Portfolio Manager Commentary Q4 '21

Dear Client,

Nick Crow, President, Motley Fool Wealth Management — Nick Crow
President, Motley Fool Wealth Management

2021 has been a difficult year for our portfolio strategies. The last time we ended the year in a comparable situation was Q4 of 2016. Though most of our strategies made money that year, the Large Cap Aggressive Growth strategy was actually down -0.77% net of fees, while the S&P broadly experienced healthy growth of nearly +12%.

At the conclusion of Q4 2021, all of our equity strategies made money for the year, but we underperformed relative to each of our benchmarks.

Making modest gains is no comfort at all when Large Cap Aggressive Growth, one of our core strategies, basically held flat (0.86% net of fees) while the S&P 500 sprinted 28.72% into the distance.

So, what happened?

When the markets are moving in your favor, it’s generally easy to accept the old adage that the price of admission into the arena of long-term outperformance is short-term underperformance.

I’m sure that isn’t a surprise to hear; the surprise of course is the magnitude of the underperformance in 2021 specifically. Being willing to endure a bit of underperformance is very different than actually underperforming by 28% and paying for that privilege to boot.

I believe the relative magnitude of potential underperformance and outperformance is related.

As investors who want the opportunity to trounce the market over the long-term, as we did in 2020 (55.65% vs. 18.40%), we believe we must invest very differently than the market and remain concentrated in our best ideas.

Big differences should mean different outcomes. That’s the whole idea.

But we do need to be cautious. Different isn’t necessarily better, as 2021 demonstrated, just as good years don’t always follow bad ones.

And so we must take a good hard look in the mirror and ask ourselves, have we lost our touch? Is our investing process broken?

As President of Motley Fool Wealth Management, I keep a vigilant and steadfast watch over our investing process.

This quarter is no different. At the conclusion of deep-dive discussions with our investing team and Bryan Hinmon, our Lead Portfolio Manager, and upon personally inspecting our strategies, I remain confident that we pursue a well-founded, thoughtfully grounded, and entirely Foolish investing approach.

I’d like to share with you a portion of Bryan’s discussion with me and our advisors.

...Our team’s investing philosophy is that independent research with a long-term mindset can outperform. We truly believe this is the formula that gives us the greatest chance to generate stellar long-term results.

The ‘independent research’ piece of that equation means that we do our own work and spend our time on the things we think matter most: bottom-up, company research through our lens of Quality.

There is no promise that the market will agree that, at any given time, that is what matters most. We most certainly will misevaluate situations and miss things that seem obvious in hindsight. But we remain steadfast in our commitment to Quality and its ability to win over the long-term.

For more long-term context on all of our strategies, I invite you to take a look at our 3-year, 5-year, and since-inception returns as compared to our benchmarks in our performance charts here.

Much of the market’s rise this past year was driven by cyclical industries and rebounding sectors. Thus, many investors in individual companies – especially high growth companies – saw their stocks go down even while the market rose to record highs.

Those investors who made timely investments in Energy or Real Estate likely did quite well over the past year. But market timing is not what we do here at Fool Wealth. That’s more than a statement; it’s a commitment. Because we believe the market to be far too unpredictable and plays based on market timing to be far too risky to be responsible for your future growth.

It’s incredibly difficult to sit back and watch companies we don’t believe in have great stock performance. It can be tempting to hop on “hot trends” or pick up potentially “easy wins” based on market sentiment.

But we don’t believe that we should do that with our clients’ portfolios. Your portfolio is built around companies; not feelings, not trends, not current events. Your portfolio is composed of companies we believe will thrive well into the future, even though they experienced a down or stagnant year in 2021’s particular market environment.

Still, 2021’s relative performance stings. Here is what I can tell you with certainty:

#1. We hold ourselves to high standards and play to win.

#2. We hate the periods of underperformance, which is why we ensure that we still believe the process we’ve developed will lead to long-term outperformance.

#3. We remain committed to being a deserving steward of your portfolios. We also have proprietary capital invested in the same strategies, so some of our money is being managed right alongside yours. In other words, we have “skin in the game.”

I hope you’ll give us the opportunity to prove that our approach is still the most prudent, and potentially the most fruitful, over the long-term. We certainly believe it ourselves.

Thank you for your patience, and for your continued faith in us. Here’s to smarter, happier, and hopefully richer days ahead.

Sincerely,

Nick Crow
President,
Motley Fool Wealth Management

The above information and the following Portfolio Manager Quarterly Reports (“Reports”) are intended solely for current clients of Motley Fool Wealth Management (“MFWM”) for the purpose of providing insight into how we manage our strategies and our investment philosophy. This information should not be disclosed to third parties or duplicated or used for any purpose other than the purpose for which it has been provided.

Similarly, all information presented herein is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. This information reflects the opinions, estimates and projections of MFWM as of the date of publication, which are subject to change without notice.

Performance results discussed herein and in the Reports represent past performance, which does not guarantee future results. The investment return and principal value of an investment will fluctuate so that current performance may be lower or higher than the performance discussed in the Reports.

Dividend

Portfolio Managers

Tony Arsta, CFA
Jeremy Myers, CFA

One year ago, we wrote that the number one thing we learned in 2020 was that “we should expect the unexpected”, and 2021 certainly didn’t disappoint. Between “meme” stocks, non-fungible tokens (NFTs), supply chain disruptions, and surging inflation there was plenty to keep us on our toes. Despite the chaotic environment, the Dividend strategy held up well. During the fourth quarter, the Dividend strategy posted a 9.89% return, net of fees, versus an 11.03% return for its benchmark, the S&P 500®. That brings returns for the year to 20.86%, net of fees, versus 28.72% for the benchmark.

Annualized Net Returns as of 12/31/2021
	1 Year	3 Years	5 Years
US Large Cap Dividend	20.86%	21.41%	16.20%
Benchmark (S&P 500)	28.72%	26.08%	18.48%

Though we endeavor to beat our benchmark, we expect that this more conservative strategy will rarely outperform in years where the market surges higher. Instead, the Dividend strategy usually shows its merit when markets fall or remain choppy throughout the year. Overall, we’re pleased with a return of nearly 21%, especially considering that we did it with much less volatility than the overall market.

