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QUARTERLY REPORT June 30, 2016 FMI Large Cap Fund (FMIHX) FMI Common Stock Fund (FMIMX) FMI International Fund (FMIJX) FMI Funds Advised by Fiduciary Management, Inc. FMI Funds TABLE OF
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QUARTERLY REPORT June 30, 2016 FMI Large Cap Fund (FMIHX) FMI Common Stock Fund (FMIMX) FMI International Fund (FMIJX) FMI Funds Advised by Fiduciary Management, Inc. FMI Funds TABLE OF CONTENTS FMI Large Cap Fund Shareholder Letter Statement of Net Assets FMI Common Stock Fund Shareholder Letter Statement of Net Assets FMI International Fund Shareholder Letter Statement of Net Assets Schedule of Forward Currency Contracts Summary and Disclosure Information FMI Large Cap Fund June 30, 2016 Dear Fellow Shareholders: The FMI Large Cap Fund ( Fund ) returned 1.87% in the June quarter compared to 2.46% for the Standard & Poor s 500 Index ( S&P 500 ). Sectors that outperformed included Health Services, Retail Trade and Consumer Services, while laggards included Process Industries, Distribution Services and Producer Manufacturing. Stocks that helped relative performance included UnitedHealth Group, Dollar General and Comcast, while Potash, AmerisourceBergen and PACCAR underperformed. The Fund, being value-oriented, has performed about as expected over the course of this bull market, which is to say it has slightly lagged the growth-oriented benchmarks and the S&P 500. Heavy flows coming out of active management and going to passive index products have created a negative feedback loop for active participants and the opposite for passive. These things generally move in cycles and have reversed dramatically in the past two bear markets. While the current cycle is particularly long, we are confident the same general pattern will occur. We ve already seen a glimpse of this in the international arena, where over the past twelve months the MSCI EAFE Index (local currency) is down 10.19% while the FMI International Fund is up 0.75%. The same phenomenon has transpired, albeit not as strongly, in our domestic small cap portfolios, where the trailing twelve months return of the Russell 2000 Index is -6.73% compared to the FMI Common Stock Fund s return of -1.77%. The FMI Large Cap Fund over the past year is 0.76% compared to a 3.99% gain for the S&P 500. Of course, in the next rocky market there is no guarantee the FMI Large Cap Fund will behave in a like-minded fashion to our other two products, but the characteristics of the stocks and the discount valuations are similar, so we are optimistic about relative performance. Investors running to passive strategies are engaging in another form of performance chasing. Any asset can become overvalued, leading to a disappointment and eventual underperformance. People have been trained to think in short-term time frames but sometimes cycles can last a very long time, as evidenced by the current one beginning in March of Memories are short in this business but it s healthy to be reminded of history. In the last bear market, which began in the fourth quarter of 2007, the average price-to-sales ratio of the S&P Industrials was approximately 1.5, which was quite high. Five quarters later this figure was below 0.9 and the total return of the S&P 500 was -55.0%. In the cycle before that, which peaked in March of 2000, the average price-to-sales ratio of the S&P Industrials was over 2.1. Ten quarters later the ratio was approximately 1.2, with the S&P 500 suffering a 47% negative total return. Today, the S&P Industrials trade at a priceto-sales ratio of approximately 1.7, compared to the 60-year median of slightly less than 1.0. High valuations have been around for so long that people s guards are down. Complacency is like a fog permeating the investment landscape. Investors convince themselves it will be different this time for a host of reasons, e.g., low interest rates, low inflation, equity scarcity, and an omniscient Federal Reserve. Today s market trades in the 8th decile (10th being the most expensive), based on the median of 50 valuation measures the Leuthold Group publishes. There are very few good companies that can be had at truly bargain prices. This makes the current cycle quite different than the last two, wherein it was not that difficult to build a cheap and adequately diversified portfolio despite the benchmarks trading at high valuations. Yes, it took great resolve to be contrarian and avoid a couple of highly-speculative and popular sectors or over-levered financials, but at least there were plenty of attractive alternatives. Today, investors face a difficult set of choices: Concede defeat to the index products and join the crowd. Invest in a few isolated opportunities, foregoing diversification. Carry a large amount of cash. Invest in a portfolio of good businesses that, while not cheap, trade at a very significant discount to the popular benchmarks. We continue to choose the last option. Equity investing still trumps cash over the long run, but we anticipate a bumpy