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Meridian Growth Fund 4th Quarter Commentary

- By Holly LaFon


U.S. stock markets advanced during the quarter, responding to signs of improving economic growth. In November, the unexpected outcome of the U.S. presidential election sparked a market rotation out of sectors such as healthcare and into areas expected to benefit from the new administration. Financials gained in anticipation of a lighter regulatory environment and higher interest rates, while industrials advanced on optimism that President-elect Trump will increase spending on infrastructure and defense.

Stocks in all capitalization ranges posted gains, according to the Russell indices. Small cap stocks were especially strong, followed by large caps and mid caps. Value-oriented stocks also performed well, outpacing growth stocks by a wide margin across the capitalization spectrum.


For the fourth quarter of 2016, the Meridian Growth Fund (the "Fund") returned 1.30%, underperforming its benchmark, the Russell 2500(TM) Growth Index, which returned 2.60%.

Our investment process prioritizes the management of risk over the opportunity for return. Our goal is to build an all-weather portfolio that can perform in a variety of market conditions. We look to build a portfolio that can mitigate capital losses on the downside and, secondarily, provide 100% upside participation. While our risk-first approach is particularly effective during heightened volatility, Q4 was characterized by fairly limited volatility. While this held back performance during the quarter, we remain optimistic that volatility will pick up in the future.

From a sector perspective, leading drivers of underperformance included healthcare, where a number of our holdings declined. Particularly weak were the Fund's healthcare equipment stocks. Our investments in the information technology sector also held back relative gains, most notably our software & services exposure. Meanwhile, relative performance was buoyed by strong stock selection in both the energy and financials sectors.


The three largest detractors from the Fund's performance during the period were Endologix, Inc. (ELGX), 2U, Inc. (TWOU), and Diplomat Pharmacy, Inc. (DPLO).

Endologix, Inc. (ELGX) is a medical device company that develops, manufactures, and markets minimally invasive treatments for vascular diseases. We invested in Endologix based on our belief that the company's innovative technologies will allow it to capture an increasingly larger portion of the $2 billion market for vascular devices. Endologix lost ground after the FDA announced the need for additional follow-up data from patients in clinical trials for Nellix, its endovascular aneurysm sealing system. Other negative developments included a manufacturing issue with an endovascular device in the U.S. and the suspension of a similar device in Europe. We believe these setbacks are only temporary and the long-term potential for the company's products remains strong. We consequently maintained our position in the stock.

2U, Inc. (TWOU) is an educational technology company that partners with leading nonprofit colleges and universities to offer online degree programs. Key factors that attracted us to this company were its revenue growth, improving margins, and strong partnerships. Since its initial public offering in 2014, 2U has consistently beat quarterly estimates and has grown its revenue by more than 30% a year. The stock pulled back during the quarter, although we believe that fundamentals remain intact. With a three-year financial outlook that includes continued revenue growth upwards of 30%, we expect a recovery in the stock and therefore maintained our position.

Diplomat Pharmacy, Inc. (DPLO) is the nation's largest independent specialty pharmacy. We invested in Diplomat because it was an opportunity to participate in new biotechnology discoveries without committing to a specific drug. We felt the company was well positioned to benefit from a trend in which manufacturers of specialty drugs are increasingly moving toward limited distribution. The stock sold off on news of higher than expected direct and indirect remuneration (DIR) fees charged by pharmacy benefit managers (PBMs). We exited the stock based on our discomfort with Diplomat's lack of control over its economic destiny.


The three largest contributors to the Fund's performance during the period were Grand Canyon Education, Inc. (LOPE), RigNet, Inc. (RNET), and LPL Financial Holdings, Inc. (LPLA).

Grand Canyon Education, Inc. (LOPE) operates Grand Canyon University, a for-profit Christian research university in Phoenix, Arizona. Through its highly efficient education delivery model, the university serves more than 17,000 students at its physical campus and 75,000 students online. We like the company's solid, mid-to-high single digit top line growth and strong operating margins. Moving forward, we see opportunities for margins to scale higher, particularly as the company nears the completion of its most recent campus expansion project. As the project winds down, capital expenditures will decline, allowing the company to substantially increase free cash flow. We expect more of the same going forward and maintained our position.

RigNet, Inc. (RNET) is a communications service provider to offshore oil rigs. With one of the better balance sheets in the small-cap energy space, RigNet successfully weathered the collapse in oil prices over the last two years. A recent recovery in oil prices and stabilization in the offshore rig count during the second half of the year contributed to positive gains in the stock. We maintained our position in the company.

LPL Financial Holdings, Inc. (LPLA) is a leading financial services provider to independent advisors and registered investment advisors. After making a significant investment in compliance technology over prior years, LPL was successful in leveraging these investments in the back half of 2016 which led to better than expected margins and a positive outlook around expenses. A rising interest rate environment also supported stock gains. Although there has been recent speculation that President-elect Donald Trump may roll back the Department of Labor rule changes, we are confident that LPL is well positioned regardless of the direction the new administration takes. As the stock appreciated during the quarter, we trimmed our position.


As the U.S. transitions to new leadership, healthcare, tax reform, trade agreements, and other important issues hang in the balance. Although we are monitoring all of these issues closely, continued uncertainty will likely result in increased market volatility, which we welcome. We are poised to react when volatility picks up, and will look to add companies with predictable and recurring revenue streams, strong competitive advantages, and increasingly large market opportunities.

This article first appeared on GuruFocus.