August 10, 2017

Notes from Our 2Q 2017 Investor Call

Bill Miller – Market Comments:

Read Bill’s 2Q Letter

  • Path of least resistance continues to remain higher – Bull market began in spring of 2009 and will continue until an alternative to stocks offers better returns or the economy turns down – we don’t see evidence of either occurring in the near-term
  • Low-volatility environment is likely to continue for some time or until economic volatility or geopolitical events intercede
  • Market at around 18 times the earnings on a median basis is still very attractive relative to bonds and to cash and there are still plenty of bargains to be had.
  • High multiples on earnings become a problem when the alternatives provide better risk-adjusted rates of return. If Treasuries got to 4% to 5%, and gave investors a real yield of north of 2%, that would probably begin to provide some competition for stocks, but we’re a long way from that.
  • Bond proxies and the “safe” names have looked overpriced since the financial crisis. If there’s a bubble in anything, there’s a bubble in perceived safety, which is very expensive, and any investment which appears to be riskier is a lot cheaper
    • When interest rates go up, we will likely see a rotation out of expensive bond-like proxy stocks like consumer staples and utilities. Names like AT&T (T) and Verizon (VZ) are down for the year. The Fed’s begun to tighten. As the yield curve shifts upward, that will put a lot of valuation pressure on the so-called safe names.
  • There are opportunities outside the U.S. The dollar has been weaker, which has given them a bit of a tailwind in non-U.S.-denominated currencies. But, there are plenty of opportunities here in the U.S. – by and large, we’re U.S. investors.
  • Large- and mid-cap names generally are more attractive than small-cap names, as the small cap space is moderately expensive.
  • Regulatory environment is currently providing opportunity not risk. General move in the current administration is to reduce and simplify regulation, which is positive
  • Tech and growth momentum is largely a function of relatively low economic growth, (average 2% a year since the end of the financial crisis)
    • FAANG companies are not just growing, but taking market share and disrupting other industries.
    • If economic growth picks up, that means that growth overall will become less scarce, which is a positive for value names. That could result in a rotation out of the high-growth names and into the more cyclical names, so out of the high price-to-book names into the lower price-to-book names.

Bill Miller IV on Income Strategy

Read his 2Q 2017 Letter

  • Main objective is to outperform the stated dividend yield over the long term, which we aim to achieve by buying income-generating securities where the market is not giving them credit for what we think will be the level or duration of their distribution over the future. We build a concentrated portfolio through a bottom-up analysis of individual securities
  • The dividend yield is not only sustainable, but should grind higher over time. We own a handful of variable-rate dividend payers whose dividends bounce around with earnings from quarter-to-quarter basis
  • Bonds and preferreds are only about a third of the strategy while the bulk is in equities
    • High-yield and traditional income securities like utilities and consumer staples are currently expensive and not attractive
    • High-yield index today has a 5.5% yield, which is among the lowest ever recorded
    • Diversified high-yield funds and diversified high-yield ETFs are unlikely to produce much in the way of real return moving forward
    • Equities along with select bonds and select preferreds are likely going to provide a higher level of income, both on an absolute and risk-adjusted basis than the index
  • GEO Group (GEO) – sold in the quarter
    • Bought last year after the Obama Administration announced they were going to phase out the use of private prisons. On that announcement, the stock dropped almost 50% over the course of a day or two. We actually ran through their filings and realized that was not feasible for a variety of reasons, so we loaded up on the stocks.
    • While the Trump win was not our base case, he did win and the stock worked very well. We thought that on a forward basis, we were not going to earn significantly above the rate of the index and especially adjusted for the headline risk and other volatility, so we sold out of it.
  • Retail REITs, Washington Prime Group Inc (WPG), CBL & Associates Properties, Inc. (CBL)
    • At five-year lows because Amazon is changing the face of retail
    • Companies are pricing in a much faster rate of cannibalization than we have seen or we think we will see.
    • We’ve seen some insider buying in WPG.
    • Stocks are all coming off of five-year lows so everyone that’s owned them for the past five years absolutely hates them and we think dividends are more likely to move higher over time than lower.
  • Greenhill & Co., Inc. (GHL)
    • A boutique investment bank that focuses on transactions advisory
    • Not many financials that are trading at a 12-year low with a lower share count than where the company IPO’ed
    • 9% yield. The CEO’s committed to the dividend
    • When you look at the $90 high-end stock versus today’s $20 price, you’re actually comparing it on an apples-to-apples basis. Whereas other financials that came through the crisis, actually got diluted away.
    • Classic case of a large uncertainty discount in a highly unpredictable business
  • Seaspan (SSW)
    • A container ship lessor with massive insider ownership, one of the best fleets in the industry
    • We’re coming off what we think is a cyclical bottom and we think that may be reflected in the stock
    • 7.4% qualified dividend yield, but appears more likely to grow than it is to shrink at this point
    • We own the cumulative preferred too, meaning that those dividends, which will accumulate over time and will be an owed commitment to the preferred shareholders. Those trade above a 9% yield and have moved gradually higher since we bought them. This is also a good sign for the common stock.

