November 8, 2017

Notes from Our 3Q 2017 Call

Bill Miller – Market Comments:

Read Bill’s 3Q Letter

  • We’re still in a bull market that we think has several more years to run.
    • Bull markets typically end one of two ways:
      • Economic slowdown which turns into a recession – the market will begin to price in the declining growth rate and the decline of earnings
      • The investment alternatives become compelling relative to stocks, which we currently don’t see with bonds. A Fed governor commented that with bond yields north of 4% on the 10-year (currently they are at ~2.4%) and the Fed’s Fund rate rise to 2%-2 1/2%, we would achieve “normalization”. If that happens, we think stocks would likely be 20% higher/have a P/E around 21 -22 – then the earnings yield would be not far from the bond yield. We think that’s still a couple years out.
  • Year-to-date, we’ve had the lowest volatility in market history. October, which historically has the highest volatility of any month in the market will set the record not just for low volatility in October, but low volatility in any single month in market history.
    • French mathematician Benoit Mandelbrot demonstrated fairly conclusively that volatility doesn’t tend to mean revert. It tends to cluster – low volatility tends to beget low volatility until something knocks it off the perch. I think it wouldn’t take much to push volatility a little higher.
    • We haven’t had a 3% correction in almost close to a year of market days, which is unprecedentedly low. I wouldn’t be too concerned if we do get a 3% or 4% or 5% correction in the market.
    • Biggest potential issue is exogenous, an unpredictable geopolitical event or problem that disrupts markets.
  • We think it’s reasonable to expect that over the next 12 or so months, the market will be up in line with earnings growth, which is supposed to be 6-8% next year.
  • Passive investing – what kind of impact has the rise in passive investing had on the market’s rise or in our process?
    • A lot of speculation about the risks, but no good evidence of the impact passive investing may have on the markets
    • During the rise of the internet and telecom stocks in the late 1990s, the trend of money flowing out of value funds and into funds that owned the internet stocks was powerful, prices stayed high. This was proven to be unsustainable.
    • Michael Goldstein’s (Empirical) work has shown that the ETFs which are the most popular and get the most money in any given quarter or six months typically do poorly after that. This seems counterintuitive, but is true as people tend to buy high and sell low.
    • One of the issues is what level of passive might begin to impact the market such that the values would significantly diverge from fundamental values and there wouldn’t be enough of active managers to bring it back in. I think that’s a long way off.
    • The way in which price discovery is most effective has nothing really to do with passive versus active. A diverse group of investors with different strategies, different time horizons and different methodologies will lead to more efficient pricing in the long run.
  • Currently, we don’t see any glaring pockets of mispricing by market cap – it’s company-by company.
  • Read our 3Q 2017 Market Highlights

Bill Miller IV on Income Strategy

Read his 3Q 2017 Letter

  • Q3 was the fifth consecutive quarter that we outperformed the ML HY Master II net of fees. Trailing one-year Sharpe ratio is >2
  • Positioned pro-cyclically, as such we tend to do better as rates rise because rising rates tend to correlate with expectations for higher economic growth. This is unlike other income strategies whose performance may be negatively correlated with rising rates.
  • Alternative asset managers have been the biggest source of our performance over this past year. Group remains fundamentally undervalued; we believe it has at least another 30% upside to intrinsic value, not including the dividend.
  • 4 reasons why we like Income Strategy:
    • We’re the top investors – meaning our objective is aligned with investor objectives
    • Strategy’s current yield is 7% with positive leverage to a rising rate environment. Our main goal is to outperform the yield over the long-term by owning undervalued securities. If we’re right, we stand to gain the 7% yield and capital appreciation on top.
    • Small size means we are more nimble and opportunistic than larger income strategies that can’t look at the same names we own.
    • We have a long research list – we’re optimistic about not only the current positioning of the Strategy, but also the prospects.
  • Greenhill & Co. Inc (GHL) – read about it in the 3Q Letter
  • Frontier Communications Corp (FTR)
    • Has far too much leverage in a secularly shrinking business. Need to focus on paying back debt, instead of paying shareholders
    • Need to retain subscribers and turn around the topline
  • Master Limited Partnership Exposure? We’ve been doing work on the different kinds of MLPs. Valuations are getting more in line with levels we like.
  • Washington Prime Group (WPG)
    • Shopping center REIT, they own the real estate of all of these “terrible retailers”.
    • It’s hugely diversified retail exposure so they are able to swap in retailers when one fails, which is why we haven’t seen NOI declines.
    • ~12% dividend yield covered 1.5 times by free cash flow – they’re using that excess free cash to redevelop the centers into stable to growing entities. Generally when they redevelop these properties, NOI grows. By the end of this year, roughly 80% of their net operating income will come from flat to growing centers.
    • We think the narrative has pushed price far below reality – the stock looks like it’s implying NOI declines of almost 8% indefinitely. Right now, it’s roughly flat NOI. We’ll be looking for clues that it could decelerate over the next few quarters.