Though we’re not expecting returns in 2022 like we’ve seen over the past two years, we think the Dividend strategy is well-positioned for the current market environment. In recent quarters, we’ve seen investors start to shift their attention from growth stocks to more traditional value-oriented stocks. If that trend continues, it should provide continued tailwinds for the Dividend portfolio. In the interim, we plan to keep a close eye on our existing positions, learn about new businesses, and look to add new positions when attractive opportunities present themselves.

Factoring in position size and performance, these three companies had the largest positive impact on the strategy in the fourth quarter:

Microsoft: 19.51% return; 11.72% weighting
Paychex: 22.04% return; 6.80% weighting
Fastenal: 24.74% return; 5.02% weighting

Microsoft has been a consistent top performer thanks to the rapid growth in its Azure cloud database hosting service, as well as strong demand for its enterprise software-as-a-service (SaaS) solutions. The company is exceptionally well run and continues to execute at a high level.

Paychex weathered the pandemic surprisingly ll with high retention rates of existing customers and the company is seeing increasing demand for both its payroll and human capital management (HCM) services as the economy recovers. The company posted strong quarterly results and expects continued economic recovery in 2022 to lead to strong growth in the coming year.

Fastenal’s reputation for customer service and execution is paying off as it helps customers navigate their logistics and supply chain problems. The company is benefiting from a strengthening economy and improving investor sentiment toward more cyclical stocks in the industrial sector is helping to drive the stock higher.

Factoring in position size and performance, these three companies had the largest negative impact on the strategy in the fourth quarter:

Comcast: -9.62% return; 4.98% weighting
Ventas: -6.59% return; 2.82% weighting
Walt Disney: -8.44% return; 2.15% weighting

Comcast’s stock fell during the quarter over analyst downgrades and concerns that heavy investment in fiber assets by competing telecoms will lead to slower-than-expected subscriber growth. We think that this concern is overblown and the company’s superior assets and excellent management team will ultimately be recognized.

Ventas’ underperformance during the quarter was mostly due to concerns about the new Omicron variant leading to slower occupancy growth in the company’s senior living communities. The company is also dealing with rising labor costs, like many businesses are right now, but those should normalize when the current labor shortage subsides. Longer-term, the industry’s supply-demand dynamics look great thanks to little new construction during the pandemic, and the demographic tailwinds of aging Baby Boomers should drive growing demand for the next decade or more.

Walt Disney’s stock pulled back during the quarter thanks to disappointing earnings and slower-than-expected subscriber growth for the Disney+ streaming service. Investors also seem concerned the new Omicron variant will have an impact on the theme parks and cruise ship business. Long-term we think the company has some of the most valuable assets in the entertainment industry and it will continue to find ways to create shareholder value. (Management has stated that they expect to start dividend payments once cash flow improves and the company returns to a single-A credit rating.)

There were no new transactions during the quarter.

GICS Economic Sector As Of 12/31/2021

Dividend SMA vs SPDR S&P 500 09/30/2021 - 12/31/2021 as of 12/31/2021, GICS Economic Sector, USD

GICS Economic Sector As Of 12/31/2021
Sector Name	Weight
Information Technology	23.03%
Real Estate	20.57%
Consumer Staples	13.19%
Industrials	11.88%
Utilities	8.58%
Communication Services	6.53%
Cash & Equivalents	4.90%
Consumer Discretionary	4.31%
Financials	3.88%
Health Care	3.13%

The above information is intended solely for current clients of Motley Fool Wealth Management (“MFWM”) for the purpose of providing insight into how we manage our strategies and our investment philosophy. This information should not be disclosed to third parties or duplicated or used for any purpose other than the purpose for which it has been provided.

All information presented herein is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. This information reflects the opinions, estimates and projections of MFWM as of the date of publication, which are subject to change without notice. We do not represent that any opinion, estimate or projection will be realized. While we believe this information to be reliable, no representation or warranty is made concerning its accuracy.

Performance results are based on a representative account for each strategy, not individual client accounts. Clients can see their actual account performance on the Interactive Brokers’ website at any time. Client account results may not exactly match the performance of the representative accounts. Such variance is due to a number of factors, including differences in trade prices, transaction fees, market activity, any restrictions have you may have imposed on your account(s), and the amount and the timing of deposits or withdrawals.

The performance information presented herein has been generated during a period of extraordinary market volatility. Accordingly, the performance is not necessarily indicative of results that we may achieve in the future, and we do not represent and it cannot be assumed that the performance of our strategies will be subject to the same economic risk factors that contributed to the above returns. Performance results discussed above represent past performance, which does not guarantee future results. The investment return and principal value of an investment will fluctuate so that current performance may be lower or higher than the performance discussed above. The investment strategy and focus of our model portfolio strategies can change over time. Similarly, there is no assurance that the securities purchased will remain in a model portfolio strategy or that securities sold may not be repurchased. The mention of specific holdings does not constitute a recommendation by MFWM or its affiliates.

To the extent we invest more heavily in particular sectors or industries of the economy, the performance of our strategies will be especially sensitive to developments that significantly affect those sectors or industries. While investing in a particular sector is not a principal investment strategy of any model portfolio, client portfolios may be significantly invested in a sector or industry as a result of our portfolio management decisions. Similarly, a model portfolio’s investment may become concentrated in a small number of issuers. To the extent that we take large positions in a small number of investments, account returns may fluctuate as a result of changes in the performance of such investments to a greater extent than that of a more diversified account. Returns realized by a client account may be adversely affected if a small number of these investments perform poorly.

Index performance is discussed for illustrative purposes only as a benchmark for each strategy’s performance, and does not predict or depict performance of that strategy. While index comparisons may be useful to provide a benchmark for a strategy’s performance, it must be noted that investments are not limited to the investments comprising the indices. Each of the strategy benchmark indices are unmanaged and cannot be purchased directly by investors. It is not possible to invest in an index.

