April 18, 2018

The Story Follows the Price

Opportunity Equity 1Q 2018 Letter

Opportunity Equity lagged in the quarter as overall market volatility picked up. Given we seek out investments we believe to be significantly undervalued, dispute and controversy often surround the names. This can tend to increase volatility. Typically, underperforming in a weak market doesn’t surprise us and this quarter was no exception. We attempt to use market weakness to improve long-term returns by adding to areas with the most attractive risk-reward.

It was a bit more surprising that the first quarter was the third consecutive quarter of underperformance. After periods of really strong returns like we saw in the second half of 2016 and first half of 2017, we’d expect to underperform for a quarter or two given the market’s natural gyrations. We’ve consistently witnessed fluctuations of this sort over the life of the Strategy. However, the only times we’ve underperformed for more than two consecutive quarters were the financial crisis, 2011 and late 2015/early 2016.

The financial crisis was the worst economic malaise in nearly a century and where fundamental business values deteriorated. We think it’s unlikely to be repeated anytime soon. Weakness in both 2011 and the 2015-16 period were directly related to global macroeconomic circumstances that could have pushed the global economy into recession. In 2011, the ECB under Jean-Claude Trichet pursued disastrously tight monetary policy that pushed the Eurozone back into recessionary territory in 2012. Fortunately, Mario Draghi took over, reversed course and the weakness was contained. The market weakness in the U.S. was a fabulous buying opportunity. In the 2015-16 period, we saw extreme strength in the U.S. dollar along with weakness in commodity prices, particularly oil, at the same time the Fed was tightening and feared to overdo it. Growth slowed in China and emerging markets. The adequacy of China’s foreign currency reserves were called into question, while economic distress plagued countries like Brazil and Russia. S&P earnings actually declined year-over-year in 2015. But again, the weakness was mostly contained and short-lived, making the market weakness a great buying opportunity.

The current market volatility seems more benign than the preceding periods. 2017 set records with its low volatility. It was the only year since good records have been kept where stocks were up every single month. It had no correction of even 3%, which was unprecedented. The S&P 500 was up more than 20% and optimism started to shine through with strategists forecasting more of the same in 2018. We’d written that we expected a pickup in volatility and a return to normality with market corrections of 5-10%.

When the correction started in late January, market pundits initially attributed it to increasing interest rates and fears about inflation. As interest rates declined from the recent highs and inflation data moderated, the market malaise continued. I was reminded of one of my favorite adages of Bill’s: The story follows the price. We attributed the pullback to market internals: an extended period of strong performance without a pullback leading to overly bullish positioning and optimism. With S&P earnings expected to grow over 20% in the first quarter, we do not see a significant imminent threat to the extended economic recovery and bull market.

The most recent retest of the initial pullback seems more tied to fears about the risks of protectionism. If protectionist actions reach the point of materiality, the market and economy could be at real risk. Since 2002, S&P 500 manufacturers’ margins have nearly doubled on the back of globalization, which lowered labor costs, interest expense and tax rates. The reversal of this broad trend would not be pretty.

We believe it hasn’t yet reached the level of materiality required to pose a real risk to the status quo. Larry Kudlow, a vocal free trade advocate who was recently appointed as the Director of the National Economic Council, calmed the markets by positioning the protectionist actions against China as an initial point in negotiations that will take a long time to be worked out. While both China and the U.S. have left themselves room to negotiate, Trump’s suggestion of an additional $100B in tariffs highlights the risk of the tit-for-tat retaliatory strategy making markets swoon. How it all plays out deserves to be watched closely.

So far, it appears this pullback is a buying opportunity similar to the previous periods. The portfolio lacks significant exposure to areas that would be the most vulnerable in a trade war, namely industrial capital goods. This group has historically been cheaper than the market on free cash flow yield but is now more expensive. Exports are an important fundamental driver for them, and right now we don’t believe you are being compensated for the risk in most cases.

