January 23, 2018

The Value of Doing Nothing

Opportunity Equity 4Q 2017 Letter

The year 2017 ended up being a strong one for Opportunity Equity, which advanced 26.0% (net of fees)1, beating the S&P 500 by well over 400 basis points. A strategy’s performance always depends on a mixture of skill and luck (or lack thereof). Our strong performance is partially attributable to a bounce back after a poor first half of 2016, when many of our stocks fell to nonsensical levels relative to fundamentals. We like to think that we also did a good job picking stocks.

I was talking to an old friend who’s covered our team on the sell-side for decades. I was lamenting that despite our strong performance, we still get consistent outflows. He commented that it makes sense for people to want to take profits after being up so much and realizing how much they could lose in 2008. I contended that this way of thinking has actually cost people a lot of money in this bull market. In fact, the Wall Street Journal noted recently that $1 trillion has been pulled out of equity mutual funds since 2012 (albeit some went back into ETFs), during which time the market has risen 116%! To quantify this, you’d be better off staying in for the rise and then suffering a 50% decline than pulling out before the gain.

My friend was quite surprised when I told him that Bill has said that in his 30+ year career, it’s easier than it has ever been to construct a portfolio you have confidence will do well over five years, but more difficult to do the same over a 6-month horizon. The market is hyper-efficient in the short term but less so in the long term, especially when you focus on fundamentals.

OneMain Financial (OMF), one of our top ten holdings, illustrates this well. Early this year, OMF closed up 29% in one day because it announced that Apollo was buying Fortress’s 41% stake in the company in line with the prior night’s closing price. The announcement didn’t change OneMain’s fundamentals one bit. It is expected to earn $4.30 this year, and well over $5.00 next year, while it generates significant capital and deleverages. So at the beginning of the year, people could have paid $26 for a share of OneMain (as Apollo, who has a great track record, did) or 6x what it will earn this year. They preferred to pay much higher prices. The one-day 29% return would take a decade to earn in Treasury bonds!

Why would people sacrifice so much return? There was concern about an overhang from Fortress selling, which it had been doing because it needed to exit the holding in its limited-life private equity funds, which had held OMF for nearly a decade and were in distribution mode. Though Fortress’s sales had pressured the price somewhat, they would clearly end at some point (though it could have taken 6-12 months). Obviously, you were paid handsomely to own it before there was resolution to the overhang. In order to do so, one had to focus on long-term fundamentals. Few did.

This is exactly what we attempt to do. We believe this is one of the reasons we have had such strong performance since the financial crisis bottom (along with some good luck of course!). The conditions that have allowed us to do well still exist and give us confidence about the future. Does that mean we won’t have underperforming periods? Of course not. We are guaranteed to underperform at times. We did in 2011, and in early 2016. Both of those periods were followed by stronger outperformance than usual making them great entry points. I think this shows that a path to generating superior long-term results is to buy the dips, not sell the strength.

While it would be great to sell right before a big market decline, ample evidence exists that people cost themselves a lot of money trying to time the market. Dalbar’s well-known study on investor behavior shows that investors’ returns seriously lag those of the funds they invest in due to poor timing of purchases and sales (i.e., buying high and selling low). So while there’s lots of handwringing about passive versus active, what you invest in matters a lot less than just staying invested.

Empirical Research does some of the best quantitative work around. A few months ago, they looked at passive (ETF) investing. They concluded the poor timing decisions can be magnified with these investments. Many of the benefits of ETFs (cheap, liquid, commission-free) exacerbate investors’ counter-productive tendency to chart-chase. The best performing ETFs tend to get flows, then underperform. They also noted the worst performing ETFs continue to underperform as well.

Dalbar recently issued a study concluding that investors in passive funds do worse than those in active funds, mainly because they have shorter holding periods and sell when the funds are down. Investors spend gobs of time and money trying to pick the best investment. In reality, when it comes to diversified portfolios, the single most important determinant of long-term returns is not what you own, but how you own it. Trying to time the market costs most people dearly. It’s quite ironic that it takes the least effort to sit tight and hang on to your investments, yet most people struggle mightily to do it. I guess it should come as no surprise since it takes less physical energy to pass on that donut, but doing so is extremely challenging! At the end of the day, investors should buy things they will have confidence to hold through the ugly times.

We achieve our conviction through a deep and rigorous understanding of our companies’ fundamentals. When Delta Airlines (DAL) fell to $32 in 2016 on fears of a recession we didn’t believe was imminent, it was helpful to remind ourselves that Delta could earn roughly $2.50-$3.00 in a recession so you owned it at 10-12x trough earnings (and only 6x what it would ultimately earn one year out).

