Miller Income Strategy 1Q 2023 Letter

The Miller Income Strategy‘s representative account returned -3.51% net of fees versus 3.72% for the ICE Bank of America High Yield Index in the first quarter of 2023. It was another manic quarter for markets, as macroeconomic uncertainty spiked with the collapse of Silicon Valley Bank (SVB), the second-largest bank failure in American history2. Word made its way around the venture-backed community that SVB was having a hard time meeting depositor withdrawals, which is not something that cash-hungry companies want to hear, prompting a run on SVB as well as a few others. This event marked a clear shift in market dynamics, as well as our portfolio’s relative performance.

Exhibit 1: Performance of Income Strategy Versus High Yield, Equity Indices, through 3/31/20231

Time Period Income Strategy (net) ML HY II S&P 500
QTD -3.51% 3.72% 7.50%
1-Year -17.79% -3.56% -7.73%
5-Year 1.03% 3.06% 11.19%
10-Year 3.19% 4.03% 12.24%
YTD -3.51% 3.72% 7.50%
Inception (annualized since 4/2/2009) 9.75% 8.62% 14.67%
Source: Bloomberg, Miller Value Partners.

Through the first few trading days of March, the Income Strategy was ahead of its benchmark year-to-date. The SVB failure rattled investors’ nerves about the soundness of the underlying financial system, which became evident across asset classes. Government bond yields dropped and high-yield spreads widened as perceived risk unperformed in March with investors’ rush to safety. The equity market dusted off its playbook from just after the March 2020 COVID swoon, which involved further multiple expansion on high-multiple, large-capitalization “growth” names. Meanwhile, smaller capitalization and lower-multiple “value” stocks underperformed.

Our more tenured shareholders will recognize this environment as one that does not treat our value-oriented income strategy well, and the trailing quarter was no exception. Since our goal is a functional one – namely, undervalued income with the potential for capital appreciation – we approach the market from that perspective and construct our portfolios much differently than the benchmark with the goal of outperforming it over the long term. As such, we find it especially important to review the context around underperformance.

Approximately 80% of the portfolio today is in equities with yield, so looking at the broader equity return landscape during the quarter is instructive. Among S&P 1500 stocks with a consensus estimate for positive earnings in 2023, the average Q1 total return of the top decile when ranked by earnings multiple (the “most expensive” stocks) was 12.4% versus -9.1% for stocks with bottom-decile P/E multiples (the “least expensive” stocks), one of the worst quarterly relative performances in twenty years. Fifteen companies in the S&P 1500, or only 1% of the index, generated approximately 93% of the index’s change in market cap during the quarter.

Dividend yield also did not have a good quarter in the aggregate; if an investor had bought the top 20% of stocks in the S&P 1500 with yield on an equal-weighted basis, the total return would have been -1.8% (the annualized dividend yield of such an endeavor would be 6.5%), while the decile of stocks with the lowest positive yield generated a 10.2% total return. More information on Q1 factor returns from the S&P 1500 follows:

Average Return by Factor Quintile in Q1 2023 (%)

P/E Mkt Cap Leverage Div Yield
Q1 (high P/E, cap, leverage, yield) 11.1 4.2 (0.4) (1.8)
Q2 8.1 2.9 1.7 (2.2)
Q3 4.1 3.9 2.8 (0.5)
Q4 1.2 3.1 4.9 3.2
Q5 (5.5) 2.0 7.2 7.5
D1 (1st decile) 12.4 4.6 (0.0) 0.3
D10 (10th decile) (9.1) 0.2 5.3 10.2
NO EPS/Div (3.0) 7.0
Industry sectors that tend to generate more yield also fared much worse than those without yield. Technology stocks, which have the least yield of any sector, were up 14% on an equal-weighted basis in the first quarter, while the yield-heavy financial, energy and utilities groups all had a negative average total return.
Source: Bloomberg, Miller Value Partners.

Average Return by Sector in Q1 2023 (%)

Technology 14.0
Consumer, Cyclical 8.5
Industrial 8.5
Communications 6.0
Basic Materials 6.0
Consumer, Non-Cyclical 3.0
Utilities (0.9)
Energy (5.2)
Financial (6.4)
Source: Bloomberg, Miller Value Partners

Tracking error, or performance that deviates from the benchmark, is a real risk when pursuing a functional goal in a concentrated portfolio while being benchmarked against a diversified index, though the extent of our relative performance reversal in less than thirty days highlights an important truth – things can change quickly.

A pending recession seems to be the base case for most pundits, and understandably so – monetary policy is restrictive in an effort to reduce inflation, and the 3.5% unemployment rate feels as though it can only move in one direction off of a level not seen since 1969, which was also the last time inflation spiked after remaining under control for many years. Perhaps most concerning to pundits is the bond market, as the yield curve sits at its deepest inversion in at least forty years, suggesting investors believe short rates will need to come down in the foreseeable future if policymakers want to achieve both maximum output and stable prices.

