FMI Funds Q2 2023 Shareholder Letter

Dear Fellow Shareholders:

Global equity markets continued to advance in the second quarter, despite slower economic growth, stubbornly elevated inflation, the steepest global interest-rate hiking cycle in four decades, and record debt levels. Remarkably, in the wake of the banking turmoil in the U.S. and Europe, animal spirits have reignited, with growth outperforming value by a wide margin in the first half of 2023, particularly in the U.S. Large Cap universe. Old habits die hard, though we don’t believe the recent knee-jerk reaction will last. Year-to-date, FMI’s Common Stock Fund and International Funds have comfortably outperformed their respective benchmarks despite the relative headwind. FMI’s Large Cap Fund has outpaced the iShares Russell 1000 Value ETF (IWD), but has not kept up with a top-heavy, tech-driven S&P 500 Index (SP500, SPX). While investors have lurched back to what’s “working” with a renewed fear of missing out (FOMO), it may just be a matter of time before the select few stocks supercharging the S&P 500 normalize.

FMI’s second quarter performance commentary is outlined below:

FMI Common Stock Fund (MUTF:FMIMX, FMIUX) Performance

The FMI Common Stock Fund (“Common Stock Fund”) gained 5.69%^[1], compared to an increase of 5.21% and 3.18% in the Russell 2000 Index (“Russell 2000”) and Russell 2000 Value Index (“Russell 2000 Value”), respectively. Relative to the Russell 2000, sectors that contributed to the performance included Finance, Distribution Services, and Producer Manufacturing, while Commercial Services, Retail Trade, and a lack of exposure to Health Technology detracted. A significant underweight in banking has benefited the relative comparison. Stock performance was driven by Beacon Roofing Supply Inc., Simpson Manufacturing Co. Inc., and Triton International Ltd. (being acquired by year-end), as Genpact Ltd., BJ’s Wholesale Club Holdings Inc., and Robert Half International Inc. each lagged. Quality has been hard to come by in the Small Cap space in recent years, with extensive mergers and acquisitions activity by private equity thinning out the opportunity set. Disciplined stock picking through this environment has been critical.

FMI Large Cap Fund (MUTF:FMIHX, FMIQX) Performance

The FMI Large Cap Fund (“Large Cap Fund”) gained 5.70%^[2], compared to an increase of 8.74% and 4.08% in the S&P 500 and iShares Russell 1000 Value ETF^[3], respectively. Relative to the S&P 500, sectors that were additive to the performance included Health Technology, Producer Manufacturing, and a lack of exposure to Energy Minerals, while Technology Services, Electronic Technology, and Retail Trade detracted. CarMax Inc., Alphabet Inc. Cl A, and Masco Corp. contributed, while Dollar General Corp., Northern Trust Corp., and CDW Corp. each disappointed, despite what we feel are attractive long-term prospects. Approximately 80% of the S&P 500’s yearto-date return has been generated by only ten stocks, while the iShares Russell 1000 Value ETF has lagged its growth counterpart by nearly 24%. Today, the S&P 500 is the most concentrated it has been since 1990, with the top five firms (AAPL, MSFT, AMZN, GOOG, NVDA) comprising ~24% of the index.

FMI International Fund (MUTF:FMIJX, MUTF:FMIYX) & FMI International Fund II – Currency Unhedged (MUTF:FMIFX): Performance

The FMI International Funds (“International Funds”) gained 5.08%^[4]on a currency hedged basis and 4.95%^[5]currency unhedged, compared with the MSCI EAFE Index’s increase of 4.28% in local currency (LOC) and 2.95% in U.S. Dollars (USD). The MSCI EAFE Value Index advanced 4.50% in LOC and 3.15% in USD. Relative to the MSCI EAFE Index, sectors that aided performance included Retail Trade, Electronic Technology, and Health Technology, while Commercial Services, Consumer Non-Durables, and Consumer Durables weighed. Top individual contributors included B&M European Value Retail S.A., Ferguson PLC, and Sodexo S.A., as Nabtesco Corp., DBS Group Holdings Ltd., and DKSH Holding AG did not keep pace. A recovery in several healthcare holdings (Koninklijke Philips N.V., Fresenius Medical Care AG & Co. KGaA, Smith & Nephew PLC) has also helped the relative performance in the period. USD appreciation was a slight tailwind for FMI’s currency hedged portfolio.

