July 19, 2018

“You got to know when to hold ’em”

Opportunity Equity 2Q 2018 Letter

You got to know when to hold ’em
Know when to fold ’em
Know when to walk away
And know when to run
You never count your money
When you’re sittin’ at the table
There’ll be time enough for countin’
When the dealin’s done

-Kenny Rogers, “The Gambler”

Last quarter, I wrote about how we’d underperformed for three consecutive quarters, a rare occurrence that history suggests would reverse with strong outperformance. Given how strong reversion to the mean is in markets, my call wasn’t particularly surprising. However, I wouldn’t have been so audacious to predict that we’d have one of our best relative quarters in the history of the Strategy. Opportunity Equity was up 14.0% (net of fees)1 in the second quarter, 1,055 basis points (bps) better than the benchmark S&P 500 Index’s 3.4% return. That’s our 11th best relative quarter in the Strategy’s 74 quarter history.

We’ve had some conversations with new investors planning on initiating positions. One reaction we’ve gotten to the recent strength: we will wait for a pullback. Paying lower prices is always better, and reserving funds to deploy during weakness is likely to pay off handsomely. On the other hand, investors typically cost themselves far more by being too cautious in a strong bull run, than by experiencing temporary market pullbacks. This is particularly true since the financial crisis. Since the financial crisis, investors have pulled $1.2T from domestic equity funds (albeit some has gone back into ETFs) while the market has risen 268%, a compound annual gain of 14.7%, a return far superior to the market’s roughly 10% long-term historical average return.

Opportunity’s trailing one year return is 16.7%, 229bps better than the S&P 500’s 14.4%. So while the quarter was particularly strong, the year is pretty much in line with our long-term historical average (220bps average annual outperformance since inception). As I said, reversion to the mean is a strong force in markets, but the second quarter was the reversion to the mean.

As I mentioned, we’ve outperformed the benchmark by a little more than 200bps per year on average since inception. That performance includes a disastrous 2008 (along with some other poor periods). We’ve written and discussed extensively the mistakes we made in 2008 and why we think we won’t repeat those (though, we are sure to make new mistakes!). Interestingly, if you exclude that one year from our 18-year track record, our average annual outperformances jumps to almost 620bps per year! In the period prior to 2008, it was around 780bps per year outperformance and since 2008, it’s been more like 450-500bps.

I’m not trying to make the case that one should exclude that year. Those mistakes and losses were real. But when people think about Opportunity and how they should or shouldn’t use it, it certainly makes sense to understand how we’ve done in different periods in forming expectations. If one were to actually believe that 2008 isn’t likely to be repeated (as we do), then understanding the Strategy’s performance outside that context certainly makes sense.

Past performance is never a guarantee of future performance. What’s more important is investment process and whether there’s some sort of edge versus the market. We’ve talked a lot about how the financial crisis significantly increased risk aversion. To an even greater extent, investors loathe volatility and perceived risk. We think one important driver of our returns since the financial crisis has been being long conventional assessments of risk, places where we believe perceived risk is much higher than actual risk.

Facebook is a great recent example. As news of the Cambridge Analytica data and privacy scandal broke in March and April, Facebook fell from its prior high of ~$195 to $149 (-24%) in a matter of weeks. We happened to be traveling in Europe meeting with clients and prospects during the height of the controversy. In most meetings, we talked about how we thought it was a great buying opportunity since Facebook was still dominant with very high returns, still growing 50%+ topline and trading at 18x this year’s earnings and 15x next year’s. Importantly, from everything we could tell, there was a lot of outrage at Facebook’s data sharing practices, but little to no impact on the actual business. Without exception, our views met with skepticism and pushback. People thought Facebook was just too risky. Earlier this week, Facebook set a new all-time high at $205. It’s up 38% from the lows in just a few months and we’ve done quite well on our purchases.

Another recent example was our purchase of a couple of retailers in the latter half of 2017 when article after article bemoaned the death of brick and mortar retailing. While we certainly share the view that Amazon presents a clear and present danger to many retailers, the market started pricing in the imminent demise of a broad swath of retailers. We thought some businesses, like Foot Locker and American Eagle, were more durable and underpriced. Retailers have done well since then. In fact, in late June, the WSJ ran an article titled “Retailers Defy Prediction of Their Demise.”

