A Portfolio for a “Flexible” and “Patient” Fed

Income Strategy 4Q 2018 Letter

The Income Strategy lost 17.3% in the fourth quarter, underperforming the 4.6% loss of its benchmark, the ICE BofA Merrill Lynch High Yield Master II Index. The performance marked the Strategy’s worst calendar quarter since launch. While we thought most of our holdings were undervalued enough to potentially outperform the stock market in a downturn, approximately half of the portfolio still underperformed the equity market’s -13.5% total return. Fourth-quarter market conditions were reminiscent of those we observed toward the end of 2015 and beginning of 2016, when the Strategy performed similarly. At the time, we posited that the market had grown increasingly concerned about a Federal Reserve hiking interest rates on auto-pilot and wrote a letter titled, “The Fed: Data-Dependent or Date-Dependent?” positing that market movements implied concern about a discrepancy between the Federal Open Market Committee’s (FOMC) long-run policy statement and future actions intoned from public remarks. FOMC Chair Jay Powell said on October 3rd, “We are a long way from neutral,” implying he thought that many more interest rate hikes lay ahead. It is not coincidental, in our opinion, that this date also marked the peak in the equity market and near-peak in the bond market’s expectation for annualized inflation over the coming decade. While it is easy to dismiss short-term moves as noise, the ferocity and extent of the moves across multiple trillion-dollar markets could only point to a few broad, systemic factors, the most significant of which is the price of money. Trade wars have also contributed to lower prospects for growth, at the margin, and a looming US government shutdown did not help either.

One of the underlying assumptions behind our portfolio construction is that the Fed is likely to meet the objectives laid out in its Statement on Longer-Run Goals and Monetary Policy Strategy. As the FOMC itself notes, the Committee has much less control over the employment picture than it does over price stability, and today’s robust US employment picture means that the FOMC must primarily concern itself with its price stability goal. It is worth noting that the Fed regularly refers to this objective as a “symmetric (emphasis added) inflation goal” of 2%, because only two quarterly readings in the past ten years (40 readings) have had a rate of inflation starting with a “2,” while the other 38 have started with a “1” or “0.” If the Fed means what it says, one would think that Committee members would be in no hurry to raise rates again, but they continued to project two additional interest rate hikes in 2019 at the December meeting. Since that time, Jay Powell tweaked his communications strategy, noting that the FOMC would be “flexible” and “patient.” This suggests he is listening to the markets, which are forward-looking discounting mechanisms.

The market has certainly discounted lots of potential issues, which makes us very optimistic about Income Strategy’s prospects. For instance, we have long been fans of the alternative asset managers, which comprised just under 15% of the portfolio at the beginning of the year. They had a terrible 2018, but today’s valuations are incredibly compelling. Take Apollo Global Management (APO), for instance. This company makes money in two ways: it earns a management fee, typically 1-2% of assets in a given strategy, and it earns an incentive fee, or a portion of the profits generated when one of the funds it manages sells something (also known as “carry”). The management fees, and the costs tied to those fees, are very predictable. Apollo has said they will generate $2.00 in fee-related profits in 2019; that number has grown steadily and is likely to continue to grow over the long term. Compare that $2.00 in fee-related earnings to today’s ~$26 stock price (13x), and you are buying the stock at a below-market multiple, despite a company growing earnings power faster than the market with less capital intensity than the market (unlike many companies, Apollo does not need any more capital to continue growing). In addition, the company is almost certain to generate meaningful additional earnings as it sells companies at higher prices than it paid. The market has rarely given these companies any credit for their carry profits, but the last time Apollo traded near this multiple on fee-related earnings was the beginning of 2016, and it nearly tripled over the following two years. To be clear, we expect a poor fourth-quarter report due to the challenging market conditions, but we are immensely optimistic looking forward.

