May 15, 2018

Notes from Our 1Q 2018 Call

Bill Miller – Market Comments:

Read Bill’s 1Q Letter and the 1Q 2018 Market Highlights

  • Coming off a record year of low volatility, markets peaked Jan 26 and then had a quick 10% correction
    • Corrections are common in good markets
    • Psychologically was more damaging after coming out of 2017 which had record low vol
    • Removed most of the price risk that we’re likely to see that is a result of real change this year over last year:
      • 2017 – After Trump was elected, markets believed that his volatility, rhetoric and unpredictability would translate into markets, but did the exact opposite because his rhetoric didn’t have anything to do with markets. Tax cut had positive impact
      • 2018 – bad policy on tariffs and Mueller investigation, both causing uncertainty
      • Overall elections – Paul Ryan’s resignation symbolic that Republicans are likely to lose the House – may usher in gridlock – markets may not find that desirable as it will lead to greater polarization and potential hostility in government
  • Main issue in the market this year will be political – not economic
    • President plans to engage in direct discussions with North Korea – that could be positive or a disaster
    • Mike Pompeo and John Bolton are much more hard line, especially towards Russia, could give cause for concern especially depending on who has the President’s ear
  • Why are we bullish? The underlying conditions are intact to continue to support the bull market that began in 2009
    • solid earnings growth, good returns on capital, solid dividend growth, low inflation
    • rising earnings, expectations and estimates
    • growing global synchronized expansion
    • Fed tightening not hostile – rising rates, but low by historic standards
    • interest rates at 2.8% on the 10-year don’t provide any meaningful competition to stocks that are around 16x-17x earnings
  • Looking at the last 20 years – all cases of higher interest rates have been met with a market that’s gone higher: bull market of 1980 – bond yields rose 210 basis points and the market was up 26; 1983 – they rose 146 basis points, the market was up 17; 1996 – they rose 85 basis points and the market was up 20%; 2009 – market was up 23% and bond yields went up 160 basis points; and 2013 – bond yields were up 126 basis points and the market went up 30%.
    • We believe the financial crisis marked a significant turning point in the way the markets behave, namely with much lower interest rates, including negative interest, much greater concern about risk and volatility
    • The connection between higher yields and stock prices is, at best, more complicated, but overall, I think it looks like the market actually wants to go up.
  • If the market is up mid-single digits to low double digits this year, that would likely get the multiple back up to 17.5-18 which is not demanding against rates and market has potential to have reasonable upside over the next couple of years in that environment.
  • Low probability that we’ll have another 2008-09 financial crisis. If we had a micro crisis – a geopolitical issue, a war, etc – that could lead to a very poor market outcome.
  • Understanding risk sources in the market:
    • Asset-based crisis (06, 07, 08) really involves looking around for where there may be distortions that could upend aggregate supply or aggregate demand and where you have assets interlinked by debt that can then cascade through the system
    • Other bear markets (i.e. 1990 and 2001) were more traditional – caused by Fed tightening, liquidity shortages, etc.
    • Some concerns about a potential lack of liquidity in the overall global markets that can arise quickly (like flash crashes) – tend to be over quickly
    • If liquidity dries up and stays that way – can lead to severe disruptions in things like money markets and funding mechanisms. Would need a coordinated effort on the part of the central bank authorities to inject liquidity across whatever vectors in the economy are affected by the lack of it
    • lesson from crisis – when you have an asset-based crisis that is systemically disrupted, you do not buy into that just because the Fed starts cutting rates. You wait until there’s a coordinated effort to ameliorate whatever the problem is that destabilized those asset values.

