October 21, 2022
3Q22 Opportunity Equity Quarterly Investment Review
Market Proxy is S&P 500. Returns greater tahn 1 year are annualized. Source: Bloomberg and Miller Value Partners
The data provided is from APX and Miller Value Partners, LLC and is believed to be reliable, but is not guaranteed as to its timeliness or accuracy. Percentages and returns may not sum to 100% due to rounding effects. A three-factor attribution consists of the allocation effect, selection effect, and the interaction effect, which sum to the portfolio’s performance relative to the benchmark.
• Allocation. The allocation effect represents the portion of the portfolio’s excess return attributable to differences in sector weights between the portfolio and the benchmark index.
• Selection. The selection effect represents the portion of the portfolio’s excess return attributable to differences in the weights of individual securities within each sector between the portfolio and the benchmark index.
• Interaction. Most complex and sometimes counterintuitive, the interaction effect represents the portion of the portfolio’s excess return attributable to combining sector allocation decisions with security selection decisions, and is often thought of as measuring the accuracy of manager’s convictions.
Please note that the methodology used by our independent third-party attribution software vendor will at times present sector allocation effects that are counterintuitive. For example, the software may calculate a negative sector effect even when the portfolio, on a weighted average basis for the period, was overweight an outperforming sector. Under the vendor’s methodology, allocation effects in recent months may overwhelm the allocation effects from earlier in the period, particularly over longer time frames.
Returns illustrated above are provided gross of fees and include cash. Total portfolio return figures provided above reflect the sum of the returns of the holdings in the representative account portfolio due to price movements and dividend payments or other sources of income. Additional fees not reflected in the performance attribution include management fees, paid quarterly. For more information about Miller Value Partner’s standard management fees for separate accounts please reference the Firm’s Form ADV.
During the third quarter of 2022, the Opportunity Equity strategy generated a total return of -4.62% net of fees. In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index, returned -4.88%. The strategy outperformed in July and August but gave back some ground in September as the post-Fed meeting panic dragged down the market.
Using a three-factor performance attribution model, allocation, and selection effects contributed to the strategy’s outperformance which was partially offset by interaction effects. Karuna Therapeutics Inc., ADT Inc., Uber Technologies Inc., Puretech Health and Energy Transfer were the largest contributors to performance, while Alibaba Group Holdings, DXC Technology Company, Mattel Inc., OneMain Holdings Inc. and Vontier Corp. were the largest detractors.
Relative to the index, the strategy was overweight the Consumer Discretionary, Financials, Industrials, Materials, and Energy sectors on average during the quarter. With zero allocation to Real Estate, Consumer Staples and Utilities the strategy was underweight these sectors along with Communication Services, Information Technology, and Healthcare sectors.
The strategy added three positions and eliminated two positions during the quarter, ending the quarter with 40 holdings where the top 10 represented 49.4% of total assets compared to 27.8% for the index, highlighting the strategy’s meaningful active share of around 107.0%.
New and Eliminated
This quarter we entered three new names while exiting two names, as we looked to monetize our hedge position which performed well over the year and take tax losses. Our largest new position is Silvergate Capital Corporation (SI), a regulated and FDIC-insured commercial bank and an emerging leading service provider for the crypto space. Silvergate has followed cryptocurrencies lower throughout the year falling 56% YTD vs Bitcoin down 59%, and Ethereum down 65%. The company started as a deposit service provider for the crypto space but has since developed their own proprietary Silvergate Exchange Network (SEN). SEN is a global payment network that enables real-time transfer of USD between its digital currency exchange customers (COIN, Genesis) and institutional customers 24/7/365. The company continues to innovate with its push to add stablecoins to its business mix following the acquisition of the Diem stablecoin project from Meta Platforms earlier this year. While the market is overly focused on a crypto winter, SI will benefit from increasingly becoming the partner of choice for both exchanges and institutions in this rapidly evolving market. Furthermore, 90% of Silvergate’s $13B assets are floating-rate with zero-cost deposit funding. This makes Silvergate one of most interest rate-sensitive financial services companies in the market today. Management has noted that for every 25bp increase in interest rates, their net interest income (NII) would increase by $16M over a 12-month period. It is not often that Mr. Market allows the opportunity to invest in a business growing the top line at a 40% CAGR for the next 2-years, while it is trading at 13x this year’s earnings and 8x next.
