March 27, 2018

6 Questions on Opportunity Equity

What are some of the biggest risks investors face in the current market?

We’re in the ninth year of an economic expansion, and it seems like there’s more and more talk lately about it being late-cycle, rising rates, stocks are expensive, risk is growing, risk to the expansion. Although recessions have been fairly common in the U.S., happening about once every four years on average since 1950, there’s no iron law of cycles that makes them repeat in that pattern. Australia’s last recession was 27 years ago, Holland went from 1982 to 2008 without a recession, and in the U.S., recessions have typically been endangered by excessive Fed tightening or an external shock, such as rapidly rising oil prices. Neither is present currently, nor do we think they are likely any time soon. The Fed has signaled that it, and the market, expects three to four rate increases this year. The last jobs report couldn’t have been better, so we had strong jobs growth, rising labor force participation rate, real wage growth, and tepid inflation, which was below what people thought and the market interpreted positively. There’s no signs of systemically important imbalances, and the critical economic variables are all positive, with real GDP growth, real wage growth, low inflation, record corporate profits, record GDP, high profit margins, strong balance sheets, record household network, and the longest period of monthly job growth ever. The global economy is in a period of synchronized expansion and economic variables around the world are getting better.

That being said, there’s no shortage of things to worry about. Tariffs and a possible trade war, North Korea, Q1 GDP was slower than people expected, but that’s been common throughout the expansion with Q1 being a little weaker. Tight labor markets potentially leading to inflation is another fear, widening high-yield credit spreads, a flattening yield curve signaling slower growth in the future, rapidly rising budget deficits due to the tax cuts, the Mueller probe, and so on, and so on, and so on. But taken together, we still believe the path of least resistance for stocks is higher, but with considerably more volatility than we’ve seen in the past. Last year we had record low volatility; we went the longest time in history without a 5% pullback. We’ve already ended that streak, and we expect higher volatility to continue going forward. That being said, the economy grows most of the time and stocks go up most of the time – since 1950, both of those time series are positive about 75% of the time. The main risk that investors face is not pullbacks during recessions and bear markets, it is being persistently underinvested during long bull market moves, which is something we’ve definitely seen since the financial crisis.

You’ve said before that volatility is often the price you pay for returns. Can you discuss how we view volatility, and how volatility in the market has changed post-financial crisis?

This is something we’ve talked and written a lot about since the financial crisis, with all the market structure changes that make these pullbacks much faster and more furious. Risk parity trading has grown, where risk is adjusted based on volatility and how well the market’s doing, so these traders are selling when things are getting weaker, and buying if things are getting stronger. A lot of trading algorithms are set up to do the same thing—trade on more short-term momentum. There’s been a disappearance of a number of counter-trend traders in the market, so whether that’s the prop desk at the banks or the floor traders on the stock exchanges that would step in and buy weakness, no one is really providing that function now. There’s just a lot of people who are trading on the short-term momentum, and no one stepping in on the other side. In this particular pullback, everyone was betting on the continuation of low-vol, and as vol started to increase, there was force selling again. These factors all combined to make the pullbacks much faster, much more furious. We’ve talked a lot about how it’s nearly impossible to react in these pullbacks because they’re just so quick. You need to anticipate changes in order to profit from them. We don’t really try to hedge these small, typical market corrections, 5-10% pullbacks. We do have the ability to hedge in the strategy, and that’s something we would consider if we had some reason to believe there was some bigger problem for the market, but hedging has been very, very expensive since the post-financial crisis as people have had a very high demand for anything that lowers vol and lowers risk.

Instead, we try to monetize the volatility. We think volatility is often the price you pay for returns. In this most recent pullback, we were able to buy names that we thought got the most out-of-whack and got hit the hardest during the pullback. That’s probably, in our opinion, the most sensible way to use the volatility to your advantage — is to be able to deploy cash into attractive areas that you’ve wanted to own, when everyone is just focused on this forced selling in the short term. I think today, if you take a look at Facebook, obviously it’s caught in the midst of one of these sell-offs. On adjusted earnings it’s 18 times this year’s, 15 times next. Growing revenues, still expected to grow revenues 35% this year, 27% next, with a very dominant platform, that is a very attractive valuation. Not many people are stepping in to buy this weakness, but I think you would have to see a hit to their business fundamentals that was so extreme to really take revenue growth down immensely for those valuation levels to not be attractive.