Bill Miller IV on Income Strategy

Read the 1Q 2018 Letter

  • We believe the Income Strategy’s dividend is sustainable and our goal is to grow it over time
  • 1Q dividend was lower than expected due to a peculiarity in inflow timing – concentrated strategy with 41 positions – cash flows come in in a lumpy manner over the course of a quarter, while bulk of 1Q subscriptions came in after a significant portion of inflows
  • We see rising rates as the biggest potential risk to income investors, which we believe will continue to create headwind for bonds and more traditional bond proxy equities, like consumer staples and utilities, both of which are still expensive, in our view, relative to other opportunities
  • We try to find names whose cash flows are likely to grow and whose assets are likely to become more valuable as interest rates rise
  • REITs – challenges in rising rate environment:
    • Most significant input into a “REITs factory” is capital, rising interest rates equate to rising raw goods costs. All else being equal is going to mean lower profits
    • Many REITs have fixed rents, or escalators on a fixed percentage basis so runaway inflation can have a negative impact on the value of these leases
    • Lodging REITs are attractive because these things reset their prices every single night
  • MLPs – potentially seeing signs of a bottom of a multi, multi-year terrible run. Valuations have compressed and now are at the point where we think they are attractive for long-term holders
    • Hi-Crush Partners (HCLP) – favorite name in the space – frack sand and logistics company for shale producers; trade at about four times cash flow, buying back 10% of their stock this year, 7% dividend yield with commitment to hike that 20% a quarter
  • Alternative asset managers – have been big weights in the Strategy and big detractors so far this year – down about 20% from their highs
    • We think earnings estimates for group for Q1 are actually too high so potential disappointment. Since they are already 20% off their high, hard to trade around or take advantage of it – we would be buyers of any weakness
    • Applying a market multiple to some of the management fee earnings which are very steady, visible, growing with the market, have lower capital intensity than the market, better management than the market, in some cases, you’re paying ~0x-2x for the carried interest fee stream which is a very compelling place to be
  • CYS Investment (CYS) – new in 1Q
    • a levered portfolio of government guaranteed bonds and we expect material book value degradation this quarter and additional dividend cuts at the margin
    • One of the top contributors to performance in Q1, which is when we bought it
    • Investors tend to dump agency mortgage rates when they see rates rise quickly, which they did in CYS, often selling them too far below intrinsic value
    • For pure agency mortgage REITs, book value is actually a very good marker of intrinsic value because the company’s entire portfolio is comprised of securities that are very easy to mark and hugely liquid
    • Theoretically, if a portfolio is selling too far below book value, the managers can sell some of their holdings and buy back stock
    • At two points in the past five years (2013 taper tantrum and beginning of 2016 when the yield curve flattened dramatically), we’ve seen the markets sell these types of names down to 70% of book value and both times the oversold names produced very compelling forward-looking returns
  • Abercrombie & Fitch (ANF)
    • Started buying stock in 2Q17 after management announced they were no longer going to sell the company because they thought the best plan to maximize shareholder value was to continue to execute the turnaround plan they had been seeing some success with on Hollister brand
    • ~8% dividend yield trading at about 2.8 times EV/EBITDA which suggested that the business was going under imminently – but we didn’t believe that to be the case
    • Even if the yield isn’t where we thought it would be, we believe the company is still able to achieve its intrinsic value. When we buy undervalued securities, we hopefully watch them appreciate to our assessment of intrinsic value, which allows us to generate some capital appreciation across the portfolio, which we can reinvest into more undervalued names