The good news about the recent pressure on market prices is that buying at lower prices improves long-term returns. We are excited about the potential returns of the Strategy. Our estimate of the embedded upside sits above 80%. Opportunity trades at a steep discount to the market: only 12x forward earnings versus the S&P 500’s 17x. We have used the market volatility to make changes we think improve the Strategy’s long-term positioning. We added two new names to the portfolio: Celgene Corp (CELG) and Teva Pharmaceuticals (TEVA) and exited one: GameStop Corp (GME).

Celgene has been one of the most successful biotech companies in history, most well-known for its blockbuster multiple myeloma drug, Revlimid. Revlimid accounts for nearly two-thirds of Celgene’s sales. Fears about Revlimid going off patent in 2022 along with some pipeline disappointments have caused the stock to trade down 40% from the highs to where it currently sits in the high $80’s. At this level, Celgene trades at 10.5x this year’s earnings and 8.8x next year’s. Consensus expectations call for revenues to grow consistently at 10-15% per year for the next few years with earnings per share growing closer to 20%. The company believes it will earn more than $12.50 per share in 2020, so at ~$89, it’s only 7x 2020 earnings. At current prices, the stock seems to discount Revlimid revenues quickly going to zero after patent loss with nearly no offsetting revenues from pipeline. We think Celgene will do better than that, especially with its positions in autoimmune and immunotherapy.

Teva, a leading generics company, hit a 15-year low in the fourth quarter. Equity analysts cited fears about the amount of debt, but bond markets have viewed the risk as minimal with debt yielding in the mid 6% range. The new, well-regarded CEO Kare Schultz, who started in November, is moving fast and doing all the right things. We think guidance is conservative, yet the free cash flow yield is greater than 10%. Pharmaceuticals broadly have screened positively on quantitative factors lately, with the market ascribing no value to their defensive characteristics. Generics specifically seem to be getting closer to the end of the extreme pricing pressures plaguing the industry lately. We see the potential for Teva to be up 50-100% over the next couple years.

We exited GameStop. While the retailer remains one of the cheapest companies in the market, secular pressures have weighed on results. At the same time, the CEO departed the company due to illness. We’ve owned this investment for a number of years and it has yet to work. After an exhaustive review in 2012 of what has hurt and helped Opportunity historically, including the use of external consultants, the recommendation was made to exit names if we’ve owned them for a few years and they still hadn’t worked in order to avoid perpetual losers. This was a strategy Benjamin Graham also employed. In light of this and other more compelling opportunities, we exited GameStop.

Samantha McLemore, CFA


Strategy Highlights by Christina Siegel, CFA

During the first quarter of 2018, Opportunity Equity returned -2.51% (net of fees)1, compared to the S&P 500 Index’s -0.76% return.

Using a three-factor performance attribution model, the interaction effect and security selection contributed to the portfolio’s underperformance which was slightly offset by the allocation effects. Amazon.com Inc. (AMZN), Intrexon Corp. (XON), OneMain Holdings Inc. (OMF), RH (RH), and Quotient Technology Inc. (QUOT) were the largest contributors to performance, while Valeant Pharmaceuticals International Inc. (VRX), Mallinckrodt (MNK), Endo Pharmaceuticals Holding Inc. (ENDP), Pulte Group Inc. (PHM), and Wayfair Inc. (W) were the largest detractors.

Relative to the index, Opportunity was overweight the financials, consumer discretionary, health care, industrials, materials and telecommunications sectors on average during the quarter. With zero allocation to utilities, consumer staples, energy and real estate, 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 information technology sector, which outperformed the index, detracted the most from Opportunity’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 one position during the quarter, ending the quarter with 37 holdings where the top 10 represented 47.2% of total assets compared to 20.4% for the index, highlighting Opportunity’s meaningful active share of 101%.