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MFWM is an SEC registered investment advisor with a fiduciary duty that requires it to act in the best interests of clients and to place the interests of clients before its own. HOWEVER, REGISTRATION AS AN INVESTMENT ADVISOR DOES NOT IMPLY ANY LEVEL OF SKILL OR TRAINING. Access to MFWM is only available to clients pursuant to an Investment Advisory Agreement and acceptance of our Client Relationship Summary and Brochure (Form ADV, Parts 2A and 2B). You are encouraged to read these documents carefully. All investments involve risk and may lose money. MFWM does not guarantee the results of any of its advice or account management. Clients should be aware that their individual account results may not exactly match the performance of any of our Model Portfolios. Past performance is no guarantee of future results. Each Personal Portfolio is subject to an account minimum, which varies based on the strategies included in the portfolio. MFWM retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients.

During discussions with our Wealth Advisors, they may provide advice with respect to 401(k) and IRA rollovers into accounts that are managed by MFWM. Such recommendations pose potential conflicts of interest in that rolling retirement savings into a MFWM managed account will generate ongoing asset-based fees for MFWM that it would not otherwise receive.

Fixed Income

Portfolio Managers

Tony Arsta, CFA
Nate Weisshaar, CFA

Like a reunion with an old friend who just had a baby, the third quarter had a lot of familiar territory for debt investors, but also provided entirely new sources of terror.

Inflation continues to provide a worrying background for all discussions of interest rates, debt, and fixed income while the Evergrande default in China sparked comparisons to Lehman Brothers and the Great Financial Crisis.

I’m not a China expert, so I’ll leave the analysis of Evergrande and the Chinese government’s reaction to those developments for others. What I will suggest is that the similarities to the collapse of Lehman Brothers and the ensuing unraveling of the Western financial systems appear to be overblown, although to assume there will be no impact to the global economy seems too optimistic.

Like most things, we believe it’ll probably be somewhere in the middle.

But seeing a massive company like Evergrande default on its borrowings does have meaning for you and the Fixed Income strategy.

When you invest in fixed income securities (also known as a company’s debt), you are entering into a legal agreement with a company to provide them with money today with the promise that they will repay that money plus interest at a predetermined point down the road.

Being a debt holder gives you a special place in line when it comes to getting paid by a company. There are various types of debt and each comes with a different place in line, but usually banks are at the front. In nearly all cases, however, being a debt holder puts you in line ahead of stock (or equity) holders.

Net Returns
	Third Quarter	1 Year	3 Years	5 Years	Inception
Fixed Income Strategy	-0.21%	0.23%	2.72%	1.45%	1.43%
Bloomberg Barclays US Corporate Bond Index	0.08%	1.31%	5.83%	3.78%	4.06%

That’s why some of Evergrande’s debt holders are getting paid (at least partially) while the stock collapsed 85% from a year ago – with more than $300bn in liabilities outstanding and a lot of debt holders in front of them in line, the odds that stockholders will walk away with anything more than a bad taste in their mouths are very low.

But that doesn’t mean debt holders are guaranteed to get the payments they’re legally entitled to. If a company can’t come up with enough money, it’s possible no one gets paid.

This is why we divide companies into groups based on the likelihood they’ll make good on their promises. The two major divisions are “investment grade” and “high yield.” Investment grade companies have been deemed most likely to pay everyone back. When you’re in this group, as implied by the name of the second group, you get to borrow at lower interest rates (or yield).

Because of this, we take a cautious stance when it comes to exposing your money to default risk. We’ve invested 81% of the Fixed Income strategy into investment grade corporate debt. Another 10% is in mortgage-backed securities – which, despite the experience in 2007-2008, are relatively low-risk. Only 6% of your portfolio is allocated to high yield debt securities, and these are short-term debt (maturing in 2 years on average), so should be relatively predictable.

As mentioned in previous commentaries, we’ve invested (indirectly via ETFs) mainly in short-term debt because we anticipate interest rates will rise over the coming years (they can’t go much lower), and holding short-term debt in that scenario is beneficial for several reasons.

Of course, the combination of investment grade and short-term debt also means the interest rates on offer are not particularly attractive. However, chasing a little extra yield by taking on added risk (either via non-investment grade investments or longer maturity) doesn’t make sense to us in this market environment.

The way we’ve structured the Fixed Income strategy will mean underperforming the benchmark – as we did this quarter and since inception – unless or until we see interest rates consistently rise, but we’ve placed an emphasis on protecting your dry powder and think this is the best way to do so.

International

Portfolio Managers

Tony Arsta, CFA
Michael Olsen, CFA

While U.S. stocks posted strong returns into the year-end, their international counterparts were comparatively muted. Underlying this was a potent trifecta: resurgent COVID cases and a more infectious Omicron variant increased the likelihood of restricted social/economic activity, and supply-chain tightness and inflation raising the possibility of higher interest rates. Taken together, the two weighed on markets, and the International strategy was not immune – declining -1.0% in the fourth quarter (net of fees), versus a +1.4% gain for our benchmark, the S&P Global ex-U.S. BMI.

While we aren’t pleased with these results, we believe some context is instructive: The best businesses do not become stronger on a linear scale, but in fits and starts, as long-term investments bear fruit. Investing is much the same. In turn, our process hasn’t changed much. We continue to manage our International strategy with the same mindset as before, endeavoring to own a collection of highest quality, internationally-domiciled businesses, and taking a long view of their prospects (and our investments in them).

Annualized Net Returns as of 12/31/2021
	1 Year	3 Years	5 Years
International	5.57%	18.20%	11.69%
S&P Global ex-U.S.	8.67%	14.20%	10.43%

We believe that if we execute on these ends, our results should follow. Equally significant, we think that our results over longer periods support this view, and the importance of process adherence.

Portfolio Review

On evaluating security-specific drivers of portfolio performance, the underlying drivers are broad: idiosyncratic, company-specific elements contributed to gains in key contributors, and a confluence of macro-concerns and business-specific factors weighed on detractors. As before, a portion of the International strategy remains invested in ETFs to achieve geographic exposure: 20.5% on average, returning 0.5% on a weighted average basis.

Among key contributors, the list resembled recent history:

ICON: 18.20% return; 5.41% average weighting
Brookfield Asset Management: 13.14% return; 7.37% average weighting
Novo-Nordisk: 16.66% return; 5.01% average weighting

Contract research organization ICON once again delivered an impressive quarterly return, up 18.2% on strong backlog growth, optimistic commentary regarding its merger with PRA, and upward revisions to guidance on strong growth and cost containment efforts. Looking forward, we remain enthusiastic about the combined company’s prospects – we expect increased outsourcing of biopharma R&D, share gains by ICON, and continued margin expansion to drive sustained double-digit annualized growth to free cash flow.

