January 19, 2020
The Perils of Rearview Mirror Investing
The Overlooked Value in Cyclicals: Opportunity Equity 4Q 2019 Letter
“Oh, take your time, don’t live too fast
Troubles will come and they will pass”
-Simple Man, Lynard Skynard
Opportunity Equity ended the year with a bang. For the fourth quarter, the Strategy was up 18.68% (net of fees), more than doubling the S&P 500’s 9.07% return. After lagging the market earlier in the year, the fourth quarter boost took the Strategy ahead for the 1-year period where it gained 33.86%, outpacing the S&P’s 31.49% return.
What changed to cause such a dramatic move? The short answer: a sentiment shift driven by lower perceived risk due to greater monetary liquidity. The Federal Reserve gradually shifted from increasing rates in December 2018 to pausing early in 2019 to cutting rates from July through October. The yield curve’s inversion caused much angst about the looming risk of a recession. Easing rates allowed the yield curve to re-invert in October. While the consumer remained strong throughout, signs of improving business activity emerged late in the year. The market quickly recovered from last year’s sharp sell-off, but cautious sentiment prevailed until sometime in September when the market interpreted the economic improvements as evidence the economy would continue to grow and the bull market was safe. Cyclicals and value stocks benefited as money flowed away from more defensive names.
We saw similar market moves in 2011 and in late 2015/early 2016 when the market also feared an end to the economic cycle. The market was wrong then too. Each pullback was a buying opportunity. Buying the dips has earned a lot more money than trying to exit before the next downturn.
During each of these sell-offs, cyclicals fared worse than the market. While that may seem sensible at first glance, I think that knee-jerk reaction will prove misguided in the long run for many stocks. Cyclical stock valuations have mostly remained depressed during this bull market run because financial crisis wounds have made people continually fearful about the risk of losing money in a downturn. At the same time, many companies have improved their underlying business, given what they experienced and learned in the crisis, which reduces risk in the next recession.
For instance, during the 2016 pullback, it looked to me like airline share prices already discounted a recession. I think the next recession will look very different for airlines than historical ones when airlines hemorrhaged cash and bankruptcies ensued. Yes, they are still cyclical and earnings will decline in a downturn. But the starting level of profits and free cash flow are so much higher that even comparable levels of volatility could leave some, like Delta, with significant profits at the trough. Importantly, the balance sheets and management behavior are also much better. Risk in a downturn is much lower.
The airlines still trade at the same valuations they have historically, despite much stronger free cash flow generation, better returns on capital, and significant capital return to shareholders. I think improved performance in the next recession might be the thing that finally convinces the market that the improved economics can be sustained and that these companies deserve better valuations.
When I told Bill perhaps a recession would be beneficial for the airlines for this reason, he told me I was wrong because they would trade down a lot in the interim while the market figures it out. He’s certainly right about that. But in the long term, I think any recessionary sell-off would likely provide a great buying opportunity before the market finally assigns them multiples higher than historic ones.
A similar situation occurs with the big banks, which have far lower risk than they did prior to the financial crisis. Banks hold far more capital today than before the crisis. In 2007, bank capital amounted to just over 11% of risk-weighted assets. Today, at just shy of 16%, it’s nearly 45% greater. For the big banks, the magnitude of improvement surpasses even those levels. Bank of America took its Tier 1 Capital ratio from 6.9% in 2007 to 12.9% at the end of the third quarter 2019, a 600 basis point improvement (+87%). JP Morgan and Citigroup increased theirs roughly the same amount as well.1 Even more importantly, the vast majority of capital consists of common equity and the banks hold highly liquid securities due to new standards resulting from the crisis. No wonder JP Morgan CEO Jamie Dimon refers to his “fortress balance sheet.”
The big banks appear to be managing credit risk better as well. Credit costs remain near historically low levels. While JP Morgan remained profitable throughout the financial crisis, others have improved underwriting to fare better in the future. Bank of America, for instance, focuses on “responsible growth”. Now, it lends to its own customers with tighter underwriting standards and avoids buying loans in the secondary market, giving the bank more control over its credit risks.
