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Jul 26, 2017

In a World of Trend and Momentum, Long-Term Value Suffers

Samantha McLemore

2Q 2017 Opportunity Equity Commentary

Opportunity Equity advanced 12.0% (net of fees)1 in the quarter, relative to the S&P 500’s 3.1%, outperforming by almost 900 basis points. This ranks as our 13th best quarter on record. The third quarter of 2016 places 5th amongst our best historical relative quarters. These strong results are partially driven by reversion to the mean as the first two quarters of 2016 both fell in our top five quarters of relative underperformance. This doesn’t explain the entire story, however, as some new names we didn’t own back then have helped fuel recent performance. Over the past year, the Strategy is up 49.5% (net of fees)1, nearly tripling the market’s 17.9% gain, demonstrating yet again that the best time to invest in a strategy with a good long-term track record and process is after a period of poor performance.

Much of the commentary about our performance notes that we always seem to be one of the best, or worst performers. While not entirely true, this notion has some merit. Many of the structural changes we’ve discussed previously (new institutionalized risk mitigation structures, risk arbitrage strategies, increased focus on volatility, growth of passive strategies, etc.) combine to cause more exaggerated market swings as people tend to herd into and out of the same trades at the same time.

There’s good and bad news in these developments. Fortunately, patient, long-term investors who make buying and selling decisions based on long-term fundamentals and intrinsic value can find great opportunities as short-term noise dominates prices. This, along with some luck, is exactly what has enabled us to achieve significant outperformance. On the other hand, marching to the beat of a different drummer means market vagaries sometimes swing strongly against us causing poor performance and high volatility. In this market, people hate that. This is why we believe that in the current environment, volatility is the price you pay for returns.

For our investors, here’s the even better news. Certainly since the financial crisis, each of our periods of significant outperformance has been preceded by a period of really poor performance (2009 after 2008, 2012 and 2013 after 2011, and the past year after the first half of 2016). It’s worth noting that when we performed poorly 2011 and 2016, fundamentals remained stable to strong, unlike 2008. Market prices diverged from fundamentals creating a great opportunity.

In each case, though, bad performance signaled strong future returns. When you can find true market signals, as opposed to noise, you can profit from them. Obviously, however, the market doesn’t offer any guarantees. Also, there are no hard and fast rules about how bad the performance needs to be or how long the bad performance will persist before it reverses. Making money isn’t easy. The pattern, though, is clear enough, and contrary enough to how most people behave (buying after strong performance, and selling after poor performance), that this point is worth repeating over and over again. Reversion to the mean is a strong force in markets. As the great Warren Buffett has noted, be greedy when others are fearful and fearful when others are greedy. That guiding principle certainly improved our returns over the years.

It’s amazing that October will mark a decade since the pre-financial crisis market peak. The ensuing period traumatized market participants with massive losses and serial crises. The after-effects still cause investors to flock towards safety and low volatility. Most people would probably be shocked to learn that from the market peak to the end of this quarter, the average annual return of the S&P 500 was 6.9%, almost exactly in line with the long-term average return since 1950 of 7%.

In other words, even if you picked the exact worst time to invest in modern times, as long as you were patient enough to hold for the long-term, you earned solid returns in line with long-term averages. Unfortunately, most people let the short-term noise influence their behavior way too much, leading to sub-optimal decisions and sub-par performance (e.g. compounding the error of buying after prices have gone up by selling after they have gone down).

What sector do you think performed the worst since that market peak? Many people might guess financials given their jaw dropping losses during the financial crisis. In actuality, energy did worse (+2.6% vs. financials +3.9%). Given recent losses and headlines, that might not surprise some people. Return numbers are very sensitive to beginning and ending points. The market peak coincided with extreme optimism about the outlook for energy companies. Large capital expenditures have earned returns far below initial expectations. The market has been adjusting to a more muted oil price outlook. We are finally beginning to get intrigued by what could be blossoming potential. As expectations for the long-term oil outlook decline to more reasonable territory of $40-60, we seek to find investment opportunities after being underweight the last decade.

Overall, Opportunity remains concentrated in financials, healthcare, builders and airlines. We believe there continues to be excess returns in each of these areas. Consumer discretionary screens as overweight mainly due to a handful of names, such as Amazon (AMZN) and recent additions RH (RH) and Wayfair (W), which have contributed strongly to our performance this year.2 Though themes may emerge in the Strategy, we are driven by our bottom-up assessment of the biggest gap between market expectations and underlying fundamental value. We continue to believe our patient, long-term contrarian value approach should work well in this environment.

Read our 2Q 2017 Opportunity Equity Review.

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.

2Read our 2Q 2017 Opportunity Equity Review for Top Contributors/Detractors. 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.

©2017 Miller Value Partners