Samantha McLemore and Bill Miller on Opportunity Equity

Read our 3Q Letter

  • We’re long-term value investors and we tend to be contrarian. In a market where most people tend to go with flow and momentum – that leaves us continuing to find a lot of opportunities
  • Opportunity Equity has a Forward P/E of 14.3x versus the S&P at 19.7x, so the strategy trades at a 5-point discount with better than market long-term estimated earnings growth rates (using consensus bottoms up estimates).
  • We have significant personal investments in Opportunity and we’re optimistic about the upside
  • Intrexon (XON)
    • Price swings are a result from more sellers than buyers at a given price
    • Will start to see real revenues from products – Arctic Apple is shipping and they exclusively have the ability to gradually get almost every variety of apple approved. They’ve also sold 4.5 million pounds of their salmon in Canada
    • Rolling all of their healthcare programs under Precigen
      • Working to get the org structure complete so they have flexibility in the next year – could spin out or sell a portion of it that gets a value.
      • CEO Helen Sabzevari has an impressive track record in the industry
      • Helen is confident about the combined ability of Intrexon and Ziopharm in finding a cure for cancer
      • If they start completing more clinical trials over the course of 2018, then you could see a value of Precigen that I think is worth what the entire of market cap of Intrexon is worth now
    • We value it as a portfolio of real options and we’ll see the value or lack of value of those options over the next 3-10 years
    • Ziopharm Oncology Inc (ZIOP) – just enrolled their first pediatric patient for glioblastoma, brain cancer. They use a sleeping beauty technology as opposed to a retro-viral technology like the CAR-T treatments. Key is that it has to work.
    • Intrexon, Ziopharm, Endo (ENDP) – at their current prices hold a lot of potential
  • Flexion Therapeutics Inc (FLXN)
    • New name, first purchased it in the second quarter.
    • Has had a lot of volatility lately. It went from 16 to 32 after it got its only drug approved by the FDA
    • They have combined a steroid with a technology to make it longer lasting, and it was just approved to treat knee osteoarthritis. The stock popped at 32, but it’s traded back to 20. Actually it’s more than 50% upside just back to the level it was a couple weeks ago.
    • We think the decline is being driven by the fact that there was a number of short-term people in for the news of the FDA approval. Then they did a big equity deal afterwards which basically sopped up all the demand. Now they have enough cash to get them to profitability so they won’t need to come to the market again, but in the short-term the market dynamics are not that attractive.
    • Working to expand drug for use in hip and shoulder – restarting studies to prove safety and efficacy.
    • If you just look at the size of the injection market currently, which is just basically steroids, and assign FLXN some modest portion of that, you can get peak sales close to a billion. The market cap of this company is $800 million now. Just using the rule of thumb of 5 times, you can see scenarios where this could be worth five to ten times worth trading right now.
    • Now talking down expectations. Small launch in 2017 during holiday season and reimbursements won’t come in until late 2018. Looking to 2019 to see sales ramp
  • Foot Locker (FL)
    • Biggest advantage of physical stores, according to Bezos, is the ability to have your product immediately. Amazon can’t support that currently
    • FL’s stock was at 80 earlier in the year. Now they’re faced with some issues, namely that Nike began to sell some product directly on Amazon
    • All the valuation characteristics are very attractive and a very pessimistic future built in
      • At $30, market is pricing in declines in same store sales
      • Largest athletic footwear retailer in the world with a 4% secure dividend yield, $6/share cash net of debt before the stock buyback last quarter (which we estimate was as much as 5-6%). Single digits P/E multiple 3.5x enterprise value to EBITDA
    • Turnaround same store sales in 18-24 months, although if they don’t it might signal a permanent secular decline for the category
    • Supported by strong balance sheet, high return on invested capital
    • Even if Amazon does tear a hole in the industry, Foot Locker is the leader and the strongest company. It’s likely others will fall first
    • FL’s target market is 12-25 year old boys/men who are sneaker enthusiasts/want the newest, coolest, trendiest products
      • Nike’s agreement with Amazon is to sell a lot of their styles but not the very high-end that they use and that they distinguish their market through Foot Locker.
      • Knock-offs and high prices are problems on Amazon for these products
      • It’s in Nike’s best interest to keep the segmentation in the market so that they can sustain some of these high prices, which helps make the FL model more sustainable over the long-term.
      • Growing with other brands like Adidas as well.
  • Homebuilders
    • Recent very strong new home sale numbers that hit a new cycle high
    • Owned the builders for years. In the financial crisis they got hit really hard. At the same time we were entering a period of very positive demographics with millennials reaching their prime home buying years
    • The Harvard Joint Center for Housing estimates there will be 1.4 million new households per year over the ten-year period of 2015 to 2025 to meet demand. Add some obsolescence of inventory and then you look at how much will be satisfied by multifamily homes and you still get new home requirements at about 1.2 million units a year. Even with the cycle high, we’re still below that
    • Credit and employment issues are starting to reverse for people and have seen a big uptick in the first-time homebuyer demand. You still have a number of supply constraints which are keeping price increases strong, but there’s still good affordability with rates as low as they are now.
    • Pulte Homes (PHM) and Lennar Corp (LEN) – both trading at 10 to 11 times next year’s earnings, so a lot cheaper than the market. We expect them to have sustainable double-digit earnings growth for the next three to five years.