ride. 1 Since we start from a position of high valuations, it certainly does not seem likely that stocks can sustainably climb without fundamental improvements in sales and earnings. Both of these have been flat to down over the past twelve months for the S&P 500. Corporations have been pulling out all of the stops to keep earnings afloat, including engaging in massive earnings per share deception. The gap between reported earnings using generally accepted accounting principles (GAAP) and so-called adjusted earnings is cavernous. In the first quarter, there was a 29% difference between GAAP earnings and so-called adjusted earnings for the Dow Jones Industrial Average. According to a recent Wall Street Journal article, just 29 companies in the S&P 500 exclusively use GAAP earnings. It used to be only a handful of technology companies played this game; now it is almost ubiquitous. With margins near historically high levels (though slipping), earnings are unlikely to improve until sales improve and that s going to be hard unless the economy improves. Here the story gets difficult. Real GDP has been essentially stuck in a 0-2% channel for a decade, averaging 1.4%. We haven t printed an annual growth rate above 3% since 2005 and recent performance has been anemic. We ve posited for some time that organic growth is low because investment is low. Nearby are two charts, one for fixed business investment and the other for information technology (IT) spending, illustrating this point. 2 A few weeks ago the cover story for Barron s was The Disappearing IPO [initial public offering]. The total number of public companies today is roughly half of what it was twenty years ago (see the following chart). Business confidence has been sub-par for years. We think the increasing regulatory burden is a significant factor in the lack of business vitality over the past decade. The Code of Federal Regulations is up to 175,000 pages in 236 volumes. It contains over one million individual instructions that mandate or prohibit some activity. The Dodd Frank legislation, already the lengthiest ever, continues to expand as new rules are issued. What started as a 13,000 page behemoth is now 22,000 pages. In 2015, 114 new laws were enacted, while federal agencies issued 3,410 new regulations. Sixty federal agencies have over 3,000 regulations in the pipeline. The 2015 Federal Register contains 80,260 pages and 94,246 rules, up over 30% since The tax code is over 75,000 pages long and has grown significantly over the past decade. Businesses are choking on red tape and this is stifling new corporate formation and existing business expansion. It has particularly hurt the little guy, with difficult wage and total employment statistics. The so-called fourth branch of government (regulatory apparatus) has been emboldened by anti-business sentiment in Congress and the executive branch. The Competitive Enterprise Institute, in their annual survey, estimates that the cost of these regulations is $1.88 trillion per year, approximately 10% of GDP and a hidden tax of $15,000 per U.S. household. 3 Nobody is foolish enough to suggest or imply that regulatory oversight is unnecessary. The cost and complexity of rules and regulations, however, has to be better balanced against the benefits. Bureaucrats, sometimes with political agendas, can wreak havoc on private enterprise. In our conversations with CEOs and CFOs, the overwhelming sentiment is that the government is out of control from a regulatory standpoint. The explosion in our public sector debt buttresses this case. Everyone needs to understand that healthy democratic capitalism is essential to the welfare of both private and public sectors. This economy needs a restart. Winston Churchill once said, No matter how beautiful the strategy, you should occasionally look at the results. We ve tried fiscal stimulus; it hasn t worked. We ve tried almost nonstop accommodative monetary policy; it hasn t worked. How about a roll-back and simplification of the regulatory state and a simplified tax code? U.S. corporate tax rates are the highest among those in the Organisation for Economic Co-operation and Development (OECD). These taxes are based primarily on where the business is chartered rather than where the income is generated. Instead of demonizing corporations for seeking corporate inversions (acquiring an offshore company and changing the domicile), why not lower and simplify the tax rate? Instead of companies leaving the U.S., it might even attract new ones and it would motivate businesses to expand facilities and employment right here. A joint project between the Urban- Brookings Tax Policy Center and the American Enterprise Institute advocates cutting the federal corporate tax rate from 35% to 15%. Americans owning stock in publicly traded companies would be taxed at ordinary income tax rates on their dividends and capital gains. Capital gains on stocks would be taxed, and capital losses would be deducted, as they accrue, even if the stock had not been sold. American shareholders would