Melt-Up

Markets move in cycles and today investors are throwing money hand-over-fist at the technology sector. Generative artificial intelligence (AI) has lit the sector ablaze. While generative AI has the potential to be a game-changer for many industries, it is in the early stages of adoption, and it will likely be some time before the long-term opportunities and risks are fully understood. Though there is no shortage of hype, the commercial revenue projections over the next five years could be overblown. In the U.S., the ten largest U.S.-listed tech companies by market value have generated an average year-to-date return of 74%, compared with an S&P 500 equal-weighted index that has gained just 7%! As illustrated in the graphic below, the top-performing themes in the U.S. speak to the speculative nature of the market:

As a percentage of the S&P 500, technology represents almost three times the sector’s size in the U.S. economy (10.3% of GDP). We find it interesting that despite all the advances in technology in recent decades, productivity and economic growth have been below historical levels, both in the U.S. and globally, and are expected to weaken further (see World Bank projections below). How can this be the case if new technology is so great? We suspect part of the explanation is that there’s been heavy technology investment in entertainment (social media, gaming, streaming, virtual reality, etc.), which does little to make people more productive. Generative AI could certainly change the path of travel.

An important question that investors ought to consider: are the winners of today going to be the winners of tomorrow? History would prove skeptical, as can be observed in the graphic on the following page. Only one out of the top ten companies in the S&P 500 in 2000 was still in the top ten 20 years later. Historically, leaders change over time. Success invites competition and innovation can lead to disintermediation. Despite what may appear to be strong competitive positioning and growth prospects, any stock can get too expensive, and any trade can become overcrowded. In the 1970s, the “Nifty Fifty” were believed to be the best of the best; no price was too high for these businesses, and everyone piled in. In the 2000 tech bubble, many companies were also thought to be unassailable. In times of euphoria, lessons from the past are quickly forgotten. Rather than pay up for popular stocks, FMI purchases what we view as high-quality compounders that trade at attractive absolute valuations, where the success of the investment is not reliant on meeting extremely high growth expectations, discounting cash flows at ultra-low discount rates, or sustaining elevated valuation multiples.

Despite the recent performance in U.S. Small Cap and International equities, relative valuations in U.S. Large Cap are still (and have become more) stretched. The valuation divergences are approaching historical highs. As illustrated below, profitable U.S. Small Cap stocks are trading close to the largest discount to U.S. Large Cap stocks in over 40 years:

Similarly, European stocks now trade at an all-time discount to the U.S., as illustrated below. To be fair, economic growth in the U.S. has been much stronger than in Europe over the last 15 years, so some of this discount is warranted. Per the Financial Times, “In 2008 the EU’s economy was somewhat larger than America’s: $16.2tn versus $14.7tn. By 2022, the US economy had grown to $25tn, whereas the EU and the UK together had only reached $19.8tn. America’s economy is now nearly one-third bigger.” GDP projections in the coming years are a lot more comparable, with the U.S. expected to grow 1.6% in 2023 and 1.0% in 2024, while the Eurozone is expected to grow 0.9% and 1.5%, respectively, according to the Organisation for Economic Co-operation and Development. At the very least, a ~30% cheaper valuation should give investors in European equities some margin for error.

Ironically, despite slowing earnings growth, significant concentration risk, and what we view as expensive valuations, investors continue to funnel into the S&P 500. We think the S&P 500 carries a lot more risk than is commonly perceived. Furthermore, just as passive inflows can add fuel to the fire in a rising market, passive outflows can have the reverse effect during a decline. Investors appear to be capitulating on sensible value ideas and chasing the few growth stocks that have been winning in the stock market. They take comfort in the crowd behavior and want to own what’s been doing well. Despite history, they can’t help themselves.

Virtues of Value Investing

Value investing has nearly a 100 year history of success, with academic studies and empirical evidence supporting the case for long-term outperformance. That said, we are currently in one of the worst periods for value on record, as a confluence of factors have benefited growth and momentum investing, including years of suppressed interest rates (and discount rates), large-scale central bank asset purchases (quantitative easing, or QE), and a massive shift from active to passive investing, among others. An absence of price discovery and a lack of regard for valuation has led to significant asset price inflation. Fortunately, the backdrop is changing as interest rates are normalizing, QE has largely come to an end (Japan is an exception), and the shift to passive may be maturing, all of which should bode well for stock picking.