Obviously, our assessments of where perceived risk overstate real risk can be wrong. We started buying Valeant too soon for example. Being early in this business means being wrong, at least for a while. While we lost money on our initial purchases, it was a top contributor last year and again this year. Typically, when something dominates the headlines and pundits focus on it incessantly, it’s a sign emotions are high (particularly when paired with big stock price moves). High emotions don’t equate to faulty expectations, but since emotions swing much more wildly and widely than fundamental business values, this can be good hunting grounds for mispriced securities.

In the quarter, we purchased two new securities, ADT Inc. and Brighthouse Financial, and exited two securities, Apple call options and athenahealth. At the same time, we added to positions we’ve previously discussed and continue to like, including Facebook, Celgene and Alexion.

ADT Inc provides security solutions to businesses and consumers. ADT was spun off from Tyco in 2012 and taken private by Apollo Global in 2016. Apollo combined it with another security business, Protection 1, which it had purchased earlier. Apollo IPO’d ADT earlier this year with a disappointing debut. They initially aimed to price the equity at $17-19, but lowered the final price to $14. Since then, the stock fell to a low of $7, but has rebounded to $9. Even at current prices, the enterprise value of $16.0B is only slightly greater than the initial $15.0B Apollo paid for the combined enterprise despite improvements to the business. The company generates roughly $1 per share in free cash flow resulting in a yield of 11%. It is using cash to delever and we see potential cash flow generation of up to $1.65 in a couple years resulting in a free cash flow yield closer to 18%. We think the market has mispriced this one and see significant upside (greater than 50%) in a fairly stable business.

We bought Brighthouse Financial on a secondary offering where MetLife exited its stake. Brighthouse is a life insurance company, primarily offering variable annuities. It was spun off from MetLife last year. Like many spin-offs, it has significant opportunities to make improvements to its business now that it’s an independent entity. It currently trades around $40, a mere 37% of its $109 book value. The market is focused on the very short-term and how BHF is unlikely to return capital to shareholders this year. If you take a longer-term perspective, we see a company that should be able to improve operations, returns on equity and return significant capital to shareholders over a multi-year period. To the extent that rates continue to rise and the markets do well, that provides additional support for the business. We think this is another name with 50%+ upside in an environment where finding that kind of upside is more difficult.

We exited the Apple options, which we last added to when the stock was closer to $90. With the stock at $180-190, we think it’s closer to fair value and was a good source of funds for other ideas. We used the proceeds of athenahealth primarily to fund our Facebook purchases. While we continued to like athena, Facebook has better margins, returns and growth while trading a lower valuation, which made the swap an easy call.

We continue to think Opportunity remains very attractively positioned overall. It trades at a significant discount to the market’s valuation, 11.6x earnings versus 16.9x forward earnings, with expected long-term (3-5 year) earnings growth slightly better than the market’s (13.6% vs. 13.5%) – we do note that consensus earnings growth numbers have consistently been too high. We believe our ability to focus on fundamentals over the long-term serves us well in this environment.

Samantha McLemore, CFA


Strategy Highlights by Christina Siegel, CFA

During the second quarter of 2018, Opportunity Equity returned 13.98% (net of fees)1 compared to its unmanaged benchmark, the S&P 500 Index, return of 3.43%.

Using a three-factor performance attribution model, selection and interaction effects contributed to the portfolio’s outperformance, which was partially offset by allocation effects. RH (RH), Valeant Pharmaceuticals International (VRX), Wayfair Inc (W), Endo Pharmaceuticals Holdings (ENDP), and Genworth Financial Inc (GNW) were the largest contributors to performance, while American Airlines Group (AAL), Lennar Corp (LEN), Delta Air Lines (DAL), MGIC Investment Corp (MTG), and JP Morgan Chase Warrants were the largest detractors.

Relative to the index, Opportunity was overweight the consumer discretionary, financials, healthcare, industrials, materials, and telecommunications sectors on average during the quarter. With zero allocation to consumer staples, energy, real estate, and utilities, the Strategy was dramatically underweight these groups and more moderately underweight the information technology sector. In terms of sector allocation, the underweight position in the energy sector, which outperformed the index, detracted the most from the portfolio’s relative performance. On the other hand, the overweight in consumer discretionary, which outperformed the index, contributed the most to relative performance.

We added two positions and eliminated two positions during the quarter, ending the quarter with 37 holdings where the top 10 represented 44.1% of total assets compared to 21.4% for the index, highlighting Opportunity’s meaningful active share of around 99%.

