Q:  What is the history of the company and the fund? A : The Smaller Companies Fund has about $70 million and was started on June 30, 2003 and has four sub-advisors. The fund is just one of a number of funds that we have under the Litman Gregory Masters umbrella. Our oldest fund is the Litman Gregory Masters Equity Fund, which goes back a little over 16 years. We were almost the pioneers, if you will, of this type of strategy where we are combining the best ideas from who we consider to be the best investors. We have many years of experience in not only selecting managers, but also selecting managers who can add value through concentration. Q:  What is your investment philosophy? First, we think it is possible to identify investment managers who will deliver long-term superior performance relative to peers and benchmarks. We think that we can outperform index funds over time. Our belief is based on numerous years of experience in evaluating stock pickers and mutual funds, which we use on behalf of our investment management clients for 25 years. Second, we also think most stock pickers only have a handful of what they consider truly great ideas at any given time. When you have a portfolio limited to only these great ideas, over time they should be able to outperform, not only their benchmark and their peers, but also their broader portfolio. Stock pickers typically manage portfolios that are more diversified than just these high conviction holdings in order to reduce risk and/or facilitate the management of larger assets under management. Essentially our thesis boils down to getting only the best ideas from those who we consider to be among the best investors. And then by combining several such managers in a single fund, the overall fund portfolio is adequately but not excessively diversified. A :Q:  What is your manager selection process? A : Our manager selection process is what we would consider rigorous and highly qualitative. We ultimately want to understand how a manager thinks and how they make decisions, and why. We try to assess what differentiates this manager from the huge swath of investment managers that are out there. We try to identify an edge; something that distinguishes them, something they do better than other people that will enable them to outperform the herd over time. What this involves is a lot of hours of conversation with these managers. Initially it will start off with a couple hours of phone calls with the portfolio managers themselves and that will lead to conversations with analysts, business owners, former employees, but ultimately what we are doing is we are assessing what hopefully is a well-defined investment process. We want to see the confidence that they can act independently. We are looking for things like intellectual honesty to realize a mistake and learn from it and move on. We are looking for passion and the drive to work harder and more creatively to gain that edge. We will look for things like focus. In addition to all the hours of phone conversations, it will involve site visits. It involves some quantitative performance analysis. It also involves hours of team vetting internally so that we can all flesh out what truly is the investment edge. I think the value of doing all the upfront work is that every manager underperforms at some point or another, even the best ones. What our research enables us to do is stick with a manager through that period of underperformance provided that in the course of our ongoing due diligence we do not see anything that has changed and we think that edge is still intact. More specifically it enables us to ask the right questions when a manager does underperform. We know the key tenets of their process and we know the areas to probe deep on when mistakes are made or when performance is out of sync. Q:  How do you identify opportunities in your manager selection process? A : When we are selecting managers one of the keys is discipline. For example, whenever I look through a pitch book from firms asking us to look at their funds, inevitably in every pitch book I see the investment-process funnel. It starts with a broad universe, they screen out for company size, revenue growth, margin growth, earnings growth, and they look for strong financial companies, whittling the universe down to 250 stocks. From this shallower pool of quantitatively attractive ideas, deeper research is often conducted, and the manager picks what they believe are the best ideas. If it was that easy, every manager would outperform. That’s where discipline comes in. Discipline refers to the commitment of in-depth research to support each and every decision. There is unwavering commitment to the manager’s process and circle of competence. This combination of sound process and discipline helps to minimize decision errors by the manager, enabling them to outperform over time. So, we spend time digging deep into those specific aspects of the discipline to really understand how managers make decisions and how they minimize decision errors. We also look for creative, outside the box, deep thinkers. We consider how they approach the analysis and we want to see them doing something differently. We like to see managers mitigate investment distractions by delegating marketing duties. A manager has to go on the road to present his fund from time to time but we are looking for someone who does that more on the periphery than making it the primary focus of their job. We’re essentially the pickers of stock pickers. It boils down to us believing that it is possible to identify investment managers who will deliver superior long-term performance. Q:  Who are the managers on the fund? A : Every manager on our Litman Gregory Masters portfolios is a bottom-up fundamental investor. It boils down to stock picking for all of these managers. An example of one of our managers is Frank Sustersic who was added on December 1, 2012. He runs the more diversified Turner Emerging Growth Portfolio at Turner Investment Partners. He has been running that fund for 15 years and has an extremely strong track record there. He has a strong, long-term track record of investing in micro and small cap stocks. We have known Frank since the late 1990s and have been following him for over a decade. In our conversations with him over time we have gained confidence in his ability to manage a more concentrated portfolio. What he does is to specifically look for companies with really strong operating business models that will lead to accelerated earnings and improving earnings expectations. Typically these companies have a very specific edge, such as a compelling or unique product or service, more along the lines of a niche within an industry. Frank Sustersic’s edge is not really based on one thing; it is more of a sum of the parts analysis. If you add all these parts together, we believe he is better than most, as opposed to one specific criteria that we think he does better than others. One of the key criteria that constitute his edge is his discipline. He is very clear on the types of companies he wants to own, why he owns them, how long he thinks he will own them, how much he is willing to pay, how much of that company he wants to own in portfolio construction. He strongly emphasizes the need to be unemotional and objective in his decision-making. He clearly lays out the key drivers and key risks when he is interested in a company. When one of those is violated he falls back to his initial thesis and reacts