Infrastructure investment giant and asset manager Brookfield Asset Management sustained its recent string of standout returns, turning in a 13.1% gain on the heels of record inflows to its funds, topping its $100 billion assets under management goal, and impressive returns on recently sold investments. As one of the best-pedigreed investors in the space, we think Brookfield possesses a ready-and-reliable growth algorithm and remain happy owners of the shares.

Insulin giant Novo-Nordisk again landed on the list of key contributors, notching a 16.7% gain. Like ICON, the story was much the same as last quarter: Solid results from its core insulin business, and enthusiasm surrounding its weight loss drugs’ prospect pushed shares higher. We continue to believe Novo represents a well-moated cash cow, and it’s delivering the goods.

And the list of detractors follows:

MercadoLibre: -19.71% return; 5.51% average weighting
Medtronic: -16.96% return; 3.58% average weighting
Softbank Group: -17.18% return; 2.91% average weighting

Latin American e-commerce and payment company MercadoLibre declined 19.7%, despite strong quarterly results, continued adoption of e-commerce in its most important geographies, and ongoing share gains by its payments platform, MercadoPago. At root were a trio of factors, in our estimation: concerns over surging COVID cases on Latin American economies, a spike in non-payments of installment loans at peer companies (many e-commerce transactions are paid by installment in Latam), and market-wide declines in highly-valued tech companies. We continue to believe MercadoLibre can grow at extraordinary rates for extended periods, but remain mindful of its valuation and the macro risks of conducting business in Latam – part of the reason we trimmed our position earlier this year.

Shares of medical device company and stent-maker Medtronic fell 17% as concerns over emergent COVID cases weighed on its outlook. Because most procedures requiring Medtronic devices are elective – higher COVID cases might reduce hospital capacity or compel patients to reconsider non-essential surgeries – and healthcare workers are in short supply, Medtronic recently cut its guidance. We believe these pressures are unlikely to endure over the long-term, and in turn, continue to hold our shares.

Japanese investment conglomerate Softbank Group’s shares dropped 17.2% during the quarter, consistent with the decline in Alibaba, in which it holds a 25% stake, and which accounts for a large proportion of its underlying value.

Portfolio Activity

We made one purchase during the quarter, adding to our position in Vivendi after it completed the spin-off of Universal Music Group. At the time of our purchase, the remaining entity appeared quite cheap to us: Roughly 66% of its value could be attributed to cash and its 10% stake in UMG – allowing a valuable call option on Vincent Bollore’s outstanding long-term investment record, and the opportunity to participate in UMG’s ongoing value accretion as a public entity. Indeed, if we valued Vivendi’s cash and investments at face value, the market ascribed almost no value to two of Vivendi’s operating businesses: pay-TV and studio operator Canal, and advertising agency Havas. Acknowledging the underlying quality of UMG, as a business and asset, and our confidence in Bollore’s long-term record, we were keen to up our stake.

International Strategy vs Vanguard Total International Stock Index Fund

9/30/2021 - 12/31/2021

International SMA vs Vanguard Total International Stock Index Fund
Sector Name	Weight
Consumer Non-Cyclicals	4.08%
Healthcare	14.00%
Telecommunications Services	8.09%
Energy	1.00%
Industrials	5.35%
Consumer Cyclicals	4.50%
Financials	13.95%
Information Technology	21.62%
Cash & Equivalents	6.88%
N/A*	20.53%
*Represents ETF holdings.

Large Cap Core

Portfolio Managers

Tony Arsta, CFA
Jeremy Myers, CFA

To say that 2021 was “unusual” from a financial market perspective would be an understatement. Not only did we experience periods of widespread speculation with “meme” stocks and cryptocurrencies generating significant returns in periods of mere days, but we also experienced the highest inflation readings we’ve seen since 1982. You would think that this combination would have led to a volatile stock market, but volatility was subdued all year.

The Large Cap Core strategy was tracking just slightly behind its benchmark during most of the year, but it began losing ground in the third and fourth quarters thanks to weak performance by some of the more growth-oriented positions in the portfolio. During the fourth quarter, the Large Cap Core strategy posted a 4.46% return, net of fees, versus an 11.03% return for its benchmark, the S&P 500®. That brings returns for the year to 16.13%, net of fees, versus 28.72% for the benchmark.

Annualized Net Returns as of 12/31/2021
	1 Year	3 Years	5 Years
US Large Cap Core	16.13%	26.60%	22.20%
Benchmark (S&P 500)	28.72%	26.08%	18.48%

We’re never happy to underperform our benchmark, but had you told us at the beginning of the year that we’d earn a 16% return, we’d happily take it. Our portfolio looks very different than the overall market with higher exposure to the Information Technology sector and no exposure to sectors like Energy, Materials, or Utilities. That means in years like this when the Energy sector is the top performer, we’re likely to underperform. We accept the risk of short-term divergences from the market because we believe that our strategy of only holding high-quality businesses that control their own destiny – versus those tied to commodity prices – will generate better, more predictable returns over the long-term.

Heading into 2022 we expect that the volatility we experienced in the growth side of the portfolio will continue and create some compelling opportunities to buy great businesses. We’ll continue to monitor the performance of our existing portfolio and we hope to find a few exciting new positions to add as the year progresses. In the meantime, we expect the more value-oriented names to continue performing well if investors’ recent rotation from growth stocks to value stocks continues.

Factoring in position size and performance, these three companies had the largest positive impact on the strategy in the fourth quarter:

Apple: 25.67% return; 8.34% weighting
Microsoft: 19.51% return; 7.29% weighting
Costco: 26.54% return; 3.78% weighting

Apple has been on a roll in 2021 thanks to healthy demand for its iOS devices and the ever-growing ecosystem of products and services that compliment them. In the most recent quarter, Apple reported 33% revenue growth, mostly driven by new iPhone upgrades. The company has also done a better job than most of navigating recent supply chain disruptions to make sure its shelves were stocked for the critical holiday season.

