for aligning its customer interests (in this case, mainly dentists) with its own (selling more teeth straighteners). That has translated into growing sales, rising margins, and increasing cash flows. Management reinvests those cash flows to extend its technological lead and develop new solutions for patients, giving customers (dentists) more sales opportunities and strengthening Align's competitive advantage. Lastly, Align Technologies still has a massive opportunity to gain market share, especially in the teen market.

Based on the summary above, your team determined that Align was a high-quality business trading at a reasonable price. As such, we made a large investment in the Large Cap Core strategy on your behalf. The stock delivered the largest gain in the portfolio, increasing over 130% in 2017. That's an incredible feat, and we don't expect returns to continue at that rate. Of course, we cannot promise every investment will have that level of success; however, we do promise to work tirelessly look for businesses like Align Technologies. It's what we love to do.

As always, we value the trust you place with us to manage your money and look forward to communicating with you again next quarter.

Hedged Equity

The Hedged Equity strategy underperformed marginally during the fourth quarter (up 3.8% vs 4.6% for the benchmark) and for the year (14% for Hedged Equity vs 14.9% for the benchmark). All returns are net of fees. Since pleasing absolute returns and managed risk are what this strategy shoots for, we think 2017 should be scored a win. Still, we want to be candid - we can't help but feel we left a little on the table.

For most of the year, the strategy's net exposure was a touch over 70%. In hindsight, we should have put the pedal to the metal and run a higher net exposure. The stock market's march higher was relentless. "Relentless" may seem a strange word choice, but it is the right one. The S&P 500 spent zero days in a 5% drawdown (that is, 5% lower than its previous high-water mark). Zero days! In fact, its largest drawdown during 2017 was -2.6%.

For a little context, the maximum drawdown of the S&P 500 in 2016 was -10.3% and the index spent 41 days in a drawdown of -5% or more. The market's rise this year was truly relentless. Our portfolio's core long holdings kept pace, but our hedges and shorts were a persistent drag. We intend for our short book to be less of a hindrance in 2018.

Another reason we feel like we left a little on the table is because during the second half of the year we ceased writing puts to earn income. Put writing, you'll remember, is akin to being the seller of an insurance policy. We collect a small premium up front, and as long as nothing catastrophic happens, we keep our payment and move along.

In general, there are two primary reasons we'd stop engaging in this strategy. The first is if we expect something catastrophic on the horizon. The second is if the premium we get up front doesn't justify the risk of the potential obligation. In option land, a major determinant of the size of that premium is volatility -- the degree of zig and zag expected in stock prices. We stepped to the sidelines for the second reason. Volatility had gotten so low that the payment for accepting downside risk was unacceptable. Now, the market continued to rise smoothly and things would have worked out fine, but we still believe our move to the sidelines was warranted.

Astoundingly, 9 of the 10 lowest volatility readings on record (as measured by the VIX) occurred in 2017. In July the VIX broke through its 23-year low, and in November it closed at its lowest level ever. The outcome we achieved from moving to the sidelines was unfortunate, but we're comfortable with our disciplined respect of the data and commitment to risk management.

During the quarter, the portfolio's largest winner was Atlassian (+30%). This founder-led company makes cloud-based software for team collaboration. Demand for the company's products is strong as businesses rely more on distributed workforces. Unlike other enterprise software, Atlassian's software is bought, not sold. The products are priced inexpensively to encourage trial and built to be simple enough to use that five minutes of fiddling around reveals the value.

This combination saves Atlassian from having to spend on a huge quota-carrying salesforce, and it takes that money and plows it back into product development to improve existing products and create new ones. The formula is working.

The biggest loser during the quarter was Papa John's International (-23%). Papa John's is the fourth largest slice slinger in the US and its company-owned and franchised pizza joints released disappointing sales results. Management blamed its partnership with the NFL for dragging on results. We believe there is some truth to this, but the problem is exacerbated by increasingly adept competition. Just before Christmas, CEO John Schnatter decided to step down. While this move was a surprise, Papa John's has a strong culture and had a groomed successor ready to go. While this may refresh the brand, there is no doubt that third party delivery services are encroaching on the long-time advantage of pizza joints. Papa John's remains a small position and we're watching the situation closely.

