November 19, 2018

Bill Miller: Market Observations

Highlights from a recent Investor Call dated October 24, 2018

Market Observations

  • We try to understand the interaction between actual fundamentals and people’s beliefs about what’s going to happen. It’s the beliefs and expectations that really drive things rather than the actual fundamentals. Beliefs and expectations change much more frequently than fundamentals
  • With corporate profits growth up >20% this year, we’ve had multiple compression at the broad market and individual stock levels, and even at the industry and sector levels
  • The health of the U.S. economy is outstanding:
    • Household formations growing solidly. Fed is tightening, but rates are low by historic standards. Not in the accommodative phase, but the Fed is certainly not hostile
    • Yield curve is still positively sloped; wage growth is solid; corporate profits are great; low unemployment
    • Earnings are growing, and expect growth above the rate of inflation next year
  • The market correction started around the time that Chairman Powell made a comment that we were a long way from neutral, which likely spooked people
    • Worries about tariffs, China’s economy, the upcoming election, the Mueller investigation, the Fed tightening too much – we think it’s premature to worry about the Fed’s actions, but the market worries about what it’s going to worry about when it decides to worry about it.
  • Looking at earnings and real GDP growth regressed against the long-term history of the U.S. economy – market would on average be about four years away from the next recession. If statistics hold, shortest time would be about two years from a recession.
  • We believe this to be a very typical correction. There have been 23 corrections >5% since the market bottomed in March ’09, and every time we’ve had a correction of >5%, there’s speculation about the end of the business cycle and the causes. From the standpoint of all of market history, this was within the range of normality for a correction.
  • There has been positive news during this correction (i.e., MSFT and TSLA), but also a lot of carnage (i.e., NOW). (note: data is Y/Y)
    • Microsoft (MSFT) reported numbers well above what was expected: revenues were up 19%, operating income was up 29%, net income was up 34%, earnings per share up 35% and shareholders’ yield (money returned to shareholders via dividends and share repo) up 27% year-over-year. MSFT started down after they reported those numbers and now up about 4%.
    • Tesla (TSLA) had numbers that were, again, way above expectations. They generated $800 million of free cash flow, $2.90 of non-GAAP earnings and the stock is up almost 10% in the aftermarket.
    • ServiceNow (NOW) blew away the numbers and raised guidance and the stock is only up about 1.5% after being down 6% today and 10% in the last five days.
  • Even if we go down another 3-5%, we still think it presents an exceptionally good buying opportunity relative to the fact that it looks like interest rates have peaked in the short-run. At the long end, we’ve picked up about, what, almost 15 basis points there.
    • Homebuilders, which have been among the worst groups, and tend to be early cycle names on both side of the cycle, have been at a two-year low. Pulte (PHM) reported numbers right inline and Homebuilders certainly look like they’re in great shape.
    • Micron Technology (MU) went to 1.98x EV/EBITDA, has a 30% free cash flow yield and trades at around 3.7x earnings, which makes no sense given where this company is in a consolidated industry and they’re doing a big buyback.
    • Facebook (FB) dipped into the $147 level or so. It’s a company that will grow, on the reduced numbers, about 4x as fast as the market over the next several years and it’s around a little under 10x EV/ EBITDA on this year’s numbers against the market that, at the peak, was around 14x. Has 2.2 billion users and is still growing, and has the highest profit per employee of any company in the US. The current valuation numbers really don’t make any sense except on a very short-term, emotional basis.
  • Before today, the U.S. was the only G20 country that was not down more than 10% from its peak reached earlier in the year. Not unusual for a globally linked world. The U.S. has fared better than most. Emerging market economies have been hit by the stronger dollar.
  • Buybacks have been a good source of demand for stocks over the past several years, and will likely resume as earnings season winds down over the next couple weeks
  • There are a lot more tax losses now in the market than there were four weeks ago, and that probably brings forward selling as people realize those tax losses.
  • We’re entering a fairly seasonally strong part of the year.
  • Overall, if you want to put money to work in equities, we think this is an excellent time to do it.

Deficit

  • The deficit is rising in a mostly full employment economy. But the economy is still well below capacity on a capacity utilization basis – at about 78%. We’ve had 4% growth, but that will likely slow down to 2-2.5%, which is more sustainable at least until we get to 82-83% capacity utilization – we’re still a long way from that.
  • Whether the deficit ultimately becomes a problem or not, nobody knows. U.S. dollar is a reserve currency, which is very different from economies that don’t have a reserve currency and are reliant on markets to fund deficits.
  • In 2006-2007 the current account deficit was $800 billion and growing – every major economist out there worried; the concern was that it would cause a collapse in the dollar and a recession in the U.S. The fear was that the dollar would collapse, whereas the dollar actually soared when the financial system came close to collapse.
  • People’s ability to predict things from the macro is at best quite limited.
  • We think it’s better to look at what is happening than to try to predict what will happen. Read Bill’s 3Q Letter

Tariffs

  • Tariffs hit very unevenly and where the tariffs were designed to help U.S. industries, we haven’t seen that reflected in stock behavior.
    • Since the tariffs have been put in, U.S. steel (a big beneficiary of the tariff) is down about 40%.
  • Concerns over China and how the Chinese government will respond – they have shown no willingness to “cave-in” to the things the President wants
  • China has been an outlier in the WTO – current actions by US are most likely an attempt to get them to behave better. President claims to want zero tariffs, which would put everyone on an equal playing field and which would be quite bullish
  • President has come to a deal with both Canada and Mexico, which we don’t know now if it is better than NAFTA, but certainly better than no deal and tariffs
  • We’re more concerned about the impact of the equity market on the growth rate of earnings. If the equity market goes down another 10 or 20%, that will hit not just household net worth, it’ll hit consumer confidence and spending, and that, with the linked nature of the economy and the strong network effects across industries, actually could reduce earnings from mid-single digits next year to zero faster than tariffs would.

Interest Rates and Market’s P/E

  • Higher rates mean a higher discount rate for earnings and therefore a lower P/E ratio, other things equal
  • Based on history, an inflation rate of 2% (which is the Fed’s official target) would translate empirically into a market of somewhere in the 18 to 22 range. Current levels are about 15-16
  • When Alan Greenspan was the Fed chairman, he went by the so-called Fed model, which was essentially a rule of thumb model where basically the earnings yield on the market should be roughly equal to the yield on the long Treasury. If that were the case now, the earnings yield on the current market should be at 3.5 – 4.5% to equal that of the Treasury or about 25x earnings. The idea is that the Treasury’s returns are static and don’t grow, but the earnings on the market do grow, therefore the equity risk premium is paid for or covered by the earnings growth to the market.

Questions? Comments? Feedback? Let us know.


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 managers as of October 24, 2018, the date of the call. 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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