Top Contributors

  • RH (RH) increased 46.6% over the quarter. The company released first quarter results, which beat expectations. The company announced Earning Per Share (EPS) of $1.33 versus consensus of $1.01 due to gross margins increasing 750bps to 38% leading to operating margins of 9.6% (above guidance of 7.6-8.1%). Sales came in at $557M versus expectations of $563M. The company raised guidance for the year to gross margins of 39.3-39.6% up from 37.7-38.5% and operating margins of 10.4-11% from 9.2-10.2% leading to adjusted EPS of $6.34-6.83 from $5.45-6.20, while revenues were kept the same. The company has reiterated that it can achieve 8-12% topline growth along with 15-20% EPS growth annually starting in 2019. Insiders sold some stock over the period including officers Eri Chaya and DeMonty Price along with Karen Boone, CFO.
  • Valeant Pharmaceuticals International Inc. (VRX) had a strong quarter rising 46.0%. The company’s first quarter results beat expectations with revenue of $2B ahead of consensus of $1.95B along with adjusted Earnings before Income, Taxes, Depreciation and Amortization (EBITDA) of $832M beating expectations of $728M. The company slightly raised its full year guidance to revenues of $8.15-8.35B from $8.10-8.30B and adjusted EBITDA of $3.15-3.30B from $3.05-3.2B. The company announced that it would be changing its name to Bausch Health in July. Over the quarter, the company received a Complete Response Letter from the FDA on DUOBRII, a topical treatment for plaque-psoriasis, questioning the product’s pharmacokinetic data. While no deficiencies on the clinical efficacy or safety were found, the decision pushes back the product’s launch to later than expected.
  • Wayfair Inc. (W) climbed higher over the quarter returning 75.9%. The company reported strong first quarter results with revenues of $1.404B versus consensus of $1.36B and adjusted EBITDA of -$50M versus expectations for -$52.4M. The company added 805k active customers during the quarter bringing the total to 11.795M (33% Year-over-Year (YoY) growth). The company provided guidance for 2Q with total net revenues of $1.558B-$1.592B, but with 2Q adjusted EBITDA of -$37M to -$33M versus consensus of -$15M. Wayday was their largest sales day ever.

Top Detractors

  • Lennar Corp. (LEN) declined 10.9% over the quarter despite announcing strong 2Q results. The company had GAAP EPS of $0.94 beating consensus of $0.43. Lennar had 12,095 closings beating guidance of 11,500 units with new orders coming in at 14,440 ahead of guidance of 13,800. The company increased Fiscal Year 2018 guidance for gross margin and lowered its Selling, General & Administrative (SG&A) guidance ranges. The company raised its synergies to $160M in 2018 up from $125M previously and $380M in 2019 up from $365M.The company stated that it sees continued strong order demand. Over the period the company announced a large management transition with the promotion of Stuart Miller to Executive Chairman from CEO, Rick Beckwitt to CEO from President, Jon Jaffe will maintain his current role of COO but assume the title of President, and Diane Bessette as the newly appointed CFO in addition to her ongoing position as Treasurer and Bruce Gross will transition to CEO of Lennar Financial Services from CFO. Despite the positive fundamentals, builders broadly were pressured by fears of rising interest rates on their businesses.
  • Both American Airlines Group Inc. (AAL) and Delta Air Lines Inc. (DAL) were down over the period. American fell -26.8% after releasing first quarter results which beat expectations but lowered full year guidance due to higher fuel costs. The company had first quarter EPS of $0.75 slightly ahead of consensus of $0.73 with total revenue increasing 5.9% to $10.4B. The company lowered its 2018 EPS guidance to $5-6 from $5.50-6.50 due to higher fuel prices. The company guided for 2Q revenue per available seat mile to increase 1.5-3.5%. Delta declined -9.1% as they announced first quarter results that were largely in-line with previous guidance while maintaining full year guidance. Delta reported EPS of $0.74 beating consensus by $0.01. Total revenue for the quarter increased 8% to $9.8B while total unit revenue increased 5%. Cost per available seat mile ex-fuel (CASM-ex) increased 3.9% YoY. Management stated that first quarter would be the high point for costs and stated that they are on track to achieve flat to 2% CASM-ex growth for the full year. Later in the quarter the company provided updated guidance for 2Q with unit revenue per available seat mile (RASM) growth of 4-5% leading to a pre-tax margin of 13-14% and EPS guidance of $1.65 to $1.75. The company reiterated its full year guidance of 4-6% revenue growth and EPS of $6.35-$6.70.

Read our 2Q 2018 Market Highlights for a recap on what drove market performance.


1For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

The views expressed in this report reflect those of the Miller Value Partners strategy’s portfolio manager(s) as of the date published. 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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