be allowed to credit their share of companies corporate income tax payments against their dividend and capital gains taxes. These credits would not be provided to foreign shareholders or to tax-exempt shareholders (nonprofit organizations and retirement plans). This proposal links tax liability more closely to where shareholders, who ultimately receive corporate profits, live. It is not ideal, but it is a compromise between the left and the right and it is a good start in simplifying the overall tax code, which we believe would be very beneficial to economic growth and the people s prosperity. Finally, late in the quarter the United Kingdom referendum to leave the European Union ( EU ) proved most of the polls and the bookies wrong. It rattled stock markets significantly. The overwhelming sentiment from the pundits is that Brexit is a negative. That may be true in the short run, but it s important to consider the long term. Turn it around and ask What has the EU done for its members over the past two decades? Growth has been anemic. Debt has exploded. The number of employed, as a percentage of the working age population is abysmal. Taxes and regulations have grown significantly. Business vibrancy is low. Birth rates have plummeted. The ability to be a sovereign nation and control decisions on issues like immigration has been curtailed. The EU has been ineffective with respect to Putin. Of course, the issues are not black and white. European countries are not fighting each other as they did in the 1940s and common commerce standards have been a positive. Nevertheless, our long held belief, shared in these letters, is that it is nearly impossible to have a monetary union without a political union and we do not see a political union anytime soon. Practically speaking, it will be a few years before new treaties are signed and a lot can happen in the meantime in terms of restructuring and negotiating. Our strategy is to buy when there is the proverbial blood in the streets. Thank you for your confidence in the FMI Large Cap Fund. 100 E. Wisconsin Ave., Suite 2200 Milwaukee, WI FMI Large Cap Fund STATEMENT OF NET ASSETS June 30, 2016 (Unaudited) Shares Value (b) COMMON STOCKS 92.1% (a) COMMERCIAL SERVICES SECTOR 3.4% Advertising/Marketing Services 3.4% 3,044,000 Omnicom Group Inc $ 248,055,560 CONSUMER DURABLES SECTOR 3.2% Tools & Hardware 3.2% 2,095,000 Stanley Black & Decker Inc ,005,900 CONSUMER NON-DURABLES SECTOR 9.6% Food: Major Diversified 7.1% 20,253,000 Danone S.A. SP-ADR ,985,010 2,996,000 Nestle S.A. SP-ADR ,620, ,605,770 Household/Personal Care 2.5% 3,872,000 Unilever PLC SP-ADR ,507,520 CONSUMER SERVICES SECTOR 10.9% Cable/Satellite TV 5.0% 5,572,000 Comcast Corp. Cl A ,238,680 Media Conglomerates 3.0% 3,882,000 Twenty-First Century Fox Inc. Cl A ,008,100 4,298,000 Twenty-First Century Fox Inc. Cl B ,120, ,128,600 Other Consumer Services 2.9% 9,166,000 ebay Inc ,576,060 DISTRIBUTION SERVICES SECTOR 2.2% Medical Distributors 2.2% 1,987,000 AmerisourceBergen Corp ,608,840 ELECTRONIC TECHNOLOGY SECTOR 3.1% Electronic Components 3.1% 3,973,000 TE Connectivity Ltd ,898,030 ENERGY MINERALS SECTOR 2.4% Oil & Gas Production 2.4% 4,750,000 Devon Energy Corp ,187,500 FINANCE SECTOR 12.8% Financial Conglomerates 2.4% 2,859,000 American Express Co ,712,840 Major Banks 6.5% 6,956,000 Bank of New York Mellon Corp ,240,600 5,030,000 Comerica Inc ,883, ,124,500 Property/Casualty Insurance 3.9% 8,453,000 Progressive Corp ,175,500 HEALTH SERVICES SECTOR 5.4% Managed Health Care 5.4% 2,770,000 UnitedHealth Group Inc ,124,000 INDUSTRIAL SERVICES SECTOR 4.0% Oilfield Services/Equipment 4.0% 3,702,000 Schlumberger Ltd ,754,160 5 FMI Large Cap Fund STATEMENT OF NET ASSETS (Continued) Shares or Principal Amount COMMON STOCKS 92.1% (a) (Continued) Value (b) PROCESS INDUSTRIES SECTOR 3.2% Chemicals: Agricultural 3.2% 14,487,000 Potash Corp. of Saskatchewan Inc $ 235,268,880 PRODUCER MANUFACTURING SECTOR 13.7% Industrial Conglomerates 9.7% 895,000 3M Co ,732,400 2,452,000 Berkshire Hathaway Inc. Cl B ,025,080 1,649,000 Honeywell International Inc ,811, ,569,160 Industrial Machinery 1.1% 700,000 Rockwell Automation Inc ,374,000 Trucks/Construction/Farm Machinery 2.9% 4,123,000 PACCAR Inc ,860,010 RETAIL TRADE SECTOR 8.2% Apparel/Footwear Retail 2.9% 3,724,000 Ross Stores Inc ,113,560 Discount Stores 5.3% 4,074,000 Dollar General Corp ,956,000 TECHNOLOGY SERVICES SECTOR 6.5% Information Technology Services 4.2% 2,701,000 Accenture PLC ,996,290 Packaged Software 2.3% 3,228,000 Microsoft Corp ,176,760 TRANSPORTATION SECTOR 3.5% Air Freight/Couriers 3.5% 5,177,000 Expeditors International of Washington Inc ,880,080 Total common stocks ,711,898,200 SHORT-TERM INVESTMENTS 8.1% (a) Money Market Deposit Account 4.0% $287,668,080 U.S. Bank N.A., 0.25% ,668,080 U.S. Treasury Securities 4.1% 300,000,000 U.S. Treasury Bills, 0.17%, due 07/28/ ,961,750 Total short-term investments ,629,830 Total investments 100.2% ,299,528,030 Other assets, less liabilities (0.2%) (a) (11,685,644) TOTAL NET ASSETS 100.0% $7,287,842,386 Net