While we're not big on predictions, we don't think 2018 will be as smooth a ride as 2017 was. However, the Hedged Equity strategy is built on variety and agility. It is our job to be ready, and to position the strategy to be resilient in the near term while growing your capital over rolling three-year periods. Our goals of long-term capital appreciation, modest correlation to other asset classes, and reduced drawdowns remain sound, and will continue to guide our decision making.

Large Cap Aggressive Growth

The Large Cap Aggressive Growth investing strategy finished the 4th quarter of 2017 4.5 percentage points ahead of the S&P 500 (11.1% vs 6.6%) and bested the benchmark by 18.8 percentage points for the full year (40.6% vs 21.8%). All figures are net of fees.

2017 was an incredible year for the portfolio and a dramatic improvement over the performance in 2016. We started making changes to improve the quality of the companies in the portfolio during the summer of 2016, and those decisions have been paying off. However, we are still not satisfied. We continue to work hard for you, every day, to make sure the portfolio is set up to deliver the best investment outcomes it can.

Looking at the portfolio's performance over the past year, we're not surprised the Large Cap Aggressive Growth strategy significantly outperformed the market on up days. The companies we own have been performing extremely well, financially. So we would expect their stocks to move higher along with their strong business results.

However, we were surprised to see the strategy also outperformed the market slightly on down days. Some of that can be attributed to the quality of the businesses in the portfolio, and some of that can be the result of the reduced volatility in the market. We expect the volatility of the portfolio to increase a bit over time, but we'll work to limit it when we can.

Let's take a quick look at the top 3 and bottom 3 contributors to the portfolio and their returns in 2017. (Note that contribution is the product of a stock's allocation and its return.)

We believe that Align Technologies, Amazon, and IPG Photonics are some of the best businesses in the world and making significant investments in each of them has been very beneficial to the portfolio. Given their strength and the growth opportunities ahead, we have no plans to sell them in the near term.

We sold each of the bottom 3 contributors during 2017, as those businesses were showing signs of weakness and stopped meeting our quality standards. Those proved to be good decisions, as we reallocated the capital to stocks that delivered positive results to the portfolio. We won’t get every buy and sell decision correct. But if the contributors outpace the detractors over time, we stand a good chance of outperforming the market.

Amazon is well known to consumers and investors. Still, we think it’s helpful to highlight some of the things we’re excited about as the company moves forward. Amazon Web Services (AWS) continues to be a huge winner for the company. AWS is by far the leading in cloud-computing provider, well ahead of Microsoft’s Azure and Google’s GCP. And it’s delivering strong growth, margins, and cash flow.

Amazon is also building out its Fulfilled by Amazon (FBA) platform, which provides fulfillment services to small and medium sized businesses selling products through Amazon. FBA enables the company to get more productivity out of its incredible logistics network, strengthening Amazon’s competitive advantage. And finally, the company has entered new business segments such as digital advertising (watch out Google) and Home Devices with its Alexa, Echo, and Dot products, to name a few. Amazon is not resting on its laurels. And we’re glad it’s a significant portion of the Large Cap Aggressive Growth strategy, as the company looks poised to deliver good growth for many, many years.

We did not buy or sell any stocks during the last quarter of 2017. We’ve been looking at a few new ideas recently, and we’d love to find another investment like Amazon. But right now, we like the portfolio as it is. As always, we value the trust you place with us to manage your money and look forward to communicating with you again next quarter.

U.S. Small & Mid-Cap

Last year was a great year for the U.S. stock market, with all major indices (including our benchmark, the S&P MidCap 400) posting robust gains. Over the course of 2017, the benchmark returned 16.3%, which your U.S. Small & Mid Cap strategy beat handily, with a return of 22.6% for the year, net of fees.

Companies we own in the industrials and real estate sectors were responsible for a large part of your strategy's outperformance. Your best performers include American Woodmark, Jones Lang LaSalle, Proto Labs, and XPO Logistics. With a gain of 112%, XPO Logistics was your big winner for the year. XPO is a top ten global logistics company and their trucking and technology infrastructure is a vital to enabling commerce, particularly for "last mile" delivery of heavy items like refrigerators and washing machines to consumers. XPO's exceptional performance made it your largest holding in this strategy as of the end of the year.