Samantha McLemore and Bill Miller on Opportunity Equity

Read the 1Q 2018 Letter

  • we are long-term investors, average holding period is 3-5 years
  • Opportunity’s active share as of 3/31/18 was 101%
  • We believe volatility is often the price that you pay for returns. We use pull backs, like the recent one, to add to names that we think are attractive
  • Opportunity trades at a steep discount to the market: 12x this year’s earnings versus 17x for the market
  • As of mid-April, there was 80%+ upside to our assessment of what Opportunity is worth and that’s the higher end of the range that we’ve seen over the past few years. We think the Strategy’s pretty attractive now
  • Healthcare – Area where we’re finding value/is particularly attractive
    • Market loved it coming out of the financial crisis because it was defensive and stable – now it’s pretty much hated. We see companies with very attractive valuations and those defensive, stable characteristics are getting no value – there’s a lot of optionality and ways to win
    • From a top-down perspective, pharma has shown up on quant screens as cheap for the first time in a long time – Empirical Research has talked about this
    • Added Celgene (CELG) and Teva Pharmaceuticals (TEVA) in the quarter.
    • Allergan (AGN) – trades at 10x this year’s earnings, under 9x next. Should grow earnings 20% a year for the next few years. Fear about a cliff for their big drug Revlimid and no value for the pipeline
    • Mallinckrodt (MNK) – a deep value name. all-time high ~$134, last year’s high ~$50, now ~$14
      • generated close to $6 a share in free cash flow in 2017 so at the $14 level a 43% trailing free cash, and that’s forecast to go up
      • recently crushed due to fears around the sustainability of their main drug, Acthar, which they got through their Quest Core acquisition – has gotten a lot of criticism because the price has come up a lot and not a lot of data around the indications for which it’s prescribed – company working to remedy
      • Using free cash flow to diversify the business into other drugs and make acquisitions – which are enough to improve the return on capital of the business overall
      • It’s also got caught up in headlines – opioid, and allegations of a whistleblower suit
      • At 2x earnings expected to generate $7 to $8 in free cash flow per share over each of the next couple of years, so 50% a year free cash yield – don’t think price decline that’s priced in for Acthar is likely
      • Market’s giving them no credit for their pipeline
  • Big Tech Companies
    • NYU Professor Scott Galloway is cheerleader for the call to break up big tech companies. His book, “The Four” – big tech companies were powerful, were changing economic relation and were smothering innovation – makes a good theoretical case
    • Likelihood that politicians will pass legislation to change the Sherman Anti-Trust Act or the Clayton Anti-Trust Act is about zero
    • Nothing to do with size, have to show if there is collusion in restraint of trade meaning using your size to extort uneconomic rents or excess profits from the consumer – It’s hard for them to extort anything out of you when Facebook (FB) and Google (GOOGL) don’t even charge you for the service
  • Department of Defense cloud-service provider – currently AWS is the government’s cloud provider of record
    • Trump has been outspoken about his dislike of Jeff Bezos (note that Bezos, not Amazon, owns the Washington Post)
    • Risk because there’s a lot of opacity in how government contracts are awarded and there is a precedent here where you have two recent cases of political attempt to manipulate the law:
      • Time Warner (TWX)/AT&T (T) deal where the Justice Department blocked it for anti-competitive reasons – which the majority thought this deal was normal under consolidation rules (note that CNN is under Time Warner)
      • Sinclair is a well-known Fox News-like conservative Trump supporting group. Under deal will have access to 70% of the U.S. market. Trump told the Justice Department to find a way to make this deal happen because there’s so much fake news out there that we need a counterbalance
    • At the margin it would be a tiny loss for Amazon, as they’re bigger than the next four cloud computing things combined and poised to grow 40%
    • There are aspects of what could happen at the government level that can be harmful to not just Amazon but to companies in general
  • Facebook (FB): a classic case of risk aversion without really looking at the underlying fundamentals
    • currently 15x next year’s earnings, growing for the next few years at least 25% a year – looking at what risk the market was pricing in, we couldn’t see many scenarios that the hit would be large
  • Pandora (P)
    • no change to our view in light of Spotify’s (SPOT) IPO – continue to think Pandora is extremely undervalued
    • Trading in the fives. Sirius (SIRI) made a big investment and their convert struck in the tens. KKR (KKR) offer was convertible in the mid-13, so there’s significant upside to what various sophisticated people had just basically offered
    • a very strategic asset that’s been highly mismanaged. New management team and Sirius is on the board – decision making should be better
    • Spotify does have a competitive advantage because it is global – can scale operating costs across a larger base
    • Pandora has better content costs – partially because of U.S. focus
    • Highly competitive space – Apple (AAPL) and Amazon investing a lot in it – Pandora’s main value is as a strategic asset
  • Endurance International Group (EIGI)
    • business in transition – new CEO came in last year, Jeff Fox, and he’s trying to fix the business which has been under invested and under optimized
    • generates significant free cash flow that CEO plans to use to deleverage
    • Came out with guidance that the market thought was okay so it’s trading below 8 here. We still think its worth $12, so 50% upside
    • One change that we’ve made post-financial crisis to avoid the big losers is to exit names that haven’t worked, if they haven’t worked in a period of a few years. We’ll give them this year to see how they do with the turnaround
  • Genworth Financial (GNW)
    • Three key points from a recent sell side analyst report:
      • Genworth is a deep value special situation opportunity with near term catalyst and several ways for investors to win
      • While facing political challenges the pending merger with China Oceanwide may still close which would lead to more than 90% upside from Genworth’s current price which is ~$2.80
      • If the deal does not close, risk seemed asymmetric with modest possible downside from today’s price and longer term, we think investors could be rewarded with even greater value by Genworth continuing to raise prices and sell assets in the future
    • there still might be some downside if the deal doesn’t go through, but it’s much lower than it was given how low the stock price has stayed
    • At the same time, rates have increased which is a huge boost to their business overall
    • The skew is that it might be better for the company to not have the deal close, although I’d definitely take 90% upside and then redeploy it in some more interesting opportunities in the market
    • The gap book value on the name is 10. The sum of the parts that they come up with that off Wall Street’s 7, that’s close to what we come up with separately on our own. With both of those sum of the parts giving zero value to the long term care business and so that business is highly levered to interest rate increases and to the rate increases that they’ve been putting through and off Wall Street calculated $10 a potential value there. So, you have an upside here that could be much, much, much higher than the current stock
  • Intrexon (XON)
    • multi, multi-year holding for it to reach our assessment of its intrinsic value
    • In 4Q17 – possibly a lot of selling so investors could realize losses in portfolios, then bought it back in 1Q
    • Once it started going up, people looked at RJ Kirk’s comments that this is the year where a lot of what they are doing will be visible – and more people wanted to get in before it took off
    • Energy business (Methanotroph) – potentially big business – looking for partner, building plants and potentially generating returns by 2020
    • a big portfolio – as time goes on, some pieces will be closer to fruition and could be reflected in the stock price
  • GameStop (GME)
    • Exited mainly due to Ben Graham rule – if it hasn’t worked in a few years, move on- you can always buy it again
    • Has the number one company the video game retailing, has a collectibles business, and a business of AT&T and cell phones stores – it’s among the cheapest stocks certainly in the market – hasn’t stopped it from going down consistently
    • Currently has a dividend yield of around close to 12%. The dividend is covered 2:1. It has no net debt. It trades at ~3x EV/EBITDA, the P/E ratio is around 5, 4.5 to 5 times, but it didn’t stop it from going down
    • New CEO talks about redirecting the cash flows to brand building and I think that’s probably the right thing to do

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 25, 2017, 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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