Costco was a big winner during the pantry-stuffing days of the pandemic, and it continues to perform well as the company’s e-commerce channel slowly catches up to its peers following years of underinvestment. The company also appears to be dealing effectively with both supply chain issues and inflationary pressures and has been able to pass through price increases when necessary.

Factoring in position size and performance, these three companies had the largest negative impact on the strategy in the fourth quarter:

PayPal Holdings: -27.53% return; 5.84% weighting
Splunk: -20.03% return; 3.67% weighting
Comcast: -9.62% return; 4.37% weighting

PayPal’s business is performing well, but the management’s 2022 guidance for 18% revenue growth disappointed investors. The company’s valuation had gotten a little stretched following strong performance in 2020, which left little margin for error. We’re watching the increase in competition in the payment industry, but we think PayPal has a strong market position and will continue to invest heavily in innovation to drive future growth.

Splunk reported better than expected third quarter results, but the good news was overshadowed by the board of directors’ decision to transition to a new CEO. In the interim the company is being led by board member and former Salesforce CFO, Graham Smith. Though the business appears to be performing well, the added uncertainty of a leadership change will likely weigh on the stock for a couple more quarters.

Comcast’s stock fell during the quarter over analyst downgrades and concerns that heavy investment in fiber assets by competing telecoms will lead to slower than expected subscriber growth. We think that this concern is overblown, and the company’s superior assets and excellent management team will ultimately be recognized.

There were no new transactions during the quarter.

GICS Economic Sector As Of 12/31/2021

Large Core SMA vs SPDR S&P 500 09/30/2021 - 12/31/2021 as of 12/31/2021, GICS Economic Sector, USD

GICS Economic Sector As Of 12/31/2021
Sector Name	Weight
Information Technology	36.01%
Consumer Discretionary	29.82%
Communication Services	23.55%
Real Estate	4.43%
Cash & Equivalents	3.47%
Health Care	2.72%

Hedged Equity

Portfolio Managers

JP Bennett, CFA
Michael Olsen, CFA

How did the market respond after closing the third quarter on a near -5% swoon? With one of its strongest quarters in recent history. The S&P 500 gained 10.9%, led by a recovery in large cap growth, on the back of a continued cyclical recovery in corporate earnings and profitability. A strong economy, marked by falling unemployment and cash-rich consumers, has led to rising inflation and expectations of interest rate increases.

Even with 10-year treasury yields flat, corporate bonds fell a bit and value markedly outpaced growth in small and mid cap stocks. Richly valued growth stocks and software businesses, in particular, sold off hard. This latter point contributed to underperformance of the Hedged Equity strategy, which only gained +0.4%, versus its benchmark (70% of the S&P 500) which rose +7.7%.

We are unsatisfied with our 2021 performance, but remain pleased with longer-term outcomes – especially in controlling drawdowns during times of stress (during March 2020, for example). We can’t control what happens in any given year, but do believe that over longer measurement periods, outcomes more accurately reflect our process and decision making.

Annualized Net Returns as of 12/31/2021
	1 Year	3 Years	5 Years
Hedged Equity	4.18%	19.14%	15.05%
Benchmark (70% of S&P 500)	19.53%	18.03%	12.91%

Portfolio Review

Factoring in size and performance, these three companies had the largest positive impact on returns during the quarter:

Watsco: +19.05%, 6.81% average weight
ICON: +18.20%, 5.32% average weight
Brown & Brown: +26.95%, 3.20% average weight

While Watsco’s core business (selling replacement heating and air conditioning units and parts) is not very economically sensitive, it is benefitting from homeowners with strong finances spending more time at home. For their replacement purchases, they are opting for higher-priced, more energy-efficient products. Watsco has developed selling tools to help technicians clearly communicate the value and benefits of these products and they’re selling well. The company is also showing its ability to pass along rising input costs and to preserve, and even grow, profit margins. Watsco remains a top holding.

This is the second quarter in a row outsourced biopharma provider ICON’s shares made the list. Management is executing well in an environment ripe for complex new drug trials and integration of Pharmaceutical Research Associates appears on track. As we wrote last quarter, we believe ICON’s prospects remain strong—as we expect growth in R&D outsourcing by large biopharmaceutical companies, share gains by the largest and most capable contract research organizations, and consistent execution from management.

Brown & Brown is an insurance broker that is churning out great results – third quarter growth and profitability were outstanding. Insurance, itself, is a cyclical market and Brown is benefiting from strong pricing that won’t last forever. However, its ability to grow policy count, make smart acquisitions, and manage costs have helped its business perform well through up and down cycles.

Factoring in size and performance, these three companies had the largest negative impact on returns during the quarter:

Everbridge: -55.42%, 2.93% average weight
Upland Software: -46.35%, 1.88% average weight
Cardlytics: -21.27%, 2.73% average weight

In early December, during a widespread sell-off of many software businesses, Everbridge announced the unexpected resignation of its CEO and preliminary 2022 guidance that was lower than expected. This was a powerfully poisonous cocktail and shares fell by nearly half. We have since learned that the CEO was hired away (to a private company, in his hometown) and that there doesn’t seem to be any deeper issue at play. In our view, the slower than expected growth in 2022 doesn’t suggest an unacceptable level of demand, a weakening position, or troubled execution. While we remain believers in the industry this company has pioneered (critical event management) we acknowledge the risk of an abrupt executive departure at a critical time for execution (trying to capitalize on European Union mandates and integrating the company’s largest acquisition).

Upland Software is still the same business we thought it was when we purchased it earlier this year. We misjudged the level of organic growth others expected and shares have been driven lower. At this point expectations are low and we believe the newly hired operators can put the foundation in place for steady, if modest, organic growth. The primary reason the business model should succeed is the proven acquisition engine and pipeline. While shares are in “prove it” mode we see the building blocks in place for exactly that.

Cardlytics continued its downward slide. We suspect investors are on edge as the company renegotiates its contract with its largest partner, Bank of America. We expect this to get sorted out, and given the value Cardlytics provides, to do so at mutually beneficial economics. As this high-profile issue remains outstanding, the team at Cardlytics is hard at work building the new ad platform and bringing on new advertisers. 2022 should be an exciting year as the Bank of America contract gets resolved, US Bank gets rolled out meaningfully on the new ad server, and the self-serve platform becomes available more broadly to ad agencies.