Samantha McLemore and Bill Miller on Opportunity Equity

Read our 2Q Letter and Review

  • FAANG stocks – people still underestimate that the Internet has changed the economics and the ability to grow dramatically
    • Geoffrey West’s Scale
    • For a lot of companies, there is disruption which might lower the useful lives of some companies and extend it of others. Just to give you an example: Facebook (FB) has a market-cap rank similar to Amazon’s (AMZN) and Alphabet (GOOGL) has one that’s close to $600 billion. Both companies by and large are tackling the global ad market, which is about a $600-billion market in total, growing at the rate of global GDP. There’s $1 trillion worth of market cap chasing a market that’s only about $600 billion in size. They’re going to have to expand out beyond that. Whereas Amazon has a market cap approaching $500 billion and U.S. retail alone is $5.5 trillion and global retail is $50 trillion.
    • Apple (AAPL) now is 17 times current-year earnings before you strip out the cash, which looks close to fair. Earnings expected to grow next year over 20%, ~14 times next year’s consensus. For a company with an $800-billion market cap, it’s tough to grow much with that, but it’s not a terribly expensive stock, either.
  • Genworth Financial (GNW)
    • Long-term-carrying mortgage insurer that we’ve owned for a number of years.
    • Number of delays to closing the China Oceanwide acquisition deal – GNW had to refile notice with U.S. Committee on Foreign Investment for the second time, state regulatory approvals are still under review
    • Deals like this have a base rate of closing of around 70%, which at those odds, it still has close to 30% upside weighted for the odds
    • If the deal doesn’t close, the stock’s likely to react pretty negatively in the short term, but on a longer-term basis, there’s much broader scenarios for this company. Given the leverage of the company and some of the challenges they’ve had, there’s a zero worst-case scenario. The best-case scenario can be worth many, many multiples, especially if rates go up.
    • Even if the deal does not go through, the value of GNW should be in the $5 to $8 range.
  • Intrexon (XON)
    • A leader in the field of synthetic biology, which will be the greatest disruptive force we have ever seen in terms of health care.
    • It’s a portfolio of real options, so they have all kinds of different products that are in the pipeline at one stage or another that they’re working on.
    • Have approval for a non-browning apple and for a farm-raised salmon. The cut-apple market alone is a $500-million market and the salmon market is many times that. Expecting revenues on apple alter this year and salmon in 2018. However, they’re going to need a lot more revenues than can come from just those first two products.
    • The value of the overall business is probably three times the current stock price. The catalyst will either be more products being approved or the overhang of concern about synthetic biology generally beginning to dissipate. We believe that the company has a very large potential right-hand skew where there’s very little chance of a permanent loss of capital over the next 10 years or so.
  • Pandora (P)
    • While it is up over 40% in the past month, it’s still down about 24% year-to-date.
    • The main problem is poor management. After effectively creating the Internet radio category, they had no innovation and let streaming companies pass them by. After there were a number of large players in the space with deep pockets like Amazon and Apple and Spotify’s success, then they decided that they were going to invest hundreds of millions to go after the category and go after a subscription and streaming business.
      • Streaming and subscription will either work, in which case the stock will be worth more, or it won’t work and the company will stop spending the money on it, in which case the stock should be worth more.
    • They now have a deal with Liberty, whose management is actually very rational and smart. They can analyze things appropriately and they know how to allocate capital.
