Income Strategy 3Q 2023 Letter

In the third quarter of 2023, the Miller Income Strategy returned 1.85% (net of fees), outperforming the ICE BofA High Yield index’s 0.54% return. The strategy advance bucked the broader trend across securities markets, as the S&P 500 lost -3.27%, 5 basis points less than bonds’ -3.22% decline over the same timeframe (measured by the AGG ETF), while the median stock in the S&P 1500 lost -4.7% during the quarter. The weakness was largely tied to rates continuing their parabolic move higher. Since bond yields bottomed in the Spring of 2020, the 10-year Treasury note’s intraday low yield of 0.31% surged to end September 2023 at 4.57%, within spitting distance of the quarterly high hit just days earlier.

In January 2022, we said that supposedly “safe” government bonds were likely to prove anything but – the note “Ruminations on Returns, Rates and the World’s Biggest Buyer” contended that ongoing quantitative easing from the Fed could lead to continued economic strength and inflation, making 10-year notes yielding 1.74% a particularly unattractive risk-reward proposition, even after their already poor performance. Since that time, 7- to -10- year Treasury notes are off over 16% as of this writing, a supposedly “three-standard-deviation move” for practitioners of mean-variance portfolio optimization, something that should happen less than 0.3% of the time. All of this speaks to the idiocy of using historical volatility and return assumptions when independent, objective thinking around extreme valuations and their implications suggests otherwise.

Times have changed, though, as the “World’s Biggest Buyer” has become the “World’s Biggest Seller.” Since March 22nd of this year, the Fed has been shrinking their balance sheet by north of $27B per week, persistently draining liquidity from the system after stepping in during March’s Silicon Valley Bank collapse. In our prior note, “Who’s Afraid of an Inverted Yield Curve, Anyway?” we flagged the uselessness of economic forecasting when investing. We also pointed out that prognosticators calling for a recession because of an inverted yield curve were failing to account for the high level of uncertainty around inflation and yields, as reflected in the volatility implied by bond options markets. As of this writing, the 2- and 10- year discrepancy has reversed course, cutting the difference between the two yields by 80 basis points in just three months, generating newfound pundit optimism around a “soft landing.”

All this talk of incorrect forecasts may appear disingenuous to new readers, who might think that value investing is about “predicting” outcomes better than others. Our process actually involves almost no predictions or forecasts and instead focuses on looking for extreme valuations whose underlying logic defies probabilistic thinking around base rates and the fungibility of money. The past decade was unique, presenting a major headwind for value investors, as a world awash in capital had very little respect for it. Venture capitalists and their alphabet-soup financing model (“Series A, B, C…”) prioritized growth and scale at all costs in an effort to create either “the next monopoly” or at least the perception of such a possibility, which could then be sold to whoever was sitting on a fresh pile of free money. That game is over. Bonds are an investable asset class again, and capital is actually worth something. This means that companies which can produce excess amounts of it should trade at higher multiples than we have seen in recent memory.

So, where are we finding extremes today that might represent compelling risk-reward payoffs in light of the new paradigm? Our entire portfolio is chock-full of such opportunities, if we do say so ourselves. Our third-largest holding at quarter end was AT&T (T), a leading provider of communications and connectivity services in the US. At $15/share, the stock trades at the same price it did almost thirty years ago. The share price is much less interesting to us in relation to where it has traded in the past than in relation to how much cash the company generates and what management is doing with it. At just over 6x earnings, the stock trades near its lowest price-to-earnings (P/E) multiple ever, also representing close to its largest-ever P/E discount to the stock market. The business converts most of its earnings to free cash flow, implying a forward free cash flow yield north of 15%. Just under half of free cash flow is going toward the dividend (7.5% yield), while much of the balance is going to debt paydown. In other words, if the stock does not fall below its lowest-ever valuation, investors clip a rock-solid 7.5% in cash, while owning a growing portion of a very steady business as management reduces debt outstanding. A discounted cash flow model will suggest that intrinsic value for shares begins with a “2,” suggesting the stock is undervalued on an absolute basis. The lack of volatility in the underlying fundamentals also makes it unique when compared to many other things we own, which reduces the probability of permanent capital impairment and argues for a significant weight in the portfolio.