Portfolio Changes

We made adjustments to the portfolio towards the end of the quarter that had a few notable impacts. First, we marginally reduced gross and net exposure by trimming a trio of our largest positions and changing the nature of our credit quality short position. We also rebalanced the individual short book and our market hedges, partially in response to one of our index ETFs becoming hard to borrow, and partially to better reflect the makeup of the portfolio. Finally, we made a few position-specific changes to round out risk exposures.

We added to Howard Hughes, which should benefit from the persistent strength in the housing market and, given its status as a collection of real assets, would benefit from continued inflation. We also purchased Signature Bank. Signature is a bank, but it’s a special one. It serves mid-sized businesses and their founders with white glove service. This client-first mentality is a differentiator and runs deep through the veins of its bankers. It has grown organically and only broadened its business when it could attract the right talent to manage it. There is a culture and managerial discipline that we believe separates the company from its commodity-like peers. Signature reminds us of other special banks that exist (like First Republic and SVB Financial). Signature should be a beneficiary in a rising rate environment and should benefit from the consistent flow of entrepreneurship that drives its capital call lines.

GICS Economic Sector As Of 12/31/2021

Hedged Equity SMA vs SPDR S&P 500 09/30/2021 - 12/31/2021 as of 1/3/2022, GICS Economic Sector, USD

Hedged Equity SMA vs SPDR S&P 500 09/30/2021 - 12/31/2021 as of 1/3/2022, GICS Economic Sector, USD
	Long	Short	Net	Gross
Totals	103.05%	-23.27%	79.78%	126.31%
Materials	0.00%	-1.84%	-1.84%	1.84%
Industrials	14.77%	-2.36%	12.41%	17.13%
Consumer Discretionary	10.24%	-1.87%	8.37%	12.11%
Consumer Staples	0.00%	-0.48%	-0.48%	0.48%
Health Care	12.00%	0.00%	12.00%	12.00%
Financials	6.50%	0.00%	6.50%	6.50%
Information Technology	25.20%	-5.87%	19.33%	31.07%
Communication Services	23.59%	-0.68%	22.91%	24.27%
Real Estate	10.74%	0.00%	10.74%	10.74%
N/A	0.00%	-10.17%	-10.17%	10.17%
Cash & Equivalents	20.22%	0.00%	20.22%	20.22%

Large Cap Aggressive Growth

Portfolio Managers

Tony Arsta, CFA
Jeremy Myers, CFA

2021 was a wild year for the financial markets on multiple fronts. We started the year with widespread speculation in “meme” stocks, cryptocurrencies, and non-fungible tokens (NFTs), and ended the year with rising interest rates, supply chain disorder, and the Omicron variant. Even so, the stock market managed to push steadily with surprisingly little volatility along the way. The same can’t be said for the Aggressive Growth strategy. During the fourth quarter, the Large Cap Aggressive Growth strategy posted a -5.12% return, net of fees, versus an 11.03% return for its benchmark, the S&P 500®. That brings returns for the year to 0.86%, net of fees, versus 28.72% for the benchmark.

Annualized Net Returns as of 12/31/2021
	1 Year	3 Years	5 Years
US Large Cap Aggressive Growth	0.86%	26.19%	23.32%
Benchmark (S&P 500)	28.72%	26.08%	18.48%

Following a blowout year like 2020, this degree of underperformance is disappointing, but it is not completely unexpected. Higher-risk strategies are often characterized by a wide variance in returns from year-to-year. Further, the Aggressive Growth portfolio is concentrated among a relatively small number of individual stocks and looks very different than the overall market, so we expect that it will also behave very differently than the market overall. This short-term volatility is the price we pay to hopefully generate higher returns on our investments over longer multi-year periods. In other words, it’s nearly impossible to have years of massive outperformance, like 2020, without risking the occasional year of underperformance along the way.

Also, in years like this, when more value-oriented sectors like energy, real estate and financials are top performers – areas where we have little or no exposure – it will be incredibly difficult to match the market, let alone beat it. This situation is very similar to what happened in 2016, when we last underperformed the market by a significant margin. The good news (if you choose to view it that way) is that we’ve been here before. In 2017, instead of panicking we stayed focused on our strategy, concentrated even more on our highest conviction investment ideas, and went on to post another year of outperformance.

That’s not to say we’ll see the same thing happen in 2022, but our experience has shown that it pays to stick to our process rather than chasing what’s hot right now. We believe in the quality of businesses we own in the portfolio and we expect that will eventually be recognized by the market. In the meantime, we’ll continue to look for innovative, fast-growing companies across all industries and then filter them based on the quality of both the business and the management team. This is a strategy that will turn up a number of losers over time, but if we allow the winners to compound, over time they will more than make up those misses. This strategy has served us well in the past and we expect it will do the same in the future. There will be disappointing years like this from time to time, but we’re more motivated than ever to dig in and search for new opportunities and plant the seeds for future returns.

Factoring in position size and performance, these three companies had the largest positive impact on the strategy in the fourth quarter:

Alphabet: 8.57% return; 11.24% weighting
Palo Alto Networks: 16.23% return; 5.00% weighting
BioMarin Pharmaceutical: 14.31% return; 2.46% weighting

Alphabet put an exclamation point on an outstanding 2021 with strong fourth quarter performance. Advertising spending has rebounded strongly during the year and continues to accelerate as the global economy recovers. The company’s cloud hosting business is gaining traction against AWS and Azure and the business is moving toward profitability as it scales.

Palo Alto is benefiting from the launch of its new cloud-based security solutions to complement its market-leading security hardware. This has created cross-selling opportunities as more clients look to consolidate their security spending with fewer vendors. The increase in high-profile security breaches and ransomware attacks has made cybersecurity a mission-critical purchase and we expect budgets to continue to increase over time.

BioMarin’s stock is finally moving in the right direction again following the November approval by the FDA and EU of its drug Voxozogo, which is used to treat the most common cause of dwarfism. Investors are also optimistic that the company will receive approval for its hemophilia drug Roctavian in 2022 once it submits the additional two years of data that was requested by the FDA when it was denied in 2020.