People seem to forget that there’s a relatively recent precedent for banks outperforming in a recessionary bear market. The banks outperformed after the tech bubble burst. Over the long term, valuations and fundamentals matter more than simple narratives and rules of thumb. Yet people continue to sell “cyclicals” every time we get a macro fear surge. It’s easy to see why Peter Lynch nailed it when he said that people lost more money from fear of a recession than from a recession itself.
During the financial crisis, bears would criticize banks by saying the new regulatory limits would render them like utilities. They would be tightly controlled with little growth potential and low returns. Yet utilities provide investors exactly what investors currently demand: low earnings volatility. The S&P Utility Index trades at almost 19x 2019 earnings despite returns on capital of merely 12%. Our big banks trade for 10-13x earnings with superior returns. The best-in-class (JPM) earns 15% ROE and 17% return on tangible common equity. Bank of America and Citigroup’s returns are a few hundred basis points lower but improving. Meanwhile, they are all returning large sums of capital to shareholders. I sure hope those bears eventually prove right and the market values banks like utilities! In the meantime, they offer attractive returns for patient investors.
As a result of the financial crisis trauma, people continue to demand low volatility and limited downside. Ironically, strategies for achieving lower volatility seem to actually result in greater volatility. Everyone simultaneously rushes for the exit at any hint of risk. Valuations reflect this supply demand imbalance. We are in a market where stability is valued more dearly than potential. And volatility is the price you pay for returns. Investors can profit handsomely by taking the other side of this trade. Opportunity has compounded capital at an annual rate of 17.5% in the 11 years since the end of 2008, beating the market’s 14.7% by just shy of 20% per year.2
We aim to be patient, long term and valuation-oriented. We focus on the gap between fundamentals and expectations. We believe it is this approach has enabled us to be a top performer in this post financial crisis period. We continue to see promise going forward.
It’s easy to get caught up in the narrative but that’s rarely the best long-term approach. Early in the last decade, people loved “global cyclicals,” like energy and materials stocks, that had benefitted massively from the huge growth in China in the prior decade. Many investors confidently argued these were the most attractive names in the market and advocated buying dips. We were criticized for having too little exposure. But long-term history showed these companies earn poor returns on capital. The huge boom attracted massive amounts of capital and price levels reflected the strong recent history. The huge influx of capital ultimately earned subpar returns on capital. Market prices have suffered as a result. Today, energy represents the lowest proportion of the S&P in its history. Rearview mirror investing results in serious accidents!
We’re likely to experience a recession sometime in the next decade (though Australia’s 28 year recession-free run shows there is no certainty we will). When we reflect back on this decade 10 years from now, my guess is that cyclicals will still have provided better returns than defensive/stable stocks due to starting prices and the changes I’ve discussed. The expectations piece of the fundamentals versus expectations equation is often overlooked, yet just as crucial to returns.
In the quarter, we added three new names and exited two. We bought Farfetch Ltd, Energy Transfer LP and Centennial Resource Development. We also paid down some of our line of credit, taking our net leverage to 6% of the portfolio. We had increased our borrowings in the big sell-off in the fourth quarter of 2018. We like to use the line of credit to monetize market volatility. Our overall leverage is quite modest and will remain so (we are limited from increasing it above 10%).
Farfetch is a leading technology platform for the global luxury fashion industry based in London. It came public in September 2018 at $20 per share, above the initial range. It traded up to $32 before encountering difficulties. Competition for new customers led to more aggressive discounting of goods and the company announced a very misunderstood acquisition of New Guards Group (NGG), which the market interpreted as a defensive play. At the same time, the sudden overall market aversion to money-losing companies provided pressure. As a result, the stock plummeted, briefly hitting $7.
We view this business as a two-sided network with luxury goods suppliers on one side and consumers on the other. Farfetch’s model aligns extremely well with the luxury goods companies, allowing them better economics than traditional wholesale partners because Farfetch’s take rate is lower than retail partners. We see the potential for it to be the top online destination for luxury goods. The NGG deal was financially accretive and offers the company some exclusive content to attract customers. The company has enough cash to reach profitability next year. With strong management, we believe paying 2x this year’s revenues (where it trades now) is a bargain. We think Farfetch has the potential to double and compound capital over the long term.