Asset Value Per Share ($ par value, 500,000,000 shares authorized), offering and redemption price ($7,287,842, ,746,230 shares outstanding) $ (a) Percentages for the various classifications relate to total net assets. (b) Each security, excluding short-term investments, is valued at the last sale price reported by the principal security exchange on which the issue is traded. Securities that are traded on Nasdaq Markets are valued at the Nasdaq Official Closing Price, or if no sale is reported, the latest bid price. Short-term investments with maturities of 60 days or less were valued at amortized cost which approximates value. PLC Public Limited Company SP-ADR Sponsored American Depositary Receipt 6 FMI Common Stock Fund June 30, 2016 Dear Fellow Shareholders: The FMI Common Stock Fund ( Fund ) returned 0.71% in the June quarter compared to 3.79% for the Russell 2000 Index ( Russell 2000 ). Sectors that outperformed included Transportation, Technology Services and Consumer Services, while laggards included Commercial Services, Distribution Services and Health Technology. Stocks that helped relative performance included Kirby, Woodward and Cable One, while ManpowerGroup, MSC Industrial and Arrow Electronics underperformed. The Fund, being value-oriented, has performed about as expected over the course of this bull market, which is to say it has slightly lagged the growth-oriented benchmark, and has performed roughly in line with the Russell Heavy flows coming out of active management and going to passive index products have created a negative feedback loop for active participants and the opposite for passive. These things generally move in cycles and have reversed dramatically in the past two bear markets. While the current cycle is particularly long, we are confident the same general pattern will occur. We ve already seen a glimpse of this in the international arena, where over the past twelve months the MSCI EAFE index (local currency) is down 10.19% while the FMI International Fund is up 0.75%. The same phenomenon has transpired to a somewhat lesser degree in the FMI Common Stock Fund, where performance is down 1.77% over the trailing twelve months compared to a loss of 6.73% for the Russell Investors running to passive strategies are engaging in another form of performance chasing. Any asset can become overvalued, leading to a disappointment and eventual underperformance. People have been trained to think in short-term time frames but sometimes cycles can last a very long time, as evidenced by the current one beginning in March of Memories are short in this business but it s healthy to be reminded of history. In the last bear market, which began in the fourth quarter of 2007, the average price-to-sales ratio of the S&P Industrials was approximately 1.5, which was quite high. Five quarters later this figure was below 0.9 and the total return of the S&P 500 was -55.0%. In the cycle before that, which peaked in March of 2000, the average price-to-sales ratio of the S&P Industrials was over 2.1. Ten quarters later the ratio was approximately 1.2, with the S&P 500 suffering a 47% negative total return. Today, the S&P Industrials trade at a priceto-sales ratio of approximately 1.7, compared to the 60-year median of slightly less than 1.0. High valuations have been around for so long that people s guards are down. Complacency is like a fog permeating the investment landscape. Investors convince themselves it will be different this time for a host of reasons, e.g., low interest rates, low inflation, equity scarcity, and an omniscient Federal Reserve. Today s market trades in the 8th decile (10th being the most expensive), based on the median of 50 valuation measures the Leuthold Group publishes. There are very few good companies that can be had at truly bargain prices. This makes the current cycle quite different than the last two, wherein it was not that difficult to build a cheap and adequately diversified portfolio despite the benchmarks trading at high valuations. Yes, it took great resolve to be contrarian and avoid a couple of highly-speculative and popular sectors or over-levered financials, but at least there were plenty of attractive alternatives. Today, investors face a difficult set of choices: Concede defeat to the index products and join the crowd. Invest in a few isolated opportunities, foregoing diversification. Carry a large amount of cash. Invest in a portfolio of good businesses that, while not cheap, trade at a very significant discount to the popular benchmarks. We continue to choose the last option. Equity investing still trumps cash over the long run, but we anticipate a bumpy ride. Since we start from a position of high valuations, it certainly does not seem likely that stocks can sustainably climb without fundamental improvements in sales and earnings. Both of these have been flat to down over the past twelve months for the S&P 500. Corporations have been pulling out all of the stops to keep earnings afloat, including en
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