Today, we are excited about the prospects for the Strategy and continue to find good bargains. In fact, our biggest challenge has not been finding new investments, but rather figuring out which names to sell to fund the new ideas. We added three new names in the quarter, CenturyLink (CTL), Discovery Communications (DISCA) and Stitch Fix (SFIX) while exiting American Eagle Outfitters (AEO), Redfin (RDFN) and Gilead (GILD).

CenturyLink trades at $17 with the dividend yield approaching 13%. The main question is whether this yield is secure, and we believe the answer is yes. CenturyLink closed its merger with Level 3 in the quarter. Given challenges at other regional fixed wireline companies like Windstream, the market was dire about future prospects. We owned Level 3 for many years in the past and think highly of its management, namely CEO Jeff Storey and CFO Sunit Patel who will run the combined company. The combined company is in a much better position than the regional wireline companies to which it’s compared. Three-quarters of its business is enterprise and the combination makes it the second largest player, behind AT&T. It will generate significant free cash flow, approximately $3.3B or over $3.00 per share (18% yield with the stock at $17) – it is paying out 70% of its cash flow through dividends, which the company has reiterated numerous times it is committed to. The fact that insiders put their money where their mouths were and bought millions of dollars of stock when it dropped to $14-15 gives the team a lot of credibility. Even if the stock doesn’t appreciate from here, a 13% annualized return should beat the market. We think the stock is worth closer to $30 though.

We’ve followed Discovery Communications for a long time as well. John Malone, who is on the company’s Board, is one of the greatest investors of our (or any) time. He’s compounded capital at roughly 30% annually over his career. Discovery announced a merger deal with Scripps, which brings the company added scale and improved prospects. The stock fell from ~$26 to $16. A CNBC reporter asked Malone about the company: he replied it is “dirt cheap” and would generate tons of free cash flow financed at 3.5%. We did the work and realized that Discovery should generate $4 per share in free cash flow, implying a 20% free cash flow yield at the $20 level. Discovery has a great international business, especially with sports and the combined programming should help its positioning in OTT (over-the-top) skinny bundles. We are excited to invest alongside Malone in this one.

Stitch Fix was an IPO in the quarter. It’s a data-savvy clothing retailer that ships clothes directly to customers. We’d heard fabulous things about the company and its CEO Katrina Lake from Bill Gurley at Benchmark Capital who was an early venture backer. It priced below the initial range as Blue Apron’s disastrous IPO and fears about ramping marketing spend concerned prospective buyers. At the IPO price of $15, we were able to buy it at only 1x expected fiscal 2019 (ending Jul 2019) revenues. For a company that had clearly demonstrated profitability, making it to $1B in revenues on only $42M in venture investments, we believe that valuation was quite a deal. Stitch Fix looks to transform apparel retail. As a long-time customer who buys most of her clothes from Stitch Fix, I can attest to their value proposition. While we’ve already done quite well with the stock at $25, we look forward to a long investment in the company.

As you may have noticed, the majority of our new names (2/3) fit more in the “value” category than the “growth” one. We focus on where we see the greatest gaps between prices and our estimates of intrinsic value. We think that growth is an important input into the value equation. Some of our top contributors in 2017 (RH (RH), Wayfair (W), Amazon (AMZN)) fit more in the traditional “growth” camp, which allowed us to outperform in a year where value strategies struggled. We always try to have a mix of secularly mispriced securities (i.e. long-term durable growth) and cyclically mispriced ones (i.e. classic value names). We think this diversification serves us well in different market environments. Currently, the market is serving up more bargains in the latter bucket, although we still think many secular growers, like Amazon and Facebook, are quite attractive here.

Overall, Opportunity Equity trades at 15x earnings to the market’s 20x multiple, a significant discount, while still having significant long-term growth potential. We are excited about the future prospects for the Strategy and appreciate all our investors’ support.

Samantha McLemore, CFA


Strategy Highlights by Christina Siegel, CFA

During the fourth quarter of 2017, Opportunity Equity returned 5.46% (net of fees)1, compared to the S&P 500 Index’s 6.64% return.

Using a three-factor performance attribution model, sector allocation and interaction effect contributed to the Strategy’s performance, which was offset by security selection. Valeant Pharmaceuticals International Inc. (VRX), RH (RH), Amazon.com Inc. (AMZN), Foot Locker Inc. (FL) and Lennar Corp. (LEN) were the largest contributors to performance, while Intrexon Corp. (XON), Quotient Technology Inc. (QUOT), Mallinckrodt plc (MNK), Pandora Media Inc. (P), and Genworth Financial Inc. (GNW) were the largest detractors.