We re-entered Stitch Fix Inc. (SFIX) during the quarter, a name we have owned at different times since its IPO in 2017. Stitch Fix was best known as the company to pioneer the online styling subscription service for clothing but has since expanded into the on-demand shopping experience with their Freestyle offering. The core differentiation of Stitch Fix lies in its algorithms which have been trained over years with vast amounts of data. The company recently ran into challenges growing its core Fix business and getting traction on its new Freestyle roll-out. We believe its Board of Directors is top notch and will help guide the company to optimal outcomes. We think this company has many options to fix the current problems. The current focus is on cost-cutting and correcting past mistakes. We believe the company can reach profitability by restructuring the business. Historical take-out valuations for online retailers imply values many multiples of the current price. The company has a huge opportunity if it can deliver personalized shopping to the masses, which we believe could be possible.
S4 Capital PLC (SFOR LN), a media company providing digital advertising and marketing services worldwide, was our final addition for the quarter. The company was founded by Sir Martin Sorrell, previously CEO of WPP. We know Sir Martin well, and he’s a proven money-maker. He started S4 as the first digital-only advertising and marketing company. Pressure on the stock began with an audit delay announced in March and ended with a pre-announced guide down of full year EBITDA (£120M from £160M previously) in July due to operating subsidiaries hiring in advance of revenues. We see these challenges as growing pains that the company is making progress to resolve. The company reported a 1H that beat expectations. With operational management moving in the right direction, the market is now focused on the impact of a recession on the advertising industry leaving the shares at depressed prices. As a new model advertising agency, S4 Capital is 100% exposed to the secular shift to online digital advertising which management believes makes their business more resilient in a downturn. We think the risk/reward is extremely attractive for a business that is growing its top line at +25% while trading at a 2023 P/E of 10.2x with a proven value creator at the helm.
We exited the 20+ year Treasury Bond ETF Put Options (TLT US 1/19/24 P143) following the strong move in rates seen earlier in the year. Precigen Inc. (PGEN) was exited to capture tax losses during the period.
Top Contributors and Top Detractors
|Top Contributors||Ticker||Contribution (bps)|
|Karuna Therapeutics Inc.||KRTX||134|
|Uber Technologies Inc.||UBER||47|
|Puretech Health PLC||PRTC LN||43|
|Energy Transfer LP||ET||42|
|Top Contributors||Ticker||Contribution (bps)|
|Alibaba Group Holdings||BABA||-154|
|DXC Technology Company||DXC||-84|
|OneMain Holdings Inc.||OMF||-79|
*Contribution illustrated above are provided gross of fees and includes cash.
Karuna Therapeutics Inc. (KRTX) was a top contributor to the fund in 3Q after the company announced positive Phase 3 (P3) results for KarXT in schizophrenia, an $8B market that has not had a new innovative treatment in decades. The company expects to file an NDA submission by mid-2023, setting up regulatory approval by mid-2024. In the meantime, the company will focus on moving forward with its trials in Alzheimer’s disease psychosis (ADP), a patient population where the mechanism of action has historically demonstrated both cognitive and behavioral improvements. Readouts are expected from this indication by 2025. Following the strong P3 results, the company raised $750M in a secondary offering to fund commercialization efforts through 2025. With peak sales in both indications estimated around $4B, the company is still trading at <1x Peak Sales – far below a typical takeover multiple of roughly 3x implying upside of 245% for both indications or 72% for Schizophrenia alone.
ADT Inc. (ADT) had a strong quarter after State Farm announced a new partnership with the company as well as a strategic investment resulting in State Farm owning 15% of ADT. Apollo Global Management (APO), ADT’s large Private Equity owner, agreed to tender their shares in the buyback offering which if fully redeemed will reduce APO’s ownership from 71% to 57%. The company believes the State Farm partnership will reduce customer acquisition costs while increasing retention, both key levers to ramping free cash flow (FCF) generation rapidly. At last year’s investor day, the company guided to $1B in FCF by 2025 ($1.00/shr, 12.6% FCF Yield), and this partnership should help clear the path to reach those targets. With 13.7M homeowner policies compared to ADT’s 6.5M customers and limited overlap, the State Farm partnership should create material revenue synergies for ADT.