to it. Otherwise what he is ultimately trying to do is protect himself against value traps of justifying when things start going wrong. We are very impressed with our stock level conversations with him. He is a very thoughtful guy in terms of how he analyzes industry trends and the companies within those trends. He is intellectually honest and stays well within his circle of competency. Another example is Dick Weiss. He has over 30 years of investment experience and is only running money for our Litman Gregory Masters Funds at this point. He has a long track record running Wells Fargo Advantage Common Stock Fund, which was formally the Strong Common Stock Fund. He has been running a sleeve of The Litman Gregory Masters Equity Fund for over 16 years. He has also been on the Smaller Companies fund since its inception. Dick invests in small and mid-size companies that are more undervalued because they are not broadly recognized. Perhaps they are in transition or they are out of favor because of short-term factors. His focus is on above average growth potential that also exhibits certain factors such as low institutional investor ownership and low analyst coverage, et cetera. He is looking for unrecognized stocks where there is a sustainable competitive advantage and high quality management. Another example is Jeff Bronchick. He has his own firm called Cove Street Capital. He has been on the fund since June of 2007. He is a value investor, has a well laid out investment process, and there is a really clear focus on best ideas, which is demonstrated by his relatively concentrated portfolio. Even in his public mutual fund he runs 30 to 40 stocks, but for us he is reducing that to below 15. Most of the time he runs 10 to 12 names for us, once in a while, less. He really employs a consistent framework to identify the best combination of attractive business, valuation, and shareholder management, which is all based on thorough company and industry knowledge, as well as very detailed financial models. We have been impressed with his discipline and the deep dives he does on the businesses. The fourth sub-advisor on the fund is the firm FPA, based in Los Angeles. There we have Dennis Bryan and Rikard Ekstrand as the co-managers on our fund. They look for companies characterized by strong balance sheets, strong and improving fundamentals, strong competitive positions within their industry, strong free cash flow, quality of management and understandable business strategies. They do a deep dive on understanding the company’s operating history, the trends, and financial health of a company. They have a preference for out of favor companies and there is a particular focus on assessing whether the company is out of favor because of a problem that is either transitory or permanent. They are looking for situations where certainty is high such as a business that has strong long-term fundamentals but is temporarily out of favor and therefore undervalued which is their typical new buy. At any given time a fund manager might have a portfolio of 65 or 75 names. They might be all good names but we believe that only a handful of those names would be truly great ideas at any given time. That is the subsection that we are asking each of these managers to isolate. We want only the highest conviction stocks from those we think are among the best managers. Q:  What else are you looking for in your managers? A : At the organizational level we are looking at the overall culture and the research culture. We are looking for people that are committed to the investment process with the focus on investing, not on asset gathering. Obviously everyone wants to grow their firm but there are degrees of magnitudes. For example, are they an asset-gathering firm or a performance-oriented firm? We look at the team to see if there is a lot of turnover, do people like working there? Has the analyst team been together for a while? Are these career analysts or do these analysts want to ultimately become portfolio managers, which can lead to turnover, new products and asset growth? What do they feel is a responsible level of growth for the firm and why? Do they distribute ownership, which can promote consistency of the team, which can be a strong positive? We are trying to understand the structure of the firm to see if it aligns the shareholders interests along with the firm. We prefer not to have managers spending time on managing operational issues. We want them focused on investing. Does the firm have a structure to allow that so that the manager is not bogged down with non-investment distractions? When we conduct our upfront due diligence we are really developing an investment thesis. When a manager underperforms we fall back to that investment thesis and ask ourselves what is it that we are hanging our hat on with this manager? We will talk to the manager, and if we understand the reasons for the underperformance, and are still able to fall back on that investment thesis then we are fine. We are very willing to tolerate a period of underperformance provided that the thesis is still intact. When that thesis falls apart or changes we will move on and sell a manager. It could be changes in personnel, which are indicative of cultural problems at the firm. When key people leave it is often difficult to know how successful the firm will be in filling those roles. It could be excessive growth or poorly managed firm growth. This can negatively impact our confidence in a sub-advisor for a number of reasons, including the possibility of reduced flexibility, reduced focus due to management distractions. It could be hubris, which could lead to decision-making shortcuts. We look for managers that remain humble and do not develop an ego. A risk that can come with substantial growth is as a manager becomes successful he could decide to grow the team and delegate a lot of the work that they used to do themselves. While not always the case, it could be a less capable team. Another reason we sell is loss of focus – maybe the manager becomes burnt out, and maybe there is development of other interests. It could be that their discipline slips and a highly successful manager has strayed from his discipline and is making decisions without the analytical basis that we expect. We do an enormous amount of work before hiring a sub-advisor to avoid mistakes. We look at their broader portfolio to understand their philosophy and process. Once we get comfortable with their broader portfolio and the process of how they run money, we want to understand does their process have an element where we believe they can run concentrated money? Then we take it to the next level. If we have a lot of confidence in these managers then we can consider them for the Litman Gregory Masters Funds. Q:  How do combine managers? A : We blend managers of differing investment styles. For example, on the Smaller Companies Fund there are currently four managers and they range from value to blend to growth. The idea is that regardless of the market conditions, even though one’s investment style might be out of favor, the other cylinder could be firing. We also believe that excessive asset growth tends to diminish performance. It is a reversion towards mediocrity so what we do is we will close each fund to new investors to preserve each manager’s ability to execute the Litman Gregory Masters Funds concept so that we are not hindering them from flexibility and getting their best ideas regardless of size.