Factoring in position size and performance, these three companies had the largest negative impact on the strategy in the fourth quarter:

PayPal Holdings: -27.53% return; 6.52% weighting
MercadoLibre: -19.71% return; 8.38% weighting
Splunk: -20.03% return; 6.96% weighting

Like PayPal, MercadoLibre is also a victim of its own success – and richly priced stock. The recent pullback in shares seems to be more the result of market sentiment toward high-growth stocks than any particular failure by the company. We continue to like MercadoLibre’s position as the dominant e-commerce and payment provider in Latin America.

We sold our position in MarketAxess Holdings during the quarter. We’re optimistic about the company’s potential, but competition has increased and the future appears less certain. We are reallocating to higher conviction ideas while we reevaluate the company’s prospects.

GICS Economic Sector As Of 12/31/2021

Large Aggressive SMA vs SPDR S&P 500 09/30/2021 - 12/31/2021 as of 12/31/2021, GICS Economic Sector, USD

GICS Economic Sector As Of 12/31/2021
Sector Name	Weight
Information Technology	36.01%
Consumer Discretionary	29.82%
Communication Services	23.55%
Real Estate	4.43%
Cash & Equivalents	3.47%
Health Care	2.72%

U.S. Small & Mid-Cap

Portfolio Managers

Tony Arsta, CFA
Nate Weisshaar, CFA

The performance of the U.S. Small and Mid Cap strategy during the fourth quarter of 2021 badly lagged its benchmark, putting up returns of -3.17% net of fees vs. positive returns of 8.00% for the S&P MidCap 400. For the year, the portfolio returned 5.81% net of fees vs. 24.77% for the benchmark. This underperformance of nearly 19% exceeded last year’s portfolio outperformance of over 16% (30.03% portfolio net of fees vs. 13.64% for the benchmark), and is a reminder of the tendency of investment performance (good or bad) to revert to the mean. For the last three and five years the U.S. Small and Mid Cap strategy is still modestly outperforming its benchmark, although that outperformance has been substantially reduced by 2021’s numbers.

Annualized Net Returns as of 12/31/2021
	1 Year	3 Years	5 Years
U.S. Small & Mid-Cap	5.81%	21.56%	14.27%
Benchmark (S&P MidCap 400)	24.77%	21.41%	13.09%

An absolute loss of 3% in the quarter itself is one we have seen and will see again many times, but the relative performance of strategy against benchmark was unprecedented and we do not expect the strategy to perform so poorly against benchmark again. In fact, the “shoot first and ask questions later” reaction of the market to some specific pieces of news regarding portfolio holdings brings with it the possibility that the answers to those questions aren’t nearly as bad as initial market reaction presumed, and that a rebound in a number of positions appears merited. Let’s start with the good news for the positions.

Factoring in position size and performance, these three companies had the largest positive contribution to performance in the fourth quarter of 2021:

Brown & Brown: 26.95% return; 5.06% average portfolio weighting
Stag Industrial: 23.18% return; 3.31% average portfolio weighting
Watsco: 19.05% return; 4.81% average portfolio weighting

Stag Industrial benefitted from general market enthusiasm for real estate plays during the quarter. The REIT, focused on industrial properties, is in the right place for a growing e-commerce economy and reported results that mildly beat expectations and raised guidance for the end of the year. That recipe was enough in a market that was increasingly focused on value over growth during the quarter.

Watsco, a large and very successful holding in the portfolio, continues to see strong sales of air conditioning, refrigeration, and ventilation equipment as people focus on both homes and air quality in the time of COVID. Watsco is a stock with strong earnings, reasonably predictable growth, and excellent management. Even at all-time highs for its stock, it is a holding that is not likely to ever cost us any sleep.

On to the less pleasant side of things…

Factoring in position size and performance, these three companies had the largest negative contribution to performance in the fourth quarter of 2021:

Everbridge: -55.42% return; 3.20% average portfolio weighting
Heska: -29.42% return; 2.94% average portfolio weighting
Avalara: -26.13% return; 2.84% average portfolio weighting

Heska shares were hit after a critical report was published about the company’s business. We reviewed the allegations and determined that, in our view, there was “no there, there.” Still, in a skittish market, investors shoot first and ask questions later. The company’s third quarter earnings report was good in our eyes (with healthy growth in consumables, an evolving expansion strategy overseas, and new product launches) and we remain impressed at how the company is executing.

Avalara, the tax reporting software company, reported generally excellent results in the third quarter, tempered with the news that it was increasing costs that would impact margins slightly. The net effect was that analysts increased revenue expectations, but see the company earning about $0.10 less per share on an annual basis in 2022 and 2023. Given that Avalara is not yet profitable, this wasn’t greeted warmly, and shares took a hit. Avalara shares were up 135% in 2019 and 125% in 2020. Last year’s decline of 21% seems reasonable, and long-term shareholders should still be satisfied with both their 3-year returns and the still-bright future that this rapidly growing company has in front of it.

We made no trades during the quarter. We expect slightly more turnover in the near future, but we remain long-term investors and continue to like what we hold.

U.S. Large Cap: Vanguard S&P 500 ETF (VOO)

We believe U.S. large-cap stocks form the backbone of a diversified portfolio, and we intend for this asset class to serve as the anchor of our passively-managed investing approach. The S&P 500 index is an ideal tracking vehicle, as it offers a wide range of well-established and relatively stable companies for investment.

Domestic large-cap stocks closed out the year in strong fashion. It was not an “up and to the right” year, however. Countless catalysts for bad market performance were all overcome in the end, aided by the best quarter since Q4 2020. Market uncertainty will always be a part of investing and it goes to show that a strategic and disciplined approach is the way to go. Concerns surrounding the Omicron variant and rising interest rates have dominated the headlines recently, but you would not know it by looking at the stock market’s performance.

Most sectors contributed double-digit growth in the fourth quarter, with Communications Services being the only category to finish in the red. Overall, the domestic large-cap stock market ended the year up approximately 30%. As usual, we expect domestic large-cap stocks to continue to play a significant role in our asset allocation models going forward.

U.S. Mid Cap: Vanguard Mid-Cap ETF (VO)

U.S. mid-capitalization stocks (broadly defined as having a market cap between $2 billion and $15 billion) offer an additional layer of equity diversification by allowing investors to benefit from the return potential of companies that combine the stability of larger names with the growth potential of smaller firms.

