October 27, 2016

Notes from Our 3Q 2016 Quarterly Investor Call

Bill Miller – Comments on the market and the upcoming election:

  • Our overall analysis is that the economy is doing fine. Inflation is low and interest rates are low. Dividend yield is currently higher than the 10-year, and is expected to grow 4-5%, whereas the 10-year is not expected to grow. Our belief is that the path of least resistance for the markets is higher – absent a major geopolitical event.
  • WSJ article (note that you need to be a WSJ subscriber to read) – Why the Economy Doesn’t Roar Anymore
  • There has been a significant change in bond market; we agree with Jeffrey Gundlach – investors can’t be bullish on bonds.
    • 35-year bond bull market ended over the summer, with the yield bottom occurring in July.
    • Bonds went down with stocks in September; it’s unusual to see both go down at the same time
  • Upcoming election
    • Polls are overwhelmingly in favor of Clinton. It’s predicted that Democrats will win the Senate and the House will remain Republican. This will be a good balance.
    • Overall, the outcome will likely not be negative for markets.
  • Interest rates
    • Mrs. Yellen and Stanley Fischer comments are consistent that they have a strong desire to normalize (this is a bad word, as there’s no indication of what constitutes “normal”) rates. Mr. Fischer has also stated that he doesn’t believe we are far, a couple years, from the neutral rate (2% or less)
    • Path for rates is higher, Japanese Central Bank has reported that the curve is shifting up. We don’t think tightening or rising yield curve is an impediment to stocks rising unless the 10-year hits a 3.5-4% range.
  • Active/passive investing debate
    • Wall Street Journal published two articles just this week (note that you need to be a WSJ subscriber to read) – The Dying Business of Picking Stocks and Are Fund Managers Doomed?
    • 2 arguments for passive: Active management is more expensive and with those higher fees, passive managers over time beat active managers as a whole
    • Investors are missing the point that there are managers who do outperform the market, and looking for high active share and at a long performance record will help investors identify those managers who are truly active and have added value. For example, Will Danoff and Bill Miller
    • Passive strategies don’t beat the market either. Despite what mangers have done to cut fees, the fees on passive strategies still detract from performance – every year.
    • Every active manager goes through periods of poor performance.
    • As part of a diversified portfolio, investors should have exposure to active management. If you want to outperform over the long-term, you need to have active strategies from managers with proven long-term records in your portfolio.

Bill Miller IV on Income Opportunity Strategy

Read the 3Q2016 Commentary

  • Income Opportunity Strategy more than doubled the S&P 500’s performance this quarter and was over 300bps better than JNK (The investable version of the high-yield index) net of fees1
  • Of the 13% total return during the past two quarters, less than half came from the dividend, indicating that we are delivering on both of the strategy’s objectives: generate a high level of income and preserve the potential for capital appreciation.
  • Why is Income Opportunity better positioned than other equity-income strategies in a rising rate environment?
    • Size – we have almost no liquidity constraints, given the size of our AUM. Larger strategies are forced to hold only the largest and most liquid names. In general, yield and liquidity tend to be inversely correlated.
    • Concentration – as of the end of the quarter, we owned just 42 positions, 3 of which are different securities issued by the same company.
    • Yield – our latest strategy dividend implies an 8.7% annualized yield, compared to most equity-income funds that pay 3-5%. Put differently, other strategies have to appreciate by an incremental 3-5 percentage points to match our return from here. Most equity-income funds own what we believe are the most overvalued (expensive) areas of the market – utilities, consumer staples, telecomm. We have barely any positions in these sectors.
    • Manager Commitment – we are the largest investor in the strategy, aligning our objectives with our investors.
  • How might the strategy do if rates rise?
    • When credit spreads blow out on top of deflationary fears, our strategy is not likely to be a top performer. This is what we saw in 2Q 2015 and 3Q 2015.
    • In a benign bond bear market with gradually rising rates, we should do better.
      • Higher coupon securities have lower duration than lower coupon securities. Our starting yield is 2x that of other income strategies.
      • We own businesses that are likely to perform best as the economy advances – alternative asset management companies, credit-sensitive financials, real estate and corporate credit.
      • Over the seven-year life of the Income Opportunity Strategy, the best years have been when the 10-year rate moved up, while the worst years have been when the benchmark government rate has fallen.