Top Contributors

  • Amazon.com Inc. (AMZN) ended the quarter up 23.8% after announcing strong fourth quarter results. The company posted Q4 Revenue of $60.5B compared to consensus of $59.8B with operating income of $2.1B vs. estimates of $1.48B. AWS growth accelerated to 45% year-over-year (YoY) excluding FX to $5.1B in revenue and operating margins up to 26.5%. The company guided for Q1 net sales of $47.75B-$50.75B and operating income of $300M-$1B. Amazon also announced that they would be partnering with Berkshire Hathaway and JP Morgan to offer lower cost healthcare services to their US employees. They plan to setup an independent company that is free from profit-making incentives and constraints. The company was also reportedly in talks with banks about building a checking account like product that the company would offer to its customers.
  • Intrexon Corp. (XON) rebounded in the first quarter climbing 32.8%. The company announced 4Q revenue of $77M vs. $48M expected leading to loss per share of -$0.23 vs. the -$0.32 forecasted. The outlook for 2018 was positive with Intrexon making incremental progress in several projects in the energy sector and moving forward in their healthcare program with Ziopharm on point-of-care CAR-T trial being initiated in late 2Q18 and initiating a pivotal trial in rGBM in the second half of the year in addition to enrolling pediatric GBM patients for a Phase I study. The company is making more progress with its self-limiting insects/gene-drivers. The company disclosed a $13.7M private placement with an entity affiliated with the Chairman and CEO Randal J. Kirk.
  • OneMain Holdings Inc. (OMF) gained 15.2% during the quarter after announcing fourth quarter results with earnings per share (EPS) of $1.06 in-line with consensus and net interest income of $653M above consensus of $598M. Loan receivables increased 10% YoY to $14.8B with origination volume up 34% YoY. The company provided 2018 guidance with net receivables growth of 5-10%, net charge off (NCO) rate below 7% and operating expense growth of 5%. During the period it was announced that an investor group led by Apollo Global and Varde were planning to acquire the remainder of Fortress Investment Group’s stake in the company.

Top Detractors

  • Valeant Pharmaceuticals International Inc. (VRX) declined 24.4% over the quarter. The company announced fourth quarter results which were largely in line. The company posted revenues of $2.163B vs. $2.179B expected and adjusted earnings before income, taxes, depreciation and amortization (EBITDA) of $875M versus $875M estimated leading to adjusted net income of $347M versus consensus of $347.2M. The company disappointed on 2018 guidance with EBITDA of $3.02-3.2B versus consensus of $3.36B on revenue of $8.1-8.3B versus expectations for $8.3B. Management expects 2018 to be a trough year, reflecting conservative loss of exclusivity assumptions with the company returning to growth in 2019 with revenue and adjusted EBITDA compound annual growth rates anticipated to be 4-6% and 5-8% respectively through 2021. Over the quarter, CEO Joe Papa bought 30,000 shares and CFO Paul Herendeen bought 15,000 shares.
  • Mallinckrodt (MNK) ended the quarter down 35.6% despite solid fourth quarter results. MNK beat the quarter with sales of $792.3M versus consensus of $768.4M and adjusted EPS of $2.01 vs. $1.68 expected. Sales of Acthar were down YoY, but beat estimates with revenue of $295.2M compared to $288.2M expected. The company provided 2018 guidance with net sales expected to increase 3-6% YoY and adjusted EPS of $6.00-$6.50. The company expects Acthar revenue to be down YoY in 2018 but to still be in excess of $1B in revenue. The company announced the acquisition of Sucampo over the quarter for $1.2B.
  • Endo Pharmaceuticals Holdings Inc. (ENDP) declined 23.6% over the quarter. The company announced fourth quarter results that were better than expected with EPS of $0.77 vs. $0.61 expected, EBITDA of $327M vs. $310M on sales of $769M vs. $760M but disappointed on guidance. The company guided for 2018 free cash flow (FCF), including mesh at the midpoint of -$205M with the decline related to lower EBITDA guidance. The company guided for 2018 EBITDA of $1.2-1.3B compared to consensus of $1.32B, EPS of $2.15-2.55 compared to consensus of $2.86 on sales of $2.6-2.8B versus consensus of $3.0B. ENDP expects U.S. generic sales to decline in the mid-to-high 30% range. During the period the FDA issued draft guidance on establishing 503B bulk lists providing higher hurdles for compounding of FDA-approved Vasostrict.

Read our 1Q 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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