Domestic mid-cap stocks also had a strong end to the year. Posting a return just short of large-caps in the fourth quarter continued the trend for 2021 as mid-caps only slightly underperformed its larger counterparts by a couple points on the year. Mid-cap stocks had an outstanding year, and despite their relatively higher valuations, this asset class will continue to be represented in our models as we move into the new year.

U.S. Small Cap: Vanguard Small-Cap ETF (VB)

U.S. small-capitalization stocks (broadly defined as having a market cap of less than $2 billion) provide an opportunity for greater growth and higher potential returns than their larger equity counterparts, although those returns tend to come with a touch of higher volatility.

Although the small-caps fared worse than mid- and large-cap stocks in the fourth quarter and the year, it was refreshing to see that its advance was far broader than its counterparts. The return of an equal-weighted index of the sector was higher than the capitalization-weighted index for the year, showcasing that more companies participated in the performance than in the large-cap space. Continuing with the trend of the year was the small-cap value vs. growth story: the fourth quarter of 2021 was the fifth-straight quarter of value outperforming growth. The small-cap value index advanced just under 30% with the small-cap growth index only up a hair below 3% in 2021. The disparity was close to the record since 1979, but came in second place instead.

While small-cap stocks did not perform up to par with large-caps, looking over a longer time frame, smaller names have a very favorable risk-reward trade-off. As a result, we expect to continue to allocate to small caps within our models to capture that higher return potential.

International Developed: Vanguard FTSE Developed Markets ETF (VEA)

International stocks are a vital asset class for building a well-balanced portfolio in today’s global world. Developed stock markets are domiciled in countries with advanced economies and well-established trading and regulatory environments. As a result, they serve as the core of our international allocation.

International developed markets stocks, bouncing back from a down quarter in Q3, had a relatively strong end to the year. The sector added just over a 2.5% return in Q4 to bring its yearly return into the double digits. Although France and the United Kingdom had phenomenal growth, Japan’s performance brought down the broader market, especially since it has the largest weight in the index.

We continue to see attractive valuations in comparison to the domestic market, and will pursue meaningful investments in overseas equities in our models.

International Emerging: Vanguard FTSE Emerging Markets ETF (VWO)

Emerging market stocks are domiciled in foreign countries that tend to exhibit more rapid economic growth than developed nations, which can translate into faster stock market appreciation. This higher return potential comes with added risk, but in a carefully considered allocation this asset class can add meaningful value to a portfolio.

Continuing the trend of the third quarter, emerging markets stocks had abysmal performance in Q4. The magnitude of losses was not nearly as bad, but this section of the global market continues to underperform. The prolonged and severe underperformance is not too surprising given the concern around the Omicron variant, however, as these countries have less-developed health systems and are largely under vaccinated.

As we have mentioned this year already, China and Brazil have been large contributors to the negative performance of emerging market stocks in 2021. New in Q4, Russia reversed course and posted a return of around negative 7%, although for the year the return was close to 15% in the black.

Similar to Developed Markets, we find valuations here compelling and in the long run, we believe maintaining exposure to this rapidly-growing segment of the world market is vital.

Real Estate: Vanguard REIT ETF (VNQ)

As an asset class, real estate offers a lower correlation with many other portfolio assets, as well as meaningful return potential. This “alternative” asset class can also provide a relatively stable income flow and ongoing protection against inflation.

REIT’s got off to a great start in 2021 and rarely faltered the rest of the year. Real estate was the strongest sector in Q4 and ended the year around the 50% gain mark, closing just below Energy which was the top performer. While we don’t expect 2022 to yield as great a return, we believe that real estate has been a compelling holding over long periods of time, and we still see value in holding this asset class over the long-term.

Fixed Income: Vanguard Total Bond Market ETF (BND)

Fixed income securities are a vital diversifying complement to higher-risk equities. While bonds may not offer the same long-term return potential as stocks, they dampen overall volatility and can provide a reliable source of income, making their inclusion in most portfolios a winning proposition.

Zig-zagging around the unchanged line, the domestic bond markets ETF ended the fourth quarter slightly negative. With rates on an upward trajectory to start, November provided a head-fake in the form of the Omicron variant. Omicron spooked the markets into thinking we could see COVID-19 come back in full force, but the mild nature of this variant’s symptoms eased concerns relatively quickly. As such, rates continued their ascent into the end of the year causing bond prices to falter a bit. While we expect the foreseeable future to generally be characterized by rising interest rates, which will exert downward pressure on bond prices, we still view fixed income securities as an essential tool for managing total portfolio risk.

Fixed Income: iShares National Muni Bond ETF (MUB)

Municipal bonds offer income streams that are exempt from federal – and sometimes state and local – income taxes, making them especially useful for investors in higher tax brackets. To gain exposure to this asset class, we chose a low-cost, broad-market fund that invests in a wide variety of bonds issued by various government entities across the country.

Municipal bonds bounced back from their negative third quarter to post moderately positive returns and ended the year on a high note. The quarter’s performance was mostly due to a great month of November, with some main drivers being the revisions to the infrastructure bill and falling interest rates due to the resurgence of COVID in the form of the Omicron variant. Demand for tax-exempt bonds continues to be high, as expectations for possible tax increases are on investors’ minds. Municipal bonds maintain an astounding 24% share of outstanding debt, up steadily from 16% five years ago, according to the Federal Reserve.

We will continue holding an allocation to municipal bonds for investors as the sector should provide reasonable tax-free return opportunities over the long run and a slight asset class differentiation from taxable fixed income securities.

Fixed Income: Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)

Treasury Inflation-Protected Securities (TIPS) are designed to minimize inflation risk, providing investors with a guaranteed real rate of return. The principal component of these bonds is indexed to inflation, so as inflation rises, the principal and corresponding coupon payment also rise in step.

With the Fed finally deleting “transitory” from their vocabulary regarding inflation, it is not surprising that TIPS were the best performing bond ETF in our portfolio this quarter. Although it is unlikely that we see similarly high inflation numbers in 2022, we still believe that holding an allocation to this asset class is important, especially for investors who are close to or in retirement. TIPS help to alleviate the concern of maintaining purchasing power over time, and thus will continue to have a place in our passive portfolios for the long-term.

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Nick Crow