AT&T looks particularly attractive when compared to some of the larger names dominating the S&P 500. Compare the stock to Apple, for instance, whose revenues and profits are likely to shrink this year, even as it trades at 29x this year’s earnings estimate. The ongoing return to rationality and capital accountability, along with extreme valuations in the megacap tech stocks, have us more excited about our portfolio’s prospects than we can remember for quite some time. As always, we remain the largest investors and welcome any questions or comments.

Bill Miller IV, CFA CMT
Miller Value Partners

Strategy Highlights

In the third quarter, the Income Strategy’s representative account rose 1.85% (net of fees), outperforming the ICE BofA Merrill Lynch High Yield Master II Index’s 0.54% gain and outperforming the S&P 500’s -3.27% loss. (Exhibit 1). The strategy ended the quarter up 1.37% year-to-date (YTD) net of fees, or 461 basis points behind the high yield index and 1,170 basis points behind the S&P 500.

Exhibit 1: Performance of Income Strategy Versus High Yield, Equity Indices, Through 9/30/20231

Time Period Income Strategy (net-of-fees) ICE BofA US High Yield Index</strong S&P 500 Index
QTD 1.85% 0.54% -3.27%
YTD 1.37% 5.98% 13.07%
1-Year 13.21% 10.19% 21.62%
5-Year -0.51% 2.80% 9.92%
10-Year 2.66% 4.16% 11.91%
Inception (annualized since 4/2/2009) 9.33% 8.47% 14.53%
Source: Bloomberg, Miller Value Partners

Top Contributors

  • Chico’s FAS Inc (CHS) was the top contributor for the quarter, announcing that it will be acquired by private equity firm Sycamore Partners in a $1B deal, or $7.60/share in cash, which represented a ~65% premium to the company’s closing stock price on the last trading day prior to the announcement of the transaction. The proposed deal would result in Chico’s becoming a privately held company but includes a 30-day “go-shop” period that allows the company to solicit alternative proposals.
  • Jackson Financial Inc (JXN) was another top performer during the quarter. The company reported 2Q23 Adjusted Operating Earnings per Share (EPS) of $3.34, -26.8% year-over-year (Y/Y), below consensus of $3.54. Management noted that its estimated Risk-Based Capital (RBC) ratio increased sequentially from 1Q23 and remained within their target range of 425-500%. Total annuity account value rose 9% Y/Y to $227B, driven primarily by higher equity markets over the trailing twelve-month (TTM) period. The company returned $100MM to common shareholders in the quarter via $47MM of share repurchases and $53MM in dividends, as management reiterated its full-year 2023 (FY23) capital return target of $500MM, or ~16.0% of the company’s market cap. Statutory Total Adjusted Capital (TAC) fell to $3.8B as of quarter-end, compared to $4.7B at the end of 1Q23, with the reduction in TAC driven primarily by hedging losses as reserve releases were limited by the cash surrender minimum reserve, and related tax impacts including deferred tax asset admissibility limits.
  • Western Alliance Bancorp (WAL) also performed well during the quarter. The regional bank reported 2Q23 EPS of $1.96, -18.0% Y/Y, slightly below consensus of $1.97, and Net Interest Margin (NIM) of 3.42%, -12bps Y/Y, below consensus of 3.50%. Tangible Book Value (TBV) per share stood at $43.09 (P/TBV of ~1.1x) at the end of the quarter, +17.5% Y/Y, while the bank’s Common Equity Tier 1 (CET1) ratio came in at 10.1%, ahead of management’s estimates for 10%+, in-line with consensus. The company posted quarterly deposit growth of $3.5B, or +7.3% sequentially, with total insured and collateralized deposits representing 81% of total deposits and available liquidity coverage of 276% of uninsured deposits. For the second half of 2023 (2H23), management is guiding for deposit growth of $2B per quarter, continued CET1 growth towards the company’s 2024 target of 11%+, NIM of 3.55%, an Adjusted Efficiency ratio in the high-40’s, and net charge-offs of 10bps, at the respective midpoints.