      • LEN has been a great long-term compounder. Since the CEO, Stuart Miller, took over in 1997, that stock has compounded at 14% per year versus the market at 8%, so 75% higher even with the housing crisis. They’re always allocating capital in a really smart way – buying land when it’s cheap and small builders when it makes sense.
    • Owned KB Homes (KBH) for a number of years. We sold it because they always had execution and operational issues, we didn’t feel it was managed as well as LEN or PHM.
    • The bad news is that builders were up a lot last year. The good news is they are still available at very reasonable multiples 10, 11 times earnings with 15% to 20% growth rates.
      • Historically, and maybe counterintuitively to most people, the period when home builders have actually performed the best is a period of moderately rising interest rates which is part of the reason they’ve done well in the last year and part of the reason they’re probably going to do well for the next couple of years
  • Valeant Pharmaceuticals (VRX)
    • Rose to 18 after the last quarter because they beat their consensus/guidance. Since then it’s traded back down to 12. Had a significant selloff on the back of really no news. It was about 14 when rates bottomed in early September, so a lot of the move was actually when rates were still falling, not when they were rising.
    • Since rates bottomed, the ten-year treasury is up about 40 basis points, and Valeant’s credit spreads have contracted by about 40 basis points, so basically a complete offset.
    • A lot of the progress they’ve made on the balance sheet has been to take care of maturities through 2020. Most of its debt is fixed rate. As it delevers and pays off debt, it can refinance as its credit spreads come down. Earlier this month it actually issued some 5.5% debt to pay off some 7% higher cost debt, so bringing its interest cost down.
    • Pharma names in general have continued to be under pressure
    • Since Joe Papa and his new team came in they really have done done everything they said they would do. Different team, different strategy. The bond market, isn’t showing much worry about Valeant’s debt. Their 5% paper is yielding under 5% right now. Even the other dated papers come in in terms of yields pretty nicely which is not a perfect sign, but a good sign.
    • We don’t see much downside given how conservatively they’re managing the business right now. So far, everything is working except for the stock price.
  • Amazon (AMZN)
    • Not concerned about the so-called crowded trade except insofar as there are a lot of people who are very short-term oriented in this. If we move into a more classically valuation driven part of the market, which would not be unusual with global growth accelerating and valuations spreads historically between the so-called value stocks or price-to-book stocks and the so-called growth stocks, you could see people who are trying to surf the market rotating out of some of these names.
    • Amazon has been going sideways now for several months. Amazon is probably going to achieve 25% sales growth on average for the next several years, and if it does that, we don’t think the valuations will contract given the size of their total addressable market.
  • Airlines
    • We’ve been invested in for years and done very well.
    • Used to be one of the worst industries. Our view is that consolidation in the industry with four players controlling 90% of capacity in the US, along with the management incentive changes to a more return on capital focus would lead to a more rational industry structure; that’s what we’ve seen
    • Free cash flow generation before versus after consolidation is night and day. Before, the industry basically never generated free cash flow, a very small amount in 2 years out of 25 before. Since consolidation, free cash flow has been consistent and significant every year.
    • The valuations still don’t reflect any improvement in the industry overall, trading in line with long-term historical averages. After such a long history of being so terrible, the market is not going to believe very quickly that they’re going to sustain any improvements.
    • This year, Delta (DAL) and American (AAL) have done okay, up to 8% to 12% year-to-date. United (UAL) has done much worse – down ~18% after a disastrous recent earnings call. The quarter was okay; they missed a little on some numbers. On the call, they couldn’t answer a number of questions on cost and capacity, the stock basically tanked and there’s been calls for new management.
    • Delta and American have been much more steady while United has traded off – tells us at this point it’s a United issue rather than an industry issue. They all trade together broadly but have different drivers in the short-term, as you can see with United diverging from the others.
    • Delta we think is particularly attractive, as it’s the highest quality one of the group. It still has a 13% free cash flow yield, a 2.3% dividend yield, and they’ve grown the dividend 50% per year for the past three years. It has an investment grade balance sheet. We have a high degree of confidence that it will be profitable in the next recession
  • Oil and energy stocks?
    • Haven’t liked the energy space very much at all for a long time. The main reason is that it’s a pure commodity, number one. Its price is completely unpredictable. Global energy demand grows around 1.5% or US energy demand grows 1.5% to 2% max, and global energy demand probably a little less than global GDP. Technology continues to find ways to extract the stuff at surprisingly favorable price points. Then you’ve also got the political issue of climate change, renewables, etc.
    • Energy prices are probably heading into a period where they’re going to be pretty firm. In the energy MLP space, we think it has finally reached a point where the energy stocks in general are not discounting prices dramatically higher than this. Probably an opportunity for a trade here if energy prices go up, and I think there’s probably not a lot of downside.

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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.

©2017 Miller Value Partners, LLC

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