April 25, 2018

Volatility Presents Greater Value Opportunities

Deep Value Strategy 1Q 2018 Letter

It’s safe to say volatility has returned! The year started with significant volatility to the upside as the market posted its best January in over 20 years only to see the rest of the quarter erase the early year gains. 2017 was an aberration and not a historical norm as we saw the longest time period, 300+ days, without a 3% correction. While the marketplace may have been lulled into complacency, short-term price corrections are normal and have occurred numerous times since the beginning of the current bull market in early 2009.

Rising market volatility can lead to irrational price fluctuations that bear no relation to the stock’s actual fundamental value. We believe, similar to Benjamin Graham, that the purchaser of a common stock should act like a business owner, as the stock represents fractional ownership of an underlying business. Short-term fluctuations in market share prices are most often not factual and do not reflect the enterprise’s true value, which will only become apparent over the long-term. When a company’s market price is at a significant discount to its long-term intrinsic value, a significant margin of safety exists to not only protect the common-stock owner, but to also provide an attractive investment return over the long term. Therefore, market volatility that increases the price gap creates short-term market inefficiencies and long-term opportunities, NOT incremental risk.

We highlighted last quarter that one risk was the overcrowded trades that were taking place throughout the year. Even with the increased volatility and negative stock market returns, stocks did outperform bonds which remain very expensive and were adversely impacted with the beginning of the normalization of interest rates. However, as volatility increased during the quarter, instead of taking advantage of the market gyrations and scooping up attractively priced securities at deep discounts to their intrinsic value, the market perceived increased volatility as risk and continued to favor more growth-oriented investments.

The chart below highlights how a Pure Value subset of the S&P 500 performed versus and a Pure Growth subset since the beginning of 2009. Growth significantly outperformed Value from 2014-2015 and over the past 15 months. Value significantly outperformed Growth in mid 2012-2013, 2016, and appears well positioned to do so again over the coming year as it is currently below the 10-year low trough.

Used with permission from Deutsche Bank. May not be copied or reprinted without prior written consent.

What leads one to believe that the increased volatility will eventually favor a comeback for Value? Looking at price-to-earnings multiples for Growth and Value shows significant dispersion!

Used with permission from Cornerstone Macro. May not be copied or reprinted without prior written consent.

The low-valuation, out-of-favor subset of the market is as attractive as it was back in the late 1990’s!

Value versus Growth is as out of favor today as it was late 2015 and mid-2012, and is approaching levels of 2008-09 and the late 1990’s. With recent rising geopolitical concerns, the market appears to be forgetting that strengthening economic trends are present. U.S. leading economic indicators continue to be near 30+ year highs and should remain strong over the coming year as benefits from lower taxes and deregulation begin to have a positive impact. Value, which has a greater exposure to cyclical industries (financials, energy, basic materials), should not be significantly underperforming Growth with a strengthening economy.

Used with permission from Cornerstone Macro. May not be copied or reprinted without prior written consent.

Similar to the past, the market seems to have done a pretty good job of pricing in recession fears in the more economically sensitive areas of the market. Historically, this discrepancy has corrected itself through either a valuation correction in more expensive parts of the market and/or an increase in Value returns as recession fears subside. The improving economic environment should lead to an improving earnings profile for Value during 2018, which should enhance valuation multiples and lead to better future Value returns. Our Deep Value Strategies have always been significant beneficiaries during these Value recovery time periods.

Daniel Lysik, CFA

Daniel Lysik, CFA manages two strategies: Deep Value Strategy focuses on out of favor securities at very low valuation levels and deep discounts to their intrinsic value, whose current market price does not reflect the companies normalized earnings for free cash flow power, and Concentrated Deep Value Strategy, which is the most deeply mispriced subset of the Deep Value Strategy and typically provides greater exposure to lower market capitalization holdings. Email us for more information and how to invest.

Any views expressed are subject to change at any time, 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, and there is no guarantee dividends will be paid or continued.

©2018 Miller Value Partners, LLC