    • There’s new leadership and activists on the board. It’s a very popular service that streams more hours than YouTube. There’s a huge opportunity in the car.
  • Valeant Pharmaceuticals (VRX)
    • Big turn in performance – beat their 1Q numbers, stabilization in the organization, executed on asset sales and used proceeds to pay down debt.
    • Was our third biggest contributor in the quarter after Restoration Hardware (RH) and Wayfair (W). It was up 57% in the quarter and it’s a top ten contributor, year-to-date
    • It seems like there is consensus around the fact that Valeant has good businesses. Valeant has a bad balance sheet and that’s the issue
      • Rumor that it was in talks to sell Salix for $11 billion – we thought that that was a likely possibility all along. The sale would really help the balance sheet
    • Even after recent move up, it’s under 5 times earnings trading at $17.50. We think it can be worth a minimum of $30 in a year or two, and potentially more after that just depending on how things evolve and how they deleverage and how various things in the business work out.
  • Endo Pharmaceutical (ENDP)
    • Still down year-to-date. It’s actually one of the names I think we’re most excited about now, because it hasn’t moved up with the rest of the market.
      • Controlled by TPG – replaced the CEO with a former TPD Par Pharmaceutical CEO
      • Glenview – known hedge fund – has been picking up its investment
    • Trades at 3.5 times next year’s earnings. Headwinds to the generic business, the pain business, and the legal liabilities are known and priced in
    • It’s a great management team. They’re doing all the right things to restructure parts of the business and make sure that they’re operating efficiently and investing in certain growth areas.
    • Once past the legal liabilities in the next year or two, the free-cash-flow yield jumps up a lot. Sell side report shows a 10% free cash-flow-yield on 2018 and then 20% in 2019. As long as we get there over the next few years, the stock should do very well and should easily double in the next few years if that turns out to be right.
  • OneMain Holdings (OMF)
    • Dominates the subprime lending on a secured basis to Middle America – in the sweet spot of economic cycle for that group as we have really low unemployment and wages are starting to grow.
    • It’s a commodity business at bottom, but scale matters and they have the scale here.
    • Cheap on P/E basis that’s actually growing. 7 times this year’s earnings and 6 times next year’s earnings and 5 times the year after that’s earnings. So, it ought to trade at a multiple of ten as they build up some additional capital on the balance sheets.
  • Energy Sector – Overall, I think that energy is just a trade right in here, not investible yet. It was almost impossible at the beginning of the year to find any energy stocks that were attractive because they were discounting $75 oil. Now many of them are discounting $60 oil or $55 oil. The market isn’t worried about their financial staying power to bonds. The highest bonds in their quiver are bonds that yield maybe 7.5% or so, which is high compared to other high yield, but not for a company that’s still cash negative after CAPEX. They’ll be cash positive soon.
  • Brick and mortar retail has seen a lot of bankruptcies and there’s belief that Amazon will kill everything – stocks are down a lot and valuations are way down. We see lots of names in the space that have free-cash-flow yields around the 10%, sometimes higher than 10% areas, so we’re exploring the space.
    • Part of the reason that we invested in Wayfair we thought it had a good, sustainable, competitive advantage and it was not likely to be killed, at least, in the near term or even hurt by Amazon.

Book Recommendations

  • The End of Theory by Rick Bookstaber
  • The Adaptive Markets Hypothesis by Andrew Lo

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 July 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.

©2017 Miller Value Partners

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