The other two new names are energy companies, which may surprise you given my prior comments. Here, both sides of the fundamentals versus expectations equation have changed. Fundamentally, we have seen a shift in energy company behavior towards return on capital and free cash flow. Some research reports that 90% of companies used those metrics in incentive compensation in 2018, which is an important change that should result in better future returns. Warren Buffett’s partner, Charlie Munger, has said he believes he’s in the top 5% of his age cohort in understanding the power of incentives yet he’s underestimated it his entire life. We try not to make that mistake.
From an expectations basis, energy was the worst performing sector of the last decade (+3.3% per year versus 13.4% for the S&P 500). Recently, I’ve been told by both a generalist value investor and a specialist energy investor that either the space is uninvestable or that team members have advocated exiting. Why? Many legitimate reasons such as decline rates on shale plays, poor corporate governance and the impact on market demand from the shift towards ESG (environmental, social, governance) investing. However, as Bill’s fond of saying, if it’s in the papers, it’s in the price. Behavior has shifted. Maybe most importantly, we take periodic looks at the space and this is the very first time we’ve been able to make any compelling discounted cash flow valuation case without assuming rising prices.
The biggest position we currently have in the space is Energy Transfer LP, a pipeline company with a 9% dividend yield. That yield alone could potentially provide returns that outperform the market from these levels on a longer-term basis. Kelcy Warren, the founder and CEO, owns more than 9% of the company and he bought $45M more in the quarter. Other executives bought more too. The US continues to need more pipeline capacity and we believe the stock has the potential to appreciate 50-75% in addition to the dividend.
We also bought Centennial Resource Development, otherwise known as “CDEV”. This is a money-losing development stage company led by arguably the best CEO in the industry, Mark Papa. Papa ran EOG from late 1998 through 2013. During this time, EOG compounded capital at a 28% annual rate versus 24% for the overall market and 11% for the energy industry . When Papa was asked how he trounced the rest of the industry so badly, he replied that it was because other people thought it was a good industry and he knew it wasn’t so he allocated capital appropriately. CDEV traded down from a high of $23 to $ a low of $3. We started buying it near the lows. At the current $4.50, it trades at a fraction of the enterprise value per net acre of its peers despite having top quality land, outstanding management, and less debt on the balance sheet. We believe it can self-fund its growth through asset sales, which will allow the market to revalue its acreage. CDEV also has significant option value to an improving energy environment.
Overall, we continue to be excited about the prospects for our companies. We keep finding exciting new ideas by being contrarian, long-term and valuation focused. Opportunity celebrated its 20th anniversary at year end. We’ve been fortunate to compound capital for our investors at a better rate than the market. We thank our investors for their continued support.
Samantha McLemore, CFA
Strategy Highlights by Christina Siegel, CFA
During the fourth quarter of 2019, Opportunity Equity returned 18.36% (net of fees), compared to the S&P 500’s return of 9.07%.
Using a three-factor performance attribution model, allocation, selection, and interaction effects contributed to the portfolio’s outperformance. ADT, Inc., Bausch Health Companies Inc., Flexion Therapeutics, Endo International and Teva Pharmaceuticals were the largest contributors to performance, while Brighthouse Financial Inc., Pangaea One, Intrexon Corp., GTY Govtech Inc., and United Airlines Holding Inc. were the largest detractors.
Relative to the index, the portfolio was overweight the Consumer Discretionary, Financials, Health Care, and Industrials on average during the quarter. With zero allocation to Materials, Real Estate and Utilities, the Strategy was dramatically underweight these groups and more moderately underweight the Information Technology, Energy, Communication Services, and Consumer Staples sector. In terms of sector allocation, the overweight position in the Consumer Discretionary sector, which underperformed the index, detracted the most from the portfolio’s relative performance. On the other hand, the overweight in Health Care, which outperformed the index, contributed the most to relative performance.