We have great confidence that a value-oriented approach will win out in the end. Why? Human nature. Inevitably, fear and greed will play a role in investor behavior. On the way up, investors become too optimistic, gain comfort in numbers (herd behavior), and chase the best performing stocks, which can lead to long periods where a stock or the market can become significantly overpriced. Conversely, amidst volatility, investors can be overly pessimistic and overwhelmed by the fear of losing money. Risk aversion takes hold and selling begets selling. Again, business fundamentals are disregarded, this time leading to depressed valuations that are well below intrinsic value. Over a full cycle, markets are relatively efficient: eventually investors come to their senses and valuations settle in around fair value. While unnerving, dislocations can create exciting opportunities, but most investors aren’t patient. As we have highlighted in prior shareholder letters, the DALBAR studies^[6]show that the average investor consistently underperforms the market, doing the wrong things at the wrong times. Flows tend to follow performance.

We continue to believe that a disciplined approach, which is rooted in fundamental analysis and uses valuation as its guidepost, provides an opportunity to outperform over the long-term. As illustrated below, the valuation premium for growth versus value is near a 50-year high (using price-to-earnings) – almost a 2-standard deviation move. Any semblance of a reversion to the mean should lead to much better days ahead for those with a value-orientation. Though it’s impossible to know, it feels like we are in the later innings of the cycle for U.S. Large Caps, while U.S. Small Caps and International Large Caps appear less distended.

Across the world, we believe value investing’s recent struggles are the exception, not the rule. With a normalization of interest rates, profitability and valuations should matter over time. We own a collection of high-quality businesses, with strong balance sheets, that trade at a discount to the market and our estimates of intrinsic value, giving us confidence in our opportunity to outperform in the coming years.

Below we highlight several portfolio holdings where we are finding value:

Robert Half International Inc. (RHI) – FMI Common Stock Fund

RHI is the market leader in professional staffing for small and medium sized businesses. The company has a premier temporary and permanent placement franchise in the field of accounting (Accountemps) and finance, while its Protiviti business has become a strong domestic and international consultancy. RHI’s reinvestment in technology, including its national database, candidate performance scoring, and proprietary AI and matching capabilities are driving share gains versus fragmented competition. The business model is asset-light and generates consistently strong returns-on-capital, industry leading margins, and free cash flow. The less cyclical Protiviti business accounts for 30% of income. Capital allocation at RHI has been focused on reinvestment, share repurchases, and dividend increases. These factors should result in less overall cyclicality in EPS going forward. The shares are off 40% from its 2022 highs. We feel that the discounted valuation is reflective of current recession worries, which could lower demand for labor. Additionally, there are concerns around AI and the disruption that it could have on accounting. Our view is that the sentiment around the latter appears overdone, as demand for accountants has increased over time despite major advances in productivity tools.

CDW Corp. (CDW) – FMI Large Cap Fund

CDW is a simple business with strong returns-on-capital, serving a growing global information technology (IT) industry. As a reseller of IT solutions, the company gives investors exposure to technology growth without subjecting them to the short product cycles, cut-throat competition, and poor capital allocation decisions that are typically inherent in technology investments. While the largest player in the industry, CDW only commands a small ~5% share of the North American IT market. We believe they can capture more market share moving forward as their size and scale creates competitive advantages, making them difficult to compete against, particularly for the smaller regional players that make up the majority of the market. The company’s margins should also expand over time as they sell more software, services, and solutions to end customers. CDW’s fundamentals currently reflect a slowdown in North American corporate IT spending; we believe this will prove to be a cyclical headwind that will dissipate over time. Strong execution along with a recovery in customer spending should give CDW the ability to generate double digit earnings per share growth annually over our investment time horizon. We believe the shares are trading at reasonable multiple on depressed earnings.

Roche Holding AG (OTCQX:RHHBY) – FMI International Funds

Roche is the world’s largest biotechnology company and the global leader in in-vitro diagnostics. In an industry that struggles to earn its cost of capital, Roche is an outlier. Roche’s superior return profile has benefited from a superior research and development (“R&D”) organization and family control, which we believe has allowed management to take a long-term view and avoid the large, value destructive acquisitions that have hurt peer returns. Despite the R&D organization’s long track record of success, there have been a few recent pipeline drug setbacks that have weighed on the stock and depressed the valuation. We view these as temporary setbacks which are common for an R&D organization that focuses on first-in-class or best-in-class drugs in areas of significant unmet need. Importantly, we forecast revenue growth through 2027 based solely on the existing drug portfolio and diagnostics business without any contribution from pipeline drugs. Any pipeline drug contribution would add to this underlying growth, and our research suggests there are a handful of meaningful opportunities. The market is underappreciating this durable revenue growth outlook. We feel that the current valuation is very attractive for this high-quality company.

Thank you for your continued support of FMI Funds, Inc.

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