Top Detractors

  • Medical Properties Trust Inc (MPW) was the top detractor during the quarter. The health care real estate investment trust (REIT) reported 2Q23 revenue of $337.4MM, -15.7% Y/Y, below consensus of $351.3M, and Normalized Funds from Operations (FFO) per share of $0.48, +4.3% Y/Y, ahead of consensus of $0.38. The company ended the quarter with total debt of $10.3B and an Adjusted Net Debt to Adjusted Annualized Earnings Before Interest, Taxes, Depreciation, and Amortization for Real Estate (EBITDAre) ratio of 6.8x, compared to 6.3x at the end of 2Q22. The company announced an updated capital allocation strategy going forward, which includes: i) a ~48% quarterly dividend cut to $0.15/share (11.0% annualized yield), ii) the pursuit of refinancing, asset sales, and joint-venture opportunities that bolster liquidity and enable the repayment of debt, and iii) a reduction in discretionary operating expenses and other costs for better alignment with the expected decrease in the company’s asset base and near-term acquisition activities. Management also continues to target a long-term Net Debt to Adjusted EBITDAre leverage ratio of 5-6x. Management revised FY23 guidance for normalized FFO/share of $1.55 (vs. prior guidance of $1.58), or a P/FFO of 3.5x.
  • Organon & Co (OGN) reported 2Q23 revenue of $1.61B, +1.5% Y/Y, ahead of consensus of $1.57B, and Adjusted EPS from continuing operations of $1.31, +4.8% Y/Y, well ahead of consensus of $1.00. Adjusted Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) for the quarter came in at $530MM, or a margin of 33.0%, +66bps Y/Y. Biosimilars revenue increased 14% Y/Y (+15% excluding the impact of foreign currency (ex-FX)), driven by a 20% Y/Y ex-FX increase in Renflexis sales, while the Women’s Health segment saw top-line growth of 8% (+10% ex-FX), driven primarily by Nexplanon sales growth of 12% ex-FX. The company maintained a quarterly dividend of $0.28/share, or an annualized yield of ~6.5%. Management revised FY23 guidance for revenue of $6.35B (vs. prior guidance of $6.30B), and an Adjusted EBITDA margin of 32.3% (vs. prior guidance of 32.0%), at the respective midpoints, implying FY23 Adjusted EBITDA of $2.05B, or an Enterprise Value (EV)/EBITDA multiple of ~6.3x.
  • Medifast Inc (MED) reported 2Q23 revenue of $296.2MM, -34.7% Y/Y, ahead of consensus of $253.5MM, and EPS of $2.77, -19.0% Y/Y, ahead of consensus of $1.44. The revenue decline was primarily driven by a 21.9% decline in active earnings OPTAVIA coaches and a 16.3% decline in average revenue per active earning coach. The company generated 2Q23 free cash flow (FCF) of $41.4MM, bringing TTM FCF to $199.6MM, or a FCF yield of 24.5%. The CEO noted that the company is already ahead of their expectations for delivering 200-300bps in annualized cost savings by the end of 2025 and hopes to realize 1/3 of these savings in 2023, which will be primarily earmarked for investing in the company’s various growth initiatives. During the quarter, the company announced a new product line, OPTAVIA ACTIVE, which includes premium exercise supplements and protein powders, as the company targets new customer segments and looks to capitalize on the sports nutrition category, which possesses a total addressable market size of $30B. Management maintained its quarterly dividend of $1.65/share, or an annualized yield of 8.8%, and guided for 3Q23 revenue of $230.0MM and EPS of $1.02, at the respective midpoints.

Strategy Highlights by Jack Metzger, CFA