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

We initiated five position during the quarter and eliminated six, ending the quarter with 36 holdings where the top 10 represented 48.24% of total assets, compared with the 19.85% for the index, highlighting Opportunity’s meaningful active share of 101.03%.

Top Contributors

  • Valeant Pharmaceuticals International Inc. rose 45.01% over the period after releasing third quarter results which beat expectations. The company had revenue of $2.22B vs consensus of $2.17B and adjusted EBITDA of $951M vs. consensus of $872M due to strong Xifaxan sales and lower than expected operating expenses. The company reiterated 2017 adjusted EBITDA guidance of $3.6-3.75B on slightly lower full-year revenue guidance of $8.65B-$8.80B due to divestitures. The company has completed $6B in debt payments since 1Q16 and refinanced its debt obligations with no debt maturing until 2020. The company also announced that it received FDA approval for LUMIFY in addition to its wholly-owned subsidiary, Bausch and Lomb beginning to distribute VYZULTA. The company finalized the sale of Sprout Pharmaceuticals back to the original shareholders in exchange for a 6% royalty on global sales and announced a preliminary resolution to resolve the Allergan litigation with Valeant agreeing to pay $96M of the $290M claims.
  • RH continued to rise over the quarter returning 22.60% during the period. The company pre-announced third quarter results ahead of its analyst day which beat estimates and guided Q4 and CY18 above expectations. The company raised 3Q EPS guidance to $1.02-$1.04 vs. prior guidance of $0.68-$0.80 and consensus of $0.79. Sales guidance was raised to $592.5M from $575-590M. RH took down sales guidance for 4Q due to the delay of the opening of its New York Design Gallery but raised its net income guidance to $37-41M from $33-37M. The company gave preliminary guidance for 2018 with net revenue of $2.58-2.62B vs consensus of $2.60B with adjusted operating margins of 9-10% compared to consensus of 7.1%. The guidance implies 2018 EPS of $5.00-$5.80 vs. consensus of $3.85. Gary Friedman, CEO, bought an additional $1M of shares during the quarter while Karen Boone, CFO, sold $2M of shares during the period.
  • Amazon.com Inc. gained 21.65% over the period after releasing third quarter results beating across the board. Revenue of $43.7B beat consensus of $41.6B and came in above the high-end of guidance of $39.25-$41.75B while EPS came in at $0.52 vs $0.50. AWS grew 12% q/q and was up 42% y/y with operating margins rebounding to 25.5% from 22.3% in 2Q. The company guided for 4Q17 revenue of $56-60.5B and operating income of $300M-$1.65B. The company also announced that Cyber Monday was the single biggest shopping day in the company’s history surpassing Prime Day for the most products ordered worldwide.

Top Detractors

  • Intrexon Corp. fell 39.40% over the quarter. The company announced third quarter results which came in below consensus. Revenue of $46M was below consensus of $55M as product and collaboration revenue lagged. The company had a loss per share of -$0.33 compared to consensus of -$0.23 due to higher operating expenses. Okanagan Specialty Fruits Inc.’s Arctic (non-browning) apples finally hit stores in the fourth quarter. Right after the new year, Intrexon disclosed a $13.7M private placement with an entity affiliated with Chairman and CEO Randal J. Kirk.
  • Quotient Technology Inc. was down 24.92% for the quarter after releasing third quarter results which were largely inline. The company reported revenue of $82M and EBITDA of $12.5M compared to consensus of $83M and $11.8M, respectively. Media revenue was up 62% YoY and RetailerIQ was up 50% YoY. However, average promotion revenue per transaction was down 22% YoY to $0.059 from $0.074 in Q2. The company raised full year revenue guidance to $90-94M from $89-92M but moved EBITDA guidance to $12M-15M from $14.4-15.4M. The company also issued $175M aggregate principle amount of convertible senior notes due 2022 in a private placement.
  • Mallinckrodt plc fell 39.63% during the quarter after releasing third quarter results which missed on the topline but beat on the bottom line due to lower SG&A expenses. The company had revenue of $794M (vs. $808) and EPS of $1.97 (vs. $1.81). Acthar revenue came in weaker than expected ($309 vs $327) sighting fewer prescriptions being filled while also stating that they expect Acthar to decline sequentially in the fourth quarter. The company acquired Ocera Therapeutics over the quarter for $28M all cash. The company also announced its planned acquisition of Sucampo Pharmaceuticals for $1.2B with the deal expected to close in March of 2018.

Read our 4Q 2017 Market Highlights for a recap on what


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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