Opportunity Equity 4Q 2020 Letter
Miller Opportunity Equity ended the year on a strong note, notching a 35.4% (net of fees) gain in the quarter versus the S&P 500’s 12.15%. This brought the 2020 annual return to 37.8% (net of fees), more than doubling the market’s 18.40% return. The gains were driven by a strong market recovery from the COVID crash earlier in the year, along with good old fashion stock picking. Performance in the quarter benefited from a rebound in “value” more broadly. Over the year, we benefited from diversification between different types of values: longer-term, more growth-oriented compounders as well as classic value holdings.
The only bad news about such strong returns: they aren’t sustainable. We just made in a quarter what we might expect to earn over numerous years. Huge market bursts can’t endure forever. Many take this line of reasoning a step further, projecting a major pullback. We disagree. We think the market can continue to be stronger than many expect providing a window to earn strong returns. We estimate the portfolio currently has greater than 60%1 upside to our calculation of its intrinsic value offering strong return potential.
Market pullbacks happen frequently, and no one can consistently predict them accurately. We wouldn’t be surprised by a modest one after such a strong move. However, we believe we are in a bull market and the market can continue to move higher driven by a continuing economic recovery, attractive equity valuations relative to bonds and over a decade of underinvestment in equities relative to bonds. There are two key points we think aren’t well understood. First, this economic hit is more akin to a natural disaster than endogenous economic malaise. This has important implications on many levels. First, the sudden dramatic nature of the pandemic caught everyone’s attention garnering unprecedented resources and support. The Fed expanded its balance sheet by $3T over a few months. During the financial crisis, it took more than 5 years for a comparable dollar expansion. Likewise, we’ve seen two rounds of fiscal stimulus totaling just shy of $3T and with a Democratic-controlled Congress, more appears to be on the way. During the 2008-09 financial crisis, total stimulus was just over $1T, so a fraction of the size. In addition, corporations, universities, and the broad population have marshaled unprecedented levels of resources to combat the problem.
During and after a natural disaster, the economy behaves differently than a normal recession. The economic hit is sudden, dramatic, and extreme, but so is the ensuing recovery. After Hurricane Katrina, employment fell off a cliff but it had fully recovered a couple years later. It took nearly a decade after the financial crisis for unemployment to reach pre-crisis levels. So far, employment trends are tracking much closer to Katrina than the financial crisis.
The pandemic, lasting many months, is more prolonged than a typical disaster, but the natural disaster analogy implies a quicker and stronger recovery once we reach the other side. A combination of greater infection rates and vaccine distribution will help get us there over the coming months. This implies gains could continue to be faster and stronger than many expect.
Second, we are in a bull market. This definitely isn’t news to anyone, but I think people underappreciate the importance of the point. My partner Bill Miller writes fantastic market letters (link to recent one here). For roughly the past decade he’s started with this statement. Why? It provides the broad context you need to know how to behave optimally.
The market’s reaction function (how prices respond to news and events) differs completely in bull markets than in bear markets. How can the market mostly ignore protestors storming the capital and temporarily disrupting the smooth transition of power? A bull market can look through to economic implications, while a bear won’t.
Investors often focus on the problem of losing money during pullbacks, but over the past decade investors’ biggest mistake has been missing out on massive gains due to overwhelming risk aversion. Likewise, bubble fears caused many people to exit the market in 1998, years before the top. One of Bill’s best all-time moves was his near-perfect timing when exiting technology stocks in 2000. He pulled this off partially by being a keen observer of the market environment.
Bull markets typically don’t peak during a strong economic recovery with accommodative monetary and fiscal policy. We think it’s optimal to play offense in a bull market driven by a recovering economy. If this changes, we can adjust accordingly.
Our favorite relevant quote from Sir John Templeton (which we repeat A LOT) is: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Understanding sentiment in this way helps us frame the opportunity set along with the risks. Greater pessimism implies higher future returns, while the opposite is true of euphoria. The depths of panics, like March 2020, provide the best buying opportunities. When no one sees risks, run for the door. So where are we now? It’s hard to be precise but we’re somewhere in the later stages of the bull market. While this implies we are closer to the end, it’s important to note that the latest stages of bull markets typically generate some of the best returns. Lazlo Birinyi is a market strategist with an excellent long-term investing record. His team divides bull markets into four stages (similar to Templeton): reluctance, consolidation, acceptance and exuberance. The first (reversal off bear market lows) and last (euphoria kicks in) stages offer the best returns. They think we might be somewhere in the acceptance phase. I like to joke with Bill about how he’s usually right, just sometimes early. During the financial crisis, he shorted oil based on his view that it was economically sensitive and the world was falling apart so the price shouldn’t be rising. He nailed it fundamentally but that didn’t stop the price from continuing its rapid ascent before falling apart. A few years ago, a client asked about risks. Bill replied bonds were expensive and if stocks rose to comparable levels, it would produce massive gains but then it would be difficult to make money anywhere. That scenario seems more likely now. If true, the good news is there’s still a window to make nice returns. The bad news is that it might be followed by some ugly times. We will do our best to adapt as circumstances change.