When the future seems so obvious, it is worth considering what may cause it not to be so. One of the most interesting offsets to the aforementioned “recession is the only way forward” outlook lies in the market’s expectation for interest rate volatility. The ICE BofA MOVE Index measures the options market’s expectations for volatility in Treasuries across the maturity curve, and it just hit a 15-year high, on par with levels last seen in the global financial crisis. Expectations for record levels of volatility on what are supposed to be the “safest” assets implies a high amount of uncertainty around the interaction between markets, policy and the economy. If volatility around an asset class is expected to be very high, the pricing signals coming from those assets could be weak, as the market believes they are subject to change quickly and by a large amount. The closely watched 2-10 year Treasury spread was cut in half in just three days in March, going from “the deepest inversion in at least forty years” to “one more three-day move to a positive slope” (which would imply a lower probability of a recession to some). Uncertainty around the right cost of capital is a real challenge for financials, whose entire job is arbitraging various costs of capital, which may explain some of the sector’s recent underperformance. History also shows that this level of expected volatility tends to be short-lived, and any improvement would be good for our portfolio’s heavy allocation to financials.

None of this changes how we approach the market and manage the strategy, as the economy tends to grow most of the time, and even the economists who officially date economic peaks and troughs cannot do so until many months or years thereafter. We look for businesses that have undervalued yield in their capital structures and then own those securities until one of three things happens: 1) the market agrees with us, 2) the investment case changes, or 3) we find a better opportunity. The most significant change to the portfolio this quarter was the addition of a new name – Western Alliance Bancorp (WAL), a regional bank based in Phoenix, AZ, that saw its share price collapse with Silicon Valley Bank’s. Unlike SVB, Western Alliance has a diversified loan book with low exposure to the technology sector and is a much better underwriter; it is also very efficiently run, and management has been transparent in communicating with the market about the bank’s status throughout the turmoil. We funded it with a combination of other equities, and we exited a few financials whose valuations we thought were fair-to-high relative to other values we saw in the space.

We find the valuations across the portfolio compelling, and as always, we remain the largest investors in the Strategy and welcome any questions or comments.

Bill Miller IV, CFA, CMT

Strategy Highlights

In the first quarter, the Income Strategy’s representative account fell -3.51% (net of fees), underperforming the ICE BofA Merrill Lynch High Yield Master II Index’s 3.72% gain and underperforming the S&P 500’s 7.50% gain. (Exhibit 1). The strategy ended the quarter down -3.51% year-to-date (YTD) net of fees, or 723 basis points behind the high yield index and 1,101 basis points behind the S&P 500.

Top Contributors

  • HeidelbergCement AG (HEI GY) was the top contributor for the quarter. The company reported 4Q22 revenue of €5.29B ($5.74B), +12.0% year-over-year (Y/Y), ahead of consensus of €5.18B ($5.62B), and Operating Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) of €1.02B ($1.11B), +4.3% Y/Y, slightly ahead of consensus of €1.00B ($1.09B). HeidelbergCement generated fiscal-year 2022 (FY22) Adjusted Earnings per Share (EPS) of €9.47 ($10.26), +19.7% Y/Y, implying a Price-to-Earnings (P/E) multiple of 7.1x, and free cash flow (FCF) of €1.34B ($1.45B), or a FCF yield of 10.3%. In 4Q22, the company sold 28.9 million tons (Mt) of cement and clinkers, -6.3% Y/Y, and 70.2 Mt of aggregates, -6.1% Y/Y, and management noted that pricing gains are more than offsetting cost inflation even on the lower sales volumes. The company paid out €628MM ($681MM) in dividends and repurchased €350MM ($379MM) worth of shares in 2022, collectively returning €978MM ($1.06B) to shareholders, or 7.5% of the company’s market cap. Management guided for FY23 revenue growth driven by continuous strong pricing, Operating Earnings Before Interest and Taxes (EBIT) of €2.50B ($2.71B), at the midpoint, and recently declared a FY23 annual dividend of €2.60/share ($2.82/share), +8.3% Y/Y, implying a 3.9% yield.
  • MicroStrategy, Inc. 0.75% 12/15/2025 rose in sympathy with Bitcoin’s 71.7% gain during the first quarter. The company reported 4Q22 revenue of $132.6MM, -1.5% Y/Y (+4.1% on constant currency basis), ahead of consensus of $131.0MM, and an adjusted loss from operations of -$176.7MM, compared to a 4Q21 adjusted loss of -$124.3MM. During the quarter, MicroStrategy’s subsidiary, Macrostrategy, voluntarily paid off a $205MM loan to Silvergate Bank with a 22% discount after the bank filed for liquidation earlier this year. Additionally, MicroStrategy reported that it purchased another ~6.5K bitcoin for ~$150MM in cash, at an average price of $23.2K per token, bringing the company’s total holdings to ~139.0K bitcoin as of 3/23/23, which is worth approximately $3.95B based on a bitcoin price of ~$28.4K as of 3/31/23.
  • Jackson Financial Inc (JXN) gained after it reported 4Q22 revenues excluding net losses on derivatives and investments of $2.66B, -11.6% Y/Y, and Adjusted Operating EPS of $5.66, compared to 4Q21 EPS of $7.48, ahead of consensus of $5.21. Jackson ended the year in a strong capital position, with a Risk-Based Capital (RBC) ratio of 544% as of year-end 2022, representing a sequential improvement from a 3Q22 RBC ratio of over 500%. The company returned $86MM to shareholders in 4Q22 via $38MM of share repurchases and $48MM in dividends, bringing FY22 capital returns to $482MM, or 15.7% of the company’s market cap. Management increased the 1Q23 dividend by 12.7% to $0.62/share, or an annualized yield of 6.6%, and announced a $450MM increase to the company’s existing share repurchase authorization, as management is targeting FY23 capital returns of $500MM, at the midpoint, or 16.2% of the company’s market cap.