Uber Technologies (UBER) climbed during the quarter after announcing 2Q results that showed strong improvement on profitability, a metric the market is consistently focused on. The company showed strong incremental margins in the Mobility business of 13% vs long-term guidance of 11% while the EATs business showed an impressive 27% incremental margin far ahead of long-term guidance of 4.5%. The company reiterated their confidence in EBITDA and FCF generation noting that expenses are entirely at management’s discretion. The company has guided for EBITDA of $5B in 2024, meaning the shares are priced at 11x EBITDA with the top line expected to continue to compound at 20%. In addition, with the company focusing on FCF they should generate $2.00 in FCF by 2024, a yield of 8.2%. With CEO Dara Khosrowshahi making significant purchases at prices well above current levels, we think Uber is one of the most attractive high growth names on the market today with a clear line of sight to profitability.
Alibaba Group Holdings Inc. (BABA) reversed gains made in the second quarter following the end of the lock-down measures in Shanghai. Alibaba continues to look extremely cheap trading at 10x forward 12-month earnings, near an all-time low. However, the market continues to focus on the macro becoming concerned with the potential negative implications from China’s continued zero-COVID policy as well as the quickly deteriorating property market. Given the uncertainties around the top line, the company is now focusing on cost reduction resulting in EBITDA beating expectations by 23% in 1QFY23. The company continues to utilize its strong net cash balance of $81B for buybacks with a current authorization of $25B, 12% of shares outstanding. Even if the Chinese economy continues to be pressured in the near-term, we believe you can buy a pre-eminent business in one of the world’s largest economies at a below market multiple. We believe the company is materially undervalued.
DXC Technology Company (DXC) had a difficult quarter after their 1QFY23 results missed management’s guidance and consensus expectations with the company lowering full year expectations. The company highlighted their prioritization of profitability over top line growth which resulted in delays in 3-4 large deals in the quarter due to pricing. The market doubts the company’s ability to hit its FY24 targets that were laid out at their investor day in 2021. For FY24, the company guided for organic revenue growth of 1-3%, adjusted EBIT margins of 10-11%, EPS of $5.00-5.25 (5.3x P/E) and FCF of $1.5B (24% FCF Yield). Even if they slightly miss their guidance, a free cash flow level of $1.2B still implies a FCF yield of 20%. More recently, management confirmed the company is involved in takeover discussions.
Mattel Inc. (MAT) was flat for most of the quarter until selling off in September following increasing concerns around inventory oversupply, foreign exchange (FX) headwinds, and recession fears. While the toy industry sits within the consumer discretionary space, the industry is historically more recession resilient than other areas with overall toy sales only declining -0.9% annually during the financial crisis. We believe Mattel is uniquely positioned to benefit from its ongoing turnaround and its new efforts to capitalize on its IP portfolio. It has a large number of upcoming theatrical releases including Monster High, Barbie, Little Mermaid and Trolls which should help support strong toy demand. Furthermore, the company recently won back the rights to the Disney Princess/Frozen franchise creating strong leverage in its business through its vertically integrated manufacturing footprint, unlike competitor Hasbro which outsources its manufacturing. Despite these positive tailwinds, the company is trading at valuation levels not seen since the Great Financial Crisis with shares priced at 10x next year’s earnings and a 10% FCF Yield.
Samantha McLemores’s 3Q 2022 Opportunity Equity Commentary
Christina Siegel’s 3Q 2022 Market Highlights
The Opportunity Equity composite performance figures reflected above include the deduction of a model investment management fee of 1% (the highest fee for separate accounts under our fee schedule), paid quarterly and certain other expenses. For important information about Opportunity Equity Strategy performance, please click on the Opportunity Equity Strategy Composite Performance Disclosure . Past performance is no guarantee of future results. All holdings and portfolio data are reflective of a representative Opportunity Equity account.
Contributors detailed above represent the top five securities that contributed positively to performance during the quarter. Detractors detailed above represent the top five securities that detracted from performance during the quarter. Information detailed above is provided gross of fees, includes cash, and is based on a representative Opportunity Equity account. Contribution listed above represents the period when the security was held during the quarter. For additional information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to the representative Opportunity Equity account performance contact us.
The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. References to specific securities are for illustrative purposes only. Portfolio composition is shown as of a point in time and is subject to change without notice.
The views expressed in this commentary reflect those of Miller Value Partners analyst(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
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