Income Strategy 1Q 2018 Letter

Over the past quarter, the Income Strategy returned -0.96% versus -0.91% for our primary benchmark, the Merrill Lynch High Yield Master II Index. The first quarter of this year was much different than the prior quarter, as we generated a positive total return in Q4 and outperformed our benchmark, while we generated a negative total return in the most recent quarter and slightly underperformed our benchmark. The first-quarter market turbulence felt worse than it was due to what psychologists refer to as “the contrast principle.” Our perception of an event will differ materially based on what happened prior to the event. Heading into the equity market peak this January, tax reform and strong underlying fundamentals combined with low volatility to push the market to new highs, creating the longest period since 1929 without a correction of 5%. Then, during a period of just two weeks, the market lost nearly 12%, seemingly inexplicably. Despite the psychological pain tied to a drop of that magnitude on the heels of such low volatility, it is important to note that most pullbacks of 10% tend to be short-lived and do not turn into longer, more significant bear markets. Indeed, reasons for optimism abound, as noted in the Market Outlook: Interest rates and inflation are low by historical standards, while real wages are showing signs of life. Regulatory burdens in the US are falling, and analysts continue to push earnings estimates for the S&P higher.

It is from that perspective that we construct the Income portfolio. We continue to consider most fixed income expensive relative to equities. It may then come as a surprise that we made CYS Investments (CYS) a top holding in the portfolio in the first quarter of 2018. The company is an agency mortgage REIT (real estate investment trust), meaning that it buys mortgages whose principal and interest payments are guaranteed by a government-sponsored enterprise. It also uses significant debt to finance its holdings. In other words, CYS Investments holds a leveraged portfolio of bonds that we view as expensive, just as interest rates are starting to move higher. We also expect material degradation in agency mortgage REIT book values, along with marginal dividend reductions due to the flattening yield curve. Buying such an asset does not seem like a recipe for excess returns. However, we like to invest where the expectations implied by an asset’s price differ materially from what we think is likely to happen. CYS’s price declined by over 25% between the third quarter of 2017 and the first quarter of 2018. More importantly, the price/book multiple declined by a similar percentage. Agency mortgage REITs, unlike many other types of financials, represent some of the most liquid pools of assets traded on equity exchanges. The book value, while stale, is largely clean and not up for much debate. Book value represents a reasonable proxy for intrinsic value largely due to the portfolio’s liquidity. It is rare that agency mortgage REITs fall too far below book value, though there are precedents for it. In the 2013 “taper tantrum,” the ten-year yield moved sharply higher from 1.63% to just over 3%, nearly doubling over the course of seven months. Investors dumped agency mortgage REITs, fearing that rising rates would crush book values, pushing the stocks’ book value discounts to almost 30%. In the beginning of 2016, investors sold the group again, this time fearing that a flattening yield curve would reduce earnings and dividends, pushing the discounts again back to 30%. In both cases, the returns for forward-looking investors turned out to be compelling. There is no assurance the same will happen this time, but we think there are a variety of ways an investor can win.

Last year, we bought another name whose valuation we found too pessimistic for its prospects — Abercrombie and Fitch (ANF). The stock now yields less than 3% but is the fourth-largest weight in the portfolio. When we were last buying the stock in the summer of 2017, management announced it was no longer shopping the company to potential buyers. The announcement pushed shares down to prices last witnessed in 2000, a year that Abercrombie generated approximately one third of the sales it did in 2017. Shares traded at less than 3x EV/EBITDA after the swoon and touted a qualified dividend yield of 8%, even though management had demonstrated ongoing improvement in same-store sales with the new merchandising strategy at Hollister. The market eventually came around to our view, driving the share price higher and the yield lower than where we would normally look for new ideas. Rather than sell the shares as their yield declined below our desired level, we held on, as we viewed them as still inexpensive relative to intrinsic value. We found it worth highlighting this as an example of our flexible approach to income, as our primary focus is valuation and not yield.

We hope that providing a glimpse into some of our unique positions gives investors a sense for how we view the world and approach the market. We remain the largest shareholders in the Strategy and, as always, welcome any questions or comments.

Bill Miller IV, CFA

Strategy Highlights by Tyler Grason

Top Contributors

  • Abercrombie & Fitch Co. (ANF) was the top contributor during the quarter, rising 40.07%. The company posted Q4 earnings per share (EPS) of $1.38 and revenues of $1.19B, both surpassing analyst estimates of $1.10 and $1.16B, respectively. Net same-store sales of 9% came in better than expected, with Hollister at +11%, and the namesake brand at +5%, the first positive comp in 20 quarters. Management forecasts 2018 same-store sales and top line growth up and in the low single digits as product initiatives begin to take hold.
  • Triangle Capital Corp (TCAP) rose 20.29% over the quarter as the company reported Q4 net investment income of $0.38, surpassing consensus estimates of $0.33, and their dividend of $0.30 (10.3% annualized yield). Total investment income of $31.7M was better than expected due to an increase in non-recurring dividend and fee income, while book value per share rose 1.7% to $13.43 (0.86x Price/Book).
  • While Mortgage REIT CYS Investments (CYS) was down -13.48% over the quarter, our timely purchase of the shares resulted in the security increasing 6.21% over the period the Strategy held it. The company confirmed street expectations when they slashed their dividend -12% to $0.22/share in Q1 (13.0% annualized yield), but the cut removed a looming overhang and the stock remains attractive at 0.81x P/B.

Top Detractors

  • National CineMedia (NCMI) was the top detractor over the quarter, falling -22.02%. The company reported Q4 EPS of $0.27, surpassing analyst expectations of $0.21, but missed on revenues of $140.7M versus consensus $144.5M. The company cut their dividend -22.7% from $0.22/share to $0.17/share (11.7% annualized yield), which will allow for ongoing reinvestment, specifically in the company’s network and its integrated digital products. Management guided 2018 revenue of $425-$445M (flat to +4.5%) versus estimates of $440M and operating income before depreciation and amortization (OIBDA) of $200M-$215M (-2.5% to +4.8%) versus consensus $213M.
  • Apollo Global Management (APO) fell -9.75% over the period as the alternative asset managers group fell with the broad volatility and weakness in the equity markets. The company did, however, post strong Q4 economic net income of $1.22, handily surpassing analyst estimates of $0.66, as well as their dividend of $0.66/share (8.9% annualized yield). The beat was driven by better than expected performance in Private Equity portfolios (+9.1%), coupled with higher management and advisory/transaction fees.
  • CBL & Associates (CBL) fell -23.28% during the quarter. The company reported Q4 funds from operations of $0.56 and revenue of $235.36M, both falling short of consensus estimates of $0.57 and $242.18M, respectively, while same-store net operating income declined -6.7%. Management forecasted 2018 same-store net operating income (NOI) declines between -6.75% and -5.25% and guided 2018 funds from operations of $1.70-$1.80, which comes in well below street estimates of $1.97.