Top Detractors

  • Vonovia SE (VNA GY) was the top detractor for the quarter. Vonovia reported FY22 revenue of €5.15B ($5.58B), +42.2% Y/Y, ahead of consensus of €4.64B ($5.03B), and Adjusted EBITDA of €2.76B ($2.99B), +22.6% Y/Y, slightly below consensus of €2.78B ($3.01B). The company generated FY22 funds from operations (FFO) per share of €2.56 ($2.77), +17.4% Y/Y, implying a Price-to-Funds From Operations (P/FFO) multiple of ~6.8x. Management decided to cut the dividend from €1.66/share ($1.80/share) in FY22 to €0.85/share ($0.92/share) in FY23, implying a 4.9% yield, in order to strike a more appropriate balance between capital discipline and shareholder returns, as the company focuses on deleveraging via organic cash flow generation and potential property disposals amidst a challenging macroeconomic environment. However, management believes this dividend cut is an exception, as they reaffirmed their long-term commitment to shareholder returns and a policy of paying out ~70% of group FFO in the form of dividends. For FY23, management is guiding for rental revenue of €3.20B ($3.47B), +1.2% Y/Y, Adjusted EBITDA of €2.73B ($2.95B), -1.4% Y/Y, and FFO of €1.85B ($2.01B), -9.1% Y/Y, at the respective midpoints.
  • Medical Properties Trust Inc (MPW) fell during the period after it reported 4Q22 revenue of $380.5MM, -7.0% Y/Y, ahead of consensus of $379.0MM, and Normalized FFO/share of $0.43, -8.5% Y/Y, in-line with consensus. In February, the REIT announced it entered into a $1.2B sale-leaseback transaction, in which CommonSpirit Health will acquire and lease MPW’s Utah hospital portfolio, which is currently operated by Steward Health Care. This transaction allows Medical Properties Trust to add a new high-quality tenant, and also reduce the REIT’s tenant concentration from Steward, which previously accounted for ~20-25% of total revenues, in exchange for a rental rate step-down, which management indicated is a reflection of CommonSpirit’s A-rated credit, rather than a reflection of the cash flow generating capabilities of the relevant hospitals. Management maintained its quarterly dividend of $0.29/share, implying an annualized yield of 14.1%, and guided for FY23 Normalized FFO/share of $1.58 (-13.2% Y/Y), implying a P/FFO multiple of 5.2x, at the midpoint.
  • Viatris Inc (VTRS) dropped in the quarter after it reported 4Q22 net sales of $3.87B, -10.7% Y/Y (-2% excluding foreign exchange impact), below consensus of $3.96B, and EPS of $0.83, compared to a 4Q21 net loss per share of -$0.22, ahead of consensus of $0.72. The company generated FY22 FCF of $2.55B, or a FCF yield of 22.1% and paid down $3.3B of debt in 2022, bringing total debt reduction to $5.4B since 2021. Management maintained its annual dividend at $0.48/share for FY23, or a ~5.0% yield, and repurchased ~$250MM worth of shares in January and February of 2023, or ~2.2% of the company’s market cap. For FY23, management is guiding for revenues of $15.8B (-2.9% Y/Y), Adjusted EBITDA of $5.2B (33.0% margin), and FCF of $2.5B, at the respective midpoints. The company also announced that Scott Smith, a board member of Viatris since December 2022, has been appointed as the company’s new CEO effective 4/1/23. Smith has previously served as the president and chief operating officer at Celgene Corporation, and most recently held the position of President at BioAlta, a publicly traded biotechnology company focused on the development of Conditionally Active Biologics antibody therapeutics.

Strategy Highlights by Jack Metzger, CFA