Bill Miller and Samantha McLemore on Opportunity Equity

Read the 3Q2016 Commentary and Review

  • Airlines
    • Negative unit revenue trends have led to fears around the cycle peaking and questions about if the industry is losing discipline. However, on recent 3rd quarter investor calls, Delta (DAL) and United (UAL) cited positive unit revenue trends for December and January
    • There’s been massive consolidation, the 4 largest companies control 90% of capacity.
      • There’s a long history of growing capacity faster than GDP, which has hurt the industry and could explain recent down performance.
      • But, capacity guidance for next year is 1-1.5% – well below GDP growth.
    • Read our investment thinking on Delta
    • Airlines are taking advantage of the low valuations to buy back stock. Once investors have confidence in the industry’s newfound discipline, valuations should be much higher
  • Amazon – largest position held through call options, as of quarter end
    • It’s a completely unique enterprise, and has grown its market cap from $400 million on IPO to pushing $400 billion today without having sold new shares to the public.
    • Compare to Google (GOOGL) & Facebook (FB) – good, solid companies, but the core market for these companies is the global ad market, which is roughly $500-600 billion and grows at about the rate of global GDP. Amazon is chasing retail sales, which is roughly $5 trillion in the US alone – a much larger market, and they are completely dominating it.
  • Apple – 2nd largest position held through call options, as of quarter end
    • Apple is all about its brand, and the iPhone 7 is a great example of how impactful the brand can be. There was a huge demand for the product (the actual sales figures vastly exceeded expectations) despite the perceived mediocre tech improvements.
    • More evidence of the brand strength is that Telecomms are under pressure, however Apple continues to get stronger, due to the broad ecosystem of its brand
    • Has a higher valuation as opposed to “stable” Telecomm companies
    • Currently not pricing in growth: trading 14x this year’s earnings and 13x next year’s. If you exclude tax adjusted net cash, it’s trading closer to 12 and 11 times, respectively
    • Apple’s valuation will likely move higher on a P/E basis over the next few years, while valuations on companies, like Coke, Pepsi, Verizon, etc, will at best remain stable.
  • Intrexon (XON) – 5th largest position in portfolio as of quarter end
    • Generally, not a good year for Health Care in general. XON is not out of line with other Health Care companies
    • Leading company in synthetic biology, run by RJ Kirk, a proven money generator
    • We are comfortable to own this for multi-year basis
    • Big area for the company: using biology to improve food. GMO Salmon is the only GMO approved by the FDA.
  • Financials weight increase over the quarter
    • Our weight in Financials was high out of recession, as this is where we, as value investors, saw opportunities. Added to names this year as fears increased around economy
    • Read our investment thinking on OneMain Financial (OMF)
    • Overall, Banks announced good earnings. They surprised on upside and reported strong loan growth – a good sign for business. This was a surprisingly better quarter. People thought the bearish interest rate environment would be a drag.
      • JPMorgan (JPM) has a 2.9% dividend yield, shrunk outstanding shares by ~3% over the past year (~6% total owner’s yield) and is continuing to build capital
      • Bank of America (BAC) is extremely aggressive about cost-cutting and performance figures. They grew tangible book just shy of 11% over the past year in a bad rate environment. If that can continue, even without valuation expansion, it should be able to compound at a higher than market rate
    • Today, banks are re-engineering the business to minimize risk, and thus are much less risky than before the crisis.
    • Reporting 10-12x earnings with ability to grow yields, which is better than consumer staples
    • Wells Fargo (WFC) is a behavioral anomaly in the market – has had a 3-4% dividend yield for the past 5 years – almost double the treasury yield. Treasury doesn’t grow, but Wells had a low payout ratio, which may grow 10-15% a year minimally.
  • Twitter (TWTR) – sign its turning around would be a full-time CEO
    • We would like to see:
      • A more rational capital allocation program
      • Better ad load growth
      • Increased optionality – live program is good, but too narrow.
      • Full time CEO with strategic vision
  • NXP Semiconductors (NXP)
    • We’ve held this for a long time. Company has always had good management.
    • Confirmation that Qualcomm & NXP are in discussions for a merger – it could go in the $120 range for NXP.
    • It’s a deal for both parties. Currently, NXP trading slightly below high in 2015. We expect more consolidation across this industry.
  • Homebuilders
    • Current tone is good, despite that the stocks haven’t done a lot over the past year.
    • Read our investment thinking on Lennar Corp (LEN)
    • We still like housing. There’s strong fundamentals, good demographics with millennial growth, constrained supply, and great affordability.
    • Median incomes are increasing, 2015 was the best year for growth of median incomes ever. Income drives home purchasing.
    • Overall, homebuilders are behaving much more conservatively, minimizing the downside.
  • FIAT/Chrysler (FCAU)
    • There’s too much capacity, but that is not a new story line. Automobile manufacturers have historically had too much capacity.
    • Stocks are cheap. Auto sales are close to or at record levels. Many think this is the peak of the cycle, whereas we think it’s a plateau. Valuations are too low for the industry, which is not headed for a steep decline.
    • A lot of reorganization in the industry. Auto manufacturers are showing they can be profitable at 9-10 million units –which is low even for a recession. This will probably lead to significant up movement in overall valuations.
  • Platform Specialty Products Corp (PAH)
    • They have high leverage, but they are growing their business. We don’t believe there’s bankruptcy risk.
    • Bonds are pushing par, showing significant improvement in company cash flows and prospects. Stock hasn’t caught on to that yet
    • We believe that they will be a strong performer next year given the company’s reported outlook: 12.5x earnings this year, 10x earnings next year. Free Cash Flow yield – 9.5% this year, 11% next year
    • Chairman Martin Franklin bought a huge chunk of the company on the deal. He has a long history of creating value/timing purchases.
    • Free Cash Flow is about 10% more than estimated earnings, which have been under pressure. 12.5x this year and 10.5 next year with 10.5% free cash flow yield this year and 11-12% free cash flow yield next year – we think this is likely to be a strong performer in the next 12 months.
  • Valeant Pharmaceuticals (VRX) and Endo International (ENDP)
    • Past month, there’s some headline risk with Hillary Clinton presumably coming into the Presidential office
    • Valeant’s new CFO, Paul Herendeen, is well regarded. He is demanding a fresh set of eyes on guidance and accounting policies, which could lead to possible write downs and lower guidance.
    • We view these companies as effectively public private equity companies and believe that they could generate 25% rate of return in the next couple years

Was this recap of our quarterly investor call helpful? Let us know if we should publish this going forward.

1Income Opportunity Strategy performance reflects the deduction of an annual model investment management fee of 1% (the highest fee for separate accounts under our fee schedule) and certain other expenses. For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of October 18, 2016, the date of the call. Any views are subject to change at any time based on market or other conditions, and LMM 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.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.

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