Buck Showalter and Income Opportunity Strategy’s 3rd Quarter

Market Commentary

The Baltimore Orioles in 2014 had a year that few expected. A roster of lesser-known players stepped up to overcome a few season-ending injuries, and it seemed like there was a different hero every night. Manager Buck Showalter used the phrase “I like our guys” so often in response to questions about his roster that the organization printed it on T-shirts for a fan giveaway. Despite a disappointing third quarter for Income Opportunity Strategy, we feel the same way about the portfolio’s holdings. In the third quarter, Income Opportunity Strategy lost -3.72% (net of fees)¹, underperforming both the S&P 500’s 1.13% return as well as the BofA Merrill Lynch High-Yield Master II’s² -1.92% loss. While we generally take a long-term approach to our positions, it is nonetheless frustrating to underperform over any time period.

As the Strategy’s primary goal is to generate a high level of income, we think it’s useful to take a close look at the characteristics and changes in cash received from the portfolio’s holdings. Changes in a company’s dividend policy often provide a tangible reflection of management’s confidence in the business. One might expect dividend cuts and a lower amount of cash received from the Strategy’s holdings in light of a falling net asset value that underperformed unmanaged indices. However, the Strategy saw exactly the opposite in the third quarter. Thirteen of the holdings as of 9/30/14 increased their dividends or initiated a payout during the quarter, compared with four that reduced their payouts. Of these four sequential “reductions,” three came from alternative investment managers, whose distributions bounce around unpredictably with portfolio company exits and tend to provide little insight into future distributions. Excluding these companies, there were 12 increases or initiations against one reduction. The aggregate cash received by the portfolio on a per-share basis was significantly higher in the third quarter than it was in the second quarter.

So, while the price action within the portfolio was disappointing in the third quarter, we are optimistic given the new information and higher cash flows declared by the Strategy’s holdings during the quarter. In the words of Buck Showalter, we “like our guys” even more at these prices than we did entering the quarter. We will continue to be among the largest investors in the Strategy for the duration of our tenure, and we welcome any questions or comments.

Strategy Highlights

During the third quarter of 2014, Income Opportunity Strategy generated a total return of -3.72% (net of fees). In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned -1.92% and 1.13%, respectively.

The portfolio initiated seven positions and eliminated one during the quarter, ending the quarter with 87 holdings.

Top Contributors:

New Media Investment Group (NEWM) was the portfolio’s largest contributor, rising 20.0%. The local newspaper company announced its first quarterly dividend of $0.27, approximately half of free cash flow. The company also completed three acquisitions over the period, totaling $61.3M, and raised over $100M of equity to finance new acquisitions, as the company continues to find attractive papers up for sale. The most recent acquisitions included a Texas & Virginia newspaper portfolio, Alice Newspapers Inc., and the Providence Journal.
Windstream Holdings Inc. (WIN) continued to increase over the quarter, rising 10.7%. Management announced that it plans to separate their business into a telecom operating company and a property REIT by the beginning of 2015. Investors applauded the tax efficiencies and additional cash flow flexibility that the transaction should create.
Apple Inc. (AAPL) was up 34.3% during the quarter, as Apple’s new iPhone 6 and 6 Plus hit stores. The first weekend sales for the new phones were up 11.1% year- over-year (YoY) and show promise for a strong product cycle. Apple also introduced Apple Pay which will allow it to enter into the payments space. Management also unveiled the new Apple Watch, which will be available in early 2015.

Bottom Contributors:

Herbalife Ltd. (HLF) declined over the quarter, decreasing -32.2% while it continued to suffer attacks from Bill Ackman accusing the company of being a pyramid scheme. The company also reported that second-quarter EPS declined and missed analyst estimates, even as revenue rose YoY.
QIWI PLC (QIWI) gave back all of its strong performance from the first quarter, ending the third quarter down -20.7% despite a 51.7% dividend increase and a beat on revenues and earnings in the second quarter. EPS were 22.3% ahead of consensus with revenue growing 21.1% YoY in the second quarter, resulting in management increasing their FY14 guidance for the second time this year. The underperformance appears linked to the decline in the Russian ruble along with fears of a global economic slowdown and political turmoil weighing on Russia’s economy.
Och-Ziff Capital Management Group LLC (OZM) declined -21.5% during the third quarter as asset managers continued to struggle. Och-Ziff reported distributable earnings of $0.18, up 12.5% YoY but falling a tenth of a penny shy of the consensus estimate. Management declared a $0.17 distribution, up 21.4% from the previous year, and Och-Ziff saw strong inflows of $2.6B.

¹For more detailed annualized performance information, please click here. Past performance is no guarantee of future results. LMM LLC claims compliance with the Global Investment Performance Standards (GIPS). Click here for the Income Opportunity Strategy GIPS Disclosure document.

²The BofA Merrill Lynch High Yield MAster II Index tracks the performance of below-investment grade, but not in default, U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market, and includes issues with a credit rating of BBB or lower, as rated by Moody’s and S&P. Please note that an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

Contact LMM to obtain information on how Top and Bottom Contributors were calculated 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 commentary reflect those of LMM LLC (LMM) portfolio manager(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading on behalf of any portfolio. Any data cited is from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.