So how is the Opportunity Equity strategy unique?

We are long-term value investors. We take both of those terms seriously, so we really are looking at underlying business fundamentals to determine what we call an intrinsic value — the present value of future-free cash flows, we look at that a number of different ways, and then we’re trying to buy these names at a very steep discount to what our assessment of that value is. We truly are investing for the long term, and our average holding period is 3-5 years. We’re not trying to time the next news item and say what’s this company going to do in the quarter, are they going to beat the number by a little, is this thing going to turn out well, or is it going to turn out poorly? That’s what a lot of people in the market are trying to do. That’s not what we’re trying to do. We’re trying to build a diversified portfolio of investments with significant upside. We’re very different from the benchmark; we’re benchmark-agnostic when we’re constructing portfolios, so we have active share greater than 100%, which means the Strategy basically looks entirely different from the market. Active share has been correlated with better-performing funds. So we look different from the benchmark, we act different from the benchmark, we think our style has allowed us to do well over the long term.

Currently, Opportunity trades at a very deep discount to the market. The market on this year’s earnings is at 17.5x, and our Strategy trades at 12.5x, almost a 30% discount.1 The long-term growth of our companies are roughly in line with the market, 12.5% versus the S&P 500’s 13.2%.2 We had been higher, but more recently we’re finding more opportunities in some of the more classic value names, so those have been some of the more recent additions that we’ve been building up in the portfolio. But we’ve always talked about having diversification between names that are cyclically mispriced, so classic value names that are mispriced on a short-term basis, and then more secularly mispriced securities that we think have long-term, sustainable growth, those are names like Amazon (AMZN), which we’ve owned basically since the tech bubble burst.

Both the 5-year trailing period and the period since the 2009 low have been periods of strong performance. What are the primary drivers?

Broadly, I attribute the strong performance, both over the five-year period and the longer period since the financial crisis, to our approach that I talked about earlier — being long-term, being value-oriented, and then I would also say that an important aspect of it is that we have an appropriate, I think, but not heightened and myopic focus on risk. One thing that we’ve seen coming out of the financial crisis, and we’ve written and talked about this, is that people have been obsessed with risk, and there’s been tons of new layers of risk management in every organization, at a number of different levels, and at the same time. It’s understandable, given the big losses that people suffered in the financial crisis and never wanting to make that mistake again, but at the same time we’ve been in one of the biggest bull markets in history. Focusing primarily on risk during a big bull market is a way that you can lag the benchmarks and lag performance.

If you look at the areas of the Strategy that have done the best – homebuilders, airlines, banks – those have been big drivers that we’ve owned since the financial crisis, they’ve contributed over the entire period, they were some of the names that were hit the hardest, and ultimately, they were some of the biggest beneficiaries of economic recovery. I remember, when we were part of a bigger group in 2011 and at the end of that year, one of our analysts said that we should sell homebuilders, that was at their low, they were at half their financial crisis low, Pulte (PHM) was 3, it’s 29 now, Bank of America (BAC) was recommending selling that at 6, and it’s 32 now, because those names had done so poorly and he thought the risk was too high. We disagreed, and we were adding to those names then. It’s very hard to find names that are up five or ten times like those have ultimately performed. It’s also very difficult for your view of future risks to not be highly influenced by your view of past risks, especially when you’ve had huge losses like the financial crisis. But every performance disclosure that I’ve ever seen says something like, “past performance is not a good guide to the future performance,” and it’s 100% true — it’s true when things have done well, and it’s true when things have not done well.

I think one thing you’ve seen us do consistently over the past five years and before that is add to names that we thought were cheap on an intrinsic value basis, that maybe were getting hurt in the market. We bought Netflix (NFLX) on weakness in 2012. When Amazon had a really poor year in 2014, we added to our position there. We used long-term call options which is not something that we do that much in the Strategy, but here it was a way that we could make five times our money on Amazon versus what we thought at the time was 50-100% in the stock, and usually you don’t see that kind of skew. Last year, our top contributors to performance were Restoration Hardware (RH), Apple (AAPL) through some long-term call options again, and Wayfair (W), all of which we added to on weakness based on our view of the upside over the long term. I think we benefited from not having to worry about when things will work exactly. I can’t count every time a sell-side analyst comes in to meet with us, and I ask him or her what their favorite ideas are, they’ll give me an idea with like 20% upside in the catalyst, why it’s going to work out really soon. And I’ll look at their coverage list, and I’ll see some name with 100% upside that’s rated neutral, and I’ll say, well what about this? And they said, oh yeah, that one’s really good if you can look out 3-5 years, but no one does that. The fact that they don’t even bring that up even though they’re meeting with us, I think speaks to how not many people in the market are doing that, and I think that that’s been a big advantage of ours.