In more growthy areas of the market, euphoria seems to abound. We aren’t optimistic about the long-term return prospects for certain growth names where elevated prices make it increasingly difficult to meet market embedded expectations. We know from history that the very best companies drive the overall market’s returns. When the rarefied company, like an Amazon or Apple, sustains high growth rates for extended periods of time, high multiples on current revenues and earnings are justified, while still offering attractive returns. But most companies priced to achieve this type of growth fail to do so. Currently, many growth companies trade at significant premiums to even Amazon’s historical valuations, outside of the peak of the tech bubble.
The market is pricing more and more companies as if they will achieve Amazon or Apple type growth. We estimate current market expectations imply Apple-level growth for Peloton and Amazon-level growth for insurance company Lemonade. In the past few weeks alone, we’ve heard numerous companies pitch themselves as the Amazon of this or that area. There are far more Amazon aspirants than actual Amazons.
We recently exited Peloton because of heightened risk of falling short of elevated expectations, along with our belief that other names offered better opportunities. We bought Peloton in the low $20’s right after the IPO believing it was a misunderstood disruptor with a powerful brand that could change the way large numbers of people exercise. We still see significant potential for Peloton to grow the business over the long term.
However, we estimate current market expectations imply Peloton will grow at a slightly greater rate than Apple did2 from a comparable level of revenue for the next 22 YEARS. Very few companies have a shot at this type of performance. Work by Michael Mauboussin3 shows companies’ competitive advantage periods (the period over which it can earn excess returns) average 10-15 years. Alternatively, Peloton will need to grow topline 38% annually over the next 10 years to justify the current price, well ahead of Netflix’s 28% topline growth from a comparable revenue level. Not a bet we want to make.
Part of our initial bull case on Peloton compared the brand power to Apple’s. But the analogy only goes so far. Most people can’t put down their phones. On the other hand, most can’t get off their duffs to exercise! Peloton is an amazing company, but we don’t want to bet its Apple-level amazing, especially as extremely tough comps in the back half of 2021 could present near-term risk.
A couple points: not all growth companies have elevated expectations. Despite the significant moves up we still believe Farfetch, Amazon, Stitch Fix, along with the other high growth names we still own are undervalued. Our primary job is to do the company-by-company work of sifting through market expectations relative to our assessment of fundamentals. We make bets when we think those two sides of the equation are out of whack. We think through the opportunities relative to the risks. We believe our flexibility to migrate as the opportunity set dictates offers us a significant competitive advantage relative to investors forced to stay in a more restricted area.
Since we own some high growth names, we often get asked if we are truly a value manager. The answer: absolutely! We only purchase a name is if we think it’s a good value. Likewise, we use valuations to make sell decisions (which has not helped us in this market where no valuation is too high for beloved companies!). We do believe this discipline will pay off over time.
Many people equate low accounting-based metrics (P/E, P/B, etc) with good value, but that’s simply not the case. Low accounting metrics are markers of low expectations, but fundamentals must outperform those expectations for stocks to do well. The value of any investment is the present value of future free cash flows. Those may be difficult to forecast, but they will drive the value of any investment. We spend our time understanding business values in different scenarios and what historical precedents imply on the likelihood of outcomes. We want a favorable skew between returns in the base or best case scenario relative to the worst case.
As in everything with markets, value investing evolves over time. I recently read a post saying the founder of value investing, Ben Graham, would have been very uncomfortable with Warren Buffett’s method of projecting earnings to derive a value. It’s certainly true that the cone of uncertainty widens with time. Ben Graham himself spoke of this in The Intelligent Investor:
The better a company’s record and prospects, the less relationship the price of shares will have to their book value. But the greater premium above book value, the less certain the basis of determining its intrinsic value – i.e., the more this “value” will depend on the changing moods and measurements of the stock market. Thus, we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. This means in a very real sense, the better the quality of a common stock, the more speculative it is likely to be.
So relevant to our current environment! Innovation and growth have fueled returns, but that’s led to valuations of those companies disconnecting dramatically from current revenue and earnings streams. As long as belief states about future growth prospects hold, it’s not a problem. With disappointment comes great loss.