We added three positions and eliminated two positions during the quarter, ending the quarter with 40 holdings where the top 10 represented 37.4% of total assets compared to 22.7% for the index, highlighting Opportunity’s meaningful active share of around 96.8%.
- ADT, Inc. (ADT) increased 37.5% over the quarter. The company announced 3Q results which beat expectations with revenue of $1.3B ahead of consensus of $1.275B with earnings before income, taxes, depreciation and amortization (EBITDA) of $624M versus $616.5M expected. The company reiterated their full year 2019 guidance even with the removal of the Canadian business. Total revenue of $5.0-5.15B with adjusted EBITDA of $2.47-2.5B and free cash flow (FCF) of $570-610M (10% FCF yield). During the quarter, the company announced the sale of their Canadian business to TELUS Corporation for CAD $700m as well as a $0.70 per share one-time special dividend. The company announced a new partnership with Lyft to integrate mobile safety on the platform. The company also purchased I-View Now, a video alarm verification service, during the period.
- Bausch Health Companies (BHC) gained 36.9% over the period after announcing strong third quarter results. The company reported 3Q revenue of $2.21B and earnings per share (EPS) of $1.19 versus consensus of $2.15B and $1.09. The company raised its full year guidance for a second time increasing revenue to $8.48-8.63B and EBITDA to $3.5-3.6B. The company started out the quarter by suing Sandoz for patent infringement over its application to sell a generic form of Xifaxan. The company was able to settle their ‘stock drop’ litigation for $1.21B during the period.
- Flexion Therapeutics (FLXN) increased 51.0% over the quarter after announcing that the FDA had approved a revised product label for Zilretta removing the language stating that Zilretta is “not intended for repeat administration”. The company was pleased with the change and with the inclusion of their repeat dosing study results which allows them to use the study results in marketing material. They also received FDA clearance of its investigational new drug application for FX201, a gene therapy candidate for the treatment of Osteoarthritis. Flexion’s 3Q results beat expectations with the company reporting revenues of $21.8M, 29% sequential growth, beating consensus of $19.8M with EPS -$1 slightly below consensus of -$0.95. The company narrowed full year guidance to revenue of $70-75M from $65-80M previously with a midpoint of $72.5M ahead of consensus of $70M.
- Brighthouse Financial (BHF) declined 3.1% over the quarter. The company reported 3Q adjusted EPS of $2.24 ahead of consensus of $2.18. The company had a $429M adverse non-cash charge related to the company’s annual assumptions review held in the third quarter. Total adjusted capital increased by $1.5B to $8.4B. Annuity sales increased 17% year-over-year (YoY) but were down 4% quarter-over-quarter (QoQ) with variable annuity net outflows of $1.2B with fixed annuity inflows of $0.1B. The company ended the quarter with variable annuity assets ~$1.5B above CTE 98.
- Intrexon Corp. (XON) declined 4.2% over the quarter. The company announced the divestiture of AquaBounty to TS AquaCulture LLC, an entity fully owned by Third Security of which Randal Kirk owns 100% of the equity interest. Intrexon reported 3Q revenue of $23M below expectations of $33M and EPS of -$0.35 below consensus of -$0.24. The company continued to make progress on cost management efforts and monetization of the non-health assets. Triple-Gene, a majority owned subsidiary, presented preliminary open-label Phase 1, first-in-human results for its gene-therapy candidate for heart failure, INXN-4001.
- GTY Technology Holdings Inc.(GTYH) declined 6.1% over the quarter. The company announced 3Q results reporting non-GAAP revenue of $9.8M and non-GAAP operating incoming of -$4.6M. The company added +20 sales and marketing personnel during the quarter and plan to hire another 20 in 4Q while adding 72 new customers.
Past performance is no guarantee of future results.
1JPM: 2007 8.4% to Q319 14.1%; C: 2007 7.1% to Q319 13.2%
2Performance for representative account.
For 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.
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.
©2020 Miller Value Partners, LLC