Before you mentioned diversifying the Strategy between classic value and long-term growth names. How do you incorporate growth into your assessment of value?

Warren Buffet has a great saying on this, which is that growth is an input into the value equation, and we agree with that 100%. If the value of an investment is the present value of the future cash flows, the main drivers of what those cash flows will be are the amount of profits you can generate, and then the growth in those profits. That’s how we look at it. We do look at secularly mispriced companies, names that can grow over long periods of time, like Amazon and Netflix. If you can identify those, they can be some of the biggest contributors to performance. The challenge is most companies that are priced that way don’t actually achieve that sort of growth, so we also have cyclically mispriced names that are cheap on classic price/earnings, price-to-book basis. If you look empirically, the metric that actually works the best in the market is free cash flow yield, so that’s a very important driver for us in terms of attractiveness when we’re looking at new names.

Finally, what are you most excited about in the portfolio?

If you look at the areas of focus in the Strategy, we still have a significant weight in homebuilders, financials, airlines, those have been consistent basically since the financial crisis. We still find those areas very attractive. Consumer discretionary screens as being very overweight, that isn’t really a sector view on ours, that’s more of a one-off ideas that we found attractive, like the builders are in there, and then Amazon, Restoration Hardware, and Wayfair, those all fit in that category. A new area that’s really grown in weight recently and where we’re finding a lot of new ideas and attractive opportunities now is healthcare. We don’t have any exposure to consumer staples or utilities, those are bond proxies that we think overvalued, given their stability and in this market those sort of things have traded at a premium valuation. We also don’t have any energy, just because we’ve found better opportunities elsewhere. So a lot of the names that, as I mentioned, I’m most excited about now, are in the healthcare area. This is the area that we’ve been adding to most recently. The group trades as a group, at discounts to long-term historical averages. It is a more defensive area of the market, so it has more stability in economic decline, although that’s not a reason that we like it. As I said, we’re still positive on the economy, but it isn’t something that you’re paying up for, either, at these levels.

A name I think is really attractive is Allergan (AGN). We’ve owned this one for a while, but we’ve been adding to it more recently. It got up to $250 a share last summer, and earlier this month, fell to $140 a share. It’s rebounded a little to the mid-160’s, but I still think it’s very cheap and very attractive. The most attractive part of their business is the aesthetics business, which it’s best known for Botox. Aesthetics overall is a cash-paid business with brand, much more it’s not subject to insurance reimbursement risk, and much less cyclical than other areas. This represents 40% of revenues and more like half of their cash flows. This is more of a consumer brand business that deserves a much higher valuation that a lot of analysts think should trade for 20 or 25 times earnings, and obviously with the stock currently trading at ten times earnings you’re not paying anywhere close to that for it now. Management had a brilliant sale of its generics business, obviously generics broadly have been under pressure, but they sold that to Teva at a great price. There was a lot of insider buying recently when the stock fell into the 140’s, that’s part of the reason it’s down. It bounced more recently. Brent Saunders, the CEO, was at a conference I think last week saying that all options are on the table for creating shareholder value; the board is very focused on this – they’re looking at every possible thing and they’ve accelerated their share repurchases to take advantage of these prices. At ten times this year’s earnings, you’re really paying for nothing in the pipeline, but there’s a lot of attractive stuff that they have in the pipeline and you’re getting a good deal on the aesthetics business. I think that the stock should be worth at least $250-$275, so that’s 50% upside with low risk.


1Current year forecast EPS. As of 2/28/18. Source: FactSet
2Estimated 3-5 year EPS growth as of 2/28/18. Source: FactSet

The views expressed in this report reflect those of the Miller Value Partners strategy’s portfolio manager(s) as of the date published. 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.

©2018 Miller Value Partners, LLC

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