While we are optimistic about many long-standing positions with depressed valuations, there are several new large positions in the Strategy. The one we would like to highlight here is the General Electric 5% perpetual preferred. This security traded near par until the beginning of October, which is especially interesting considering that the bulk of the value destruction in the common stock occurred prior to that time, and the beginning of October marked the start of selling pressure across many markets. Our average cost on this is ~$0.80 on the dollar, implying a yield of ~7.5%, which we think should easily outperform our primary benchmark. However, there are several other compelling ways to win here beyond coupon-clipping. While this security sits below almost all of the debt in the capital structure, we think it affords a strong margin of safety, as we still have over $75B of equity market capitalization beneath us, and the common shares appeared to find a bottom in December at almost the exact time the Board cut the common dividend, even as most stocks were declining. However, the Board maintained a stub dividend of $0.01/share, amounting to almost $350M in cash payments each year. Meanwhile, the preferred share dividend amounts to $285M per year. If times got tight, management could more-than cover the preferred dividend by eliminating the common dividend. Another interesting aspect to this paper is that its coupon begins to float in two years. At current interest rates, it would cost GE another $50M in cash payments each year into perpetuity; if short-term rates rise further, the debt will become even more expensive for GE. However, the issue is “callable,” which means GE has the option to repay the debt at the time it begins to float, which would prevent them from paying additional interest at that time. The “yield-to-call,” or annualized rate of return in the event that management decides to repay the issue, is almost 17% at our average cost.

These are just a few of the many compelling opportunities we are finding in today’s market. As always, we remain among the largest investors in the Strategy, and we welcome any questions or comments.

Bill Miller IV, CFA

Strategy Highlights by Tyler Grason

Top Contributors

Just Energy Group (JE CN) was the top contributor over the period, advancing 9.67% on strong fiscal 2Q19 results where Earnings Before Income, Taxes, Depreciation, and Amortization (EBITDA) of C$37.3M came in well ahead of consensus of C$24M. Realized gross margin expansion of 45% Year-over-Year (Y/Y) drove the beat and there were benefits from price increases implemented in the prior quarter. The company maintained their C$0.125 per share quarterly dividend (10.1% annualized yield) and improved their coverage as the payout ratio fell to 82% on a trailing twelve-month basis. Management reiterated Fiscal Year (FY) 2019 guidance of C$200-$220M in base EBITDA, up ~10% at the midpoint, which they expect to be driven by investments in international growth, smart energy initiatives, and increased weather hedges.
Chimera Investment Corp (CIM) rose 0.99% during the quarter after reporting solid core results. Earnings per share of $0.60 beat consensus estimates of $0.58 and comfortably covered the dividend of $0.50/share (10.9% annualized yield). Revenues of $147M came in above expectations of $141M, while book value rose slightly to $17.02. The beat was driven by higher-than-expected net interest income and lower deal expenses.
EIG Investors Corp 10.875s of 2024 were up 0.12% over the period with a 9.4% yield-to-worst. The company reported Q3 EBITDA of $87M, beating analyst estimates of $78M, largely due to better cost efficiencies. Management raised FY18 EBITDA guidance 3% at the midpoint to $330M-$335M (from $310M-$330M) and is continuing to pay down debt.

Top Detractors

National CineMedia (NCMI) was the top detractor over the quarter falling 37.34% after reporting Q3 revenues of $110.1M and Operating Income Before Depreciation and Amortization (OIBDA) of $53.6M, both short of estimates of $117.5M and $60.9M, respectively. The miss was driven by lower-than-expected advertising revenue and increased spending on new digital initiatives. The company maintained their $0.17/share dividend (9.7% annualized yield), raised the low end of FY18 revenue guidance to $435-$450M (from $430-$450M), and reaffirmed OIBDA guidance of $205-$215M. Further, the Board announced they will not renew CEO Andy England’s contract and have appointed President Clifford Marks as interim-CEO.
Carlyle Group (CG) fell 28.68% during the period. The company reported Q3 economic net income of $0.25, missing consensus estimates of $0.49 due to weaker-than-expected results in Asia. Distributable earnings, however, came in at $0.56 beating the $0.43 estimate and resulting in a $0.42/share distribution (9.7% annualized yield). Strong realization activity drove the cash flow beat, while fee-related earnings came in ahead of management’s expectations at $89M, +54% sequentially.
Apollo Global Management (APO) fell 27.74% over the quarter on Q3 economic net income of $0.83, below consensus of $0.99. Distributable earnings of $0.55 came in better than expected and was up 31% Y/Y, producing a distribution of $0.46/share (6.9% annualized yield).

¹For important additional information on Income Strategy performance, please click on the Income Strategy GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

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