The most notable underperformer in this strategy was Papa John's, which was down 33% last year. Papa John's has an excellent long-term track record of profit growth and the stock was flying high entering 2017 with shares trading at an historically high valuation. Unfortunately, over the second half of the year, the share price fell substantially as it became clear that the market's expectations had been overly optimistic. Additionally, right before Christmas, the company announced that founder John Schnatter stepped down as CEO and was replaced by long-time employee Steve Ritchie. All businesses go through hiccups from time to time, and we still like Papa John's competitive position as the premium quality national pizza chain. We believe its long-term growth prospects remain intact.

We have an optimistic outlook for the companies in this strategy in 2018. On average, revenue is expected to grow 10% in 2018, compared to 2017, and profit growth should be even better. Those estimates will be revised as we go through the Q4 earnings season and management teams discuss how the recent changes to U.S. corporate taxes will affect reported earnings. As we've mentioned before, companies in this strategy will benefit greatly from a lower tax rate. Over three quarters of the companies currently held in the strategy (29 out of 37) have a tax rate greater than 22%, and 20 of those companies are taxed at a rate over 30%. We'll get more specific details on individual companies in the coming weeks, but it looks like 2018 will be a windfall year for corporate profit growth.

We feel an obligation to point out that a lower corporate tax rate comes with the cost of long-term deterioration of the financial strength of our country in the form of higher deficits, higher personal income taxes for lower and middle-class Americans, and gutting of federal spending on social programs. We will not pretend that the benefits we receive as investors do not have costs that are borne by others to offset the lost corporate tax revenue. We are assessing the potential long-term effects this may have on the companies in this strategy, particularly in the consumer discretionary sector, and will keep you up to date via these quarterly updates.

U.S. Small & Mid-Cap Dividend

Last year was a great year for the U.S. stock market, with all major indices (including our benchmark, the S&P MidCap 400) posting robust gains. Over the course of 2017, the benchmark returned 16.3%, while your U.S. Small & Mid Cap Dividend strategy returned 14.2% for the year, net of fees.

Last year, tech and industrials were the strongest performing sectors in the S&P MidCap 400, posting gains of 26.5% and 23.3%, respectively. Together, those two sectors make up approximately one-third of the strategy's benchmark - but only about 17% of the Small & Mid Cap Dividend strategy itself. Since this strategy didn't keep pace with the benchmark largely because we were underexposed to 2017's best performing sectors, you're probably wondering why, and what we're planning to do about it!

Well, first and foremost, this strategy's mandate is to own businesses that pay dividends - which means, unlike the benchmark, we have a self-imposed constraint on the companies we can buy. Out of 120 tech and industrials companies in the benchmark, there are only five companies that pay a dividend: Broadridge Financial Solutions, SAIC and Sabre in tech, and KAR Auction Services and Watsco in industrials.

We do own all five of those companies in your portfolio - and not just because they pay dividends, but because we believe they are high quality companies that pay dividends. (That's a distinction we feel is important!) But given the lack of dividend paying choices amongst industrials and tech companies, this strategy is likely to always be underweight those sectors. But, that's not necessarily a bad thing - over the long term, sectors cycle in and out of overperformance and underperformance.

The wheel should turn, and if tech and industrials fall out of favor, your portfolio will feel the drag less than the benchmark, because of your limited exposure. And, in general, your Small and Midcap Dividend strategy is designed to be conservative. That means, by design, we expect the strategy to slightly lag the benchmark in periods where the market is on fire, as it was in 2017, but outperform when the market is weak.

Last year, the biggest contributors to the strategy's performance were Thor Industries (up 52%), ResMed (up 39%), and Jones Lang LaSalle (up 42%). Thor Industries is the country's largest manufacturer of RV's, and is benefitting from several tailwinds, including low interest rates, baby boomer retirees, and millennials entering the RV lifestyle with their young families. RV volumes are at their strongest levels since the 1970s, and all industry players are indicating there's no end in sight.

The three largest detractors to performance were Papa John's (down 23%), Sabre (down 16%), and Tanger Factory Outlet Centers (down 27%). Papa John's has an excellent long-term track record of profit growth, and the stock entered 2017 with shares trading at historically high valuation multiples. Unfortunately, over the second half of the year, the share price fell substantially as it became clear that the market's expectations had been overly optimistic. Additionally, right before Christmas, the company announced that founder John Schnatter stepped down as CEO and was replaced by long-time employee Steve Ritchie. All businesses go through hiccups from time to time, and we still like Papa John's competitive position as the premium quality national pizza chain and its long-term growth prospects. Of course, we will continue to monitor the situation, and keep you up to date via these quarterly updates.