January 18, 2018

Finding Income that Benefits from a Rising-Rate Environment

Income Strategy 4Q 2017 Letter

The Income Strategy returned 0.80% (net of fees)1 in the fourth quarter of 2017, outperforming its benchmark for the sixth consecutive quarter. We have long attempted to position the Strategy in anticipation of rising interest rates, and our relative performance suggests we are achieving that objective. In July of 2016, financial markets observed an eight-century low in the global risk-free rate. It is interesting to note, then, that the Strategy’s span of relative outperformance began the same quarter rates bottomed. Conversely, we underperformed our benchmark in six of the nine full quarters between February 2014 and the 2016 rate bottom. How we create such a portfolio is the topic at hand.

As interest rates rise, fixed-income securities must decline in price to compensate buyers for the higher rates they can find elsewhere in the market. The main way we overcome this challenge is through owning securities whose capacity or requirement to pay is likely to increase as rates rise. While floating-rate debt matches that description, we think we can do better in a rising-rate environment owning undervalued equities and debt that are not pricing in an accelerating economy and the associated “animal spirits” that we think may just be starting to stir with rising prospects for growth.

For instance, one of the largest positions in the Strategy is our collective holding in alternative asset managers; Carlyle (CG), Apollo (APO) and Blackstone (BX) together comprised almost 15% at year-end. These companies intend to pay out substantially all of their net income generated every single quarter. It is impossible to predict what cash earnings these companies will generate and pay in a given quarter, because market conditions and unknown idiosyncratic factors influence the timing of sales from their portfolios, and the managers reap a portion of the gains on sale. Interestingly enough, while these names have been a big contributor to the Strategy’s performance over the last year, the P/E multiples remain stubbornly low relative to other financials and the market, especially in light of the business characteristics. Our largest holding, Carlyle Group, trades at just 9.8x the consensus earnings estimate for 2018. It seems hypocritical to cite an estimated multiple after pointing out the difficulty in estimating future earnings, but the longer we look out, the more confidence we have in estimating future returns relative to historical returns. Even a pessimistic view on future returns implies material undervaluation, we think. If the economy continues to accelerate, these firms’ portfolio companies should see stronger real growth and cash flows, which the market will likely then capitalize at the time of sale. Our estimate of intrinsic value today implies 30-50% upside depending on the name, not including the substantial dividends we expect to clip.

Alternative asset managers are not the only group we think could do well in a rising-rate environment. We have not historically had a large concentration in energy master limited partnerships (“MLPs”), primarily because valuations were not compelling. At its peak in September 2014, the Alerian MLP Index yielded just over 4%, while WTI crude was trading near $100/barrel. MLP investors were quick to capitalize the high oil price and seemingly indefinite growth prospects for the group until the oil price collapsed with oversupply and deflationary fears gripping the market. Since that time, the index is now off almost 50% from its peak and yields 6.5% versus the high-yield index at 5.7%. The oil chart today is pointing to higher prices, which likely means increased need for energy services and transport as drilling increases. In other words, the market today is capitalizing hardly any growth despite growth prospects looking better than they have in years. Within that backdrop, we started buying the fracking sand company Hi-Crush Partners (HCLP) in the fourth quarter. We have owned the company in the past, and it jumped back on our radar screen after reinstating its dividend in October along with a $100M share buyback program — more than 10% of its market cap when it was announced – implying a high-teens “owner’s yield” on our initial purchase. The stock still trades at 5.7x this year’s earnings estimate, which we believe could prove too low. We also own Energy Transfer Partners (ETP), which once traded for more than $50/share and 16x EV/EBITDA with a 6% yield. Today, it trades at $20/share and 8x EV/EBITDA with a yield north of 11%; shares have also historically bottomed at 8x EV/EBITDA.

These are just a portion of our holdings that we think could do particularly well if the global synchronized recovery continues to take hold. The OECD recently reported that all 45 countries it tracks are poised to grow this year, with 33 of them likely accelerating from a year ago. This is the first time in ten years that all countries it tracks are growing at once. In the US, the New York Fed now predicts that real GDP grew at 3.9% in Q4, double the rate it was projecting at the beginning of the quarter. If GDP growth prints north of 3%, it would be the first time since 2005 that the country will string together three consecutive quarters of growth above 3%. Clearly, there is no guarantee that growth will continue, but we very much like the Strategy, especially relative to other income portfolios, in the current environment. We appreciate your support and welcome any questions or comments.

Bill Miller IV, CFA

Strategy Highlights by Tyler Grason

Top Contributors

  • Apollo Global Management LLC (APO) was the top contributor during the quarter, rising 12.70% as the alternative asset manager posted another strong quarter. Apollo reported 3Q17 economic net income of $1.07 handily surpassing the $0.61 consensus estimate. Strong performance across all segments drove the beat, most notably private equity, which returned a robust 7.3%, leading to higher-than-expected performance fees. Further, realization and fee-related earnings are expected to ramp up in Q1 2018, while credit fundraising continues at a solid pace.
  • Abercrombie & Fitch Co. (ANF) rose 22.09% over the quarter. The company reported Q3 EPS of $0.30, easily surpassing consensus estimates of $0.22, as well as their dividend of $0.20 (4.8% annualized yield). The +4% same-store sales beat, versus estimates of +0.4%, was driven by the Hollister brand’s +8% comp, while the namesake brand lagged at -2%, but was noticeably better on a sequential basis (-7% in Q2). The company has now seen multiple quarters of same-store sales improvement and now expects to post positive comps, in the low single digits, for the fourth quarter, driven by gains across the Hollister and Abercrombie brands.
  • William Lyon Homes 6.5% Preferred rose 21.84% over the period after reporting strong Q3 EPS of $0.71 and revenues of $490.3M, both surpassing estimates of $0.68 and $485.66M, respectively. Net new home orders were up 19% and gross margins increased 160 basis points sequentially to 18.1%. The company guided Q4 sequential gross margin improvement of 50-70 basis points and pretax income of $60-$65M, coming in above consensus estimates. We eliminated this position as the mandatory conversion into common shares would mean no further income.

Top Detractors

  • Triangle Capital Corp. (TCAP) was the top detractor over the quarter, falling -21.94% after reporting Q3 net interest income of $0.36, missing analyst estimates of $0.41 and lowering its dividend one-third to $0.30/share (12.3% annualized yield). Credit challenges caused an 11.0% decline in book value to $13.20 (0.74x P/B), which resulted in a slew of analyst downgrades. The positions appear to now be conservatively marked, which makes us think shareholders are likely to eventually realize a value closer to book than where shares trade today.
  • CBL & Associates Properties (CBL) fell -28.14% over the period. The company slashed the dividend 26% to $0.20/share (13.8% annualized yield) and guided funds from operations lower to $2.08-$2.12 per share, versus estimates of $2.20. Management admitted ample liquidity did not necessitate a dividend reduction, but the company wanted to hoard additional defensive liquidity in the midst of a difficult environment.
  • Maiden Holdings Ltd. (MHLD) fell -12.15% during the quarter as the company reported Q3 EPS of -$0.66, a big miss from analyst estimates of $0.09. The miss was attributed to a $77.7M, or approximately $0.88/share, reserve charge related to its AmTrust Financial Services (AFSI) reinsurance quota.

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.

©2018 Miller Value Partners, LLC

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