We can look back at the great Nifty Fifty growth stocks of the 70s to understand they actually weren’t all that overpriced, but that didn’t stop them from suffering a huge crash. Likewise, buying Amazon in 1999 was a great move long term but that didn’t protect you from losing a ton of money over the next couple years. While we don’t see near term risk to growth stocks broadly, we do think there’s a good chance this euphoria won’t end well. In the past, it’s taken a recession to end these sorts of moves. A significant move up in rates is another threat to long duration assets.
We try to think through these risks carefully. We manage them in the portfolio through security selection and portfolio diversification. We also want to understand these darling companies well enough to take advantage of any opportunity that arises from price weakness.
The key behind all value approaches, though, is a strict reckoning between what you are paying and what you are getting. That’s our lifeblood. Most sell-side analysts don’t even run long term discounted cash flows, and I don’t remember ever seeing a model that looks at numerous future scenarios. I love that because it means our approach isn’t in high demand from those on the buy side either. This means it’s a potential edge versus others.
We really love the current portfolio. It trades at a steep discount to the market (roughly 12x next 12 months earnings versus the SPX at 23x4). Even with our higher multiple growth names, we think the portfolio is very attractively valued even on near-term metrics. We constantly work to see if we can improve our risk-adjusted returns and we continue to find attractive investment opportunities. I will highlight a couple examples.
Desktop Metal is a name that made it into our top holdings at the end of year due to strong performance since our purchase at the end of the third quarter. The company is a second-generation industrial printing company led by a great team. It came public through a merger with a SPAC led by Leo Hindery, Jr. who we’ve known from his successful history at Telecommunications, Inc (TCI) where they excelled at capital allocation. One of the unique benefits of structure is that it helps us get access to unique opportunities. Here, we were able to invest in the PIPE (private investment in public equity) to take the company public based on industry relationships.
Desktop Metal is early in its commercialization, but we think the company has great potential over the next five years with a stellar list of customer partners and potential applications. We bought on the deal at a $1.8B enterprise value or 6.7x the EBITDA management estimates it can earn in 5 years before any acquisitions. For a company capable of growing at such high rates (triple digits for next couple years), with a great business with high moats and a fantastic team, this was a great deal. It’s doubled since the deal. This is a great example of an undervalued, long-term, growth-oriented opportunity that we were still able to source in this market.
In the squarely value camp, we bought Norwegian Cruise Lines in the fourth quarter. The sector has obviously been one of the hardest hit by COVID with business shut down. It should be one of the biggest beneficiaries of a normalization due to vaccines and infections helping us reach herd immunity at some point. As we got clarity around vaccine efficiency and potential timelines for disbursement, it enabled us to analyze the ability of cruise lines to make it through and what the potential balance sheet and earnings power might look like on the other side. We think Norwegian is worth somewhere in the $40s with a good ability to withstand the crisis. We think the recovery in travel is more likely to beat current recovery expectations than it is to fall short, setting up a nice risk-reward.
We also bought Diamondback Energy. For the first time in decades, we find energy to be quite attractive. Companies are finally focusing on cash flow and returns. Diamondback is a low-cost shale producer that screened well on a number of metrics we pay attention to (dividend yield, free cash flow yield, discounted cash flow, and insider buying). They recently added ROIC to their management incentive compensation. They plan to continue to pay down debt and maintain the dividend. The company is obviously levered to increasing oil prices.
Green Thumb, another new name, is a cannabis company that we have watched for a while. The company is the best capital allocator in the space with a focus on profitable growth in limited license states, while also building national brands. We believe there’s a long growth runway due to state adoption driven by budgetary needs. We believe that GTBIF is undervalued based on their current licenses alone, while state expansion is virtually guaranteed.
Another name we’re very excited about is WW (formerly known as Weight Watchers). We’ve followed it for a while. CEO Mindy Grossman, joined in 2017, is excellent. While the company has looked cheap in the past, we think the digital transition has reached an important inflection the market is not reflecting. We expect improving revenue growth and margin expansion and believe the stock can double.
Lastly, we added a small position to Netflix after the disappointment following 3Q results. Overall, it’s getting more difficult to find investment opportunities in the very high growth areas that meet our standards for attractive value. On the other hand, we continue to find opportunities in more value-oriented areas of the market. We would expect the portfolio to migrate in this direction.
We appreciate your interest in Opportunity. We continue to work hard to earn attractive returns for our investors and thank you for your support.
Samantha McLemore, CFA
Strategy Highlights by Christina Siegel, CFA
During the fourth quarter of 2020, Miller Opportunity Equity returned 35.4% (net of fees) compared to the unmanaged benchmark, the S&P 500 Index, return of 12.1%.
Using a three-factor performance attribution model selection, interaction, and allocation effects contributed to the portfolio’s outperformance. Farfetch, Stitch Fix Inc., Uber C32 1/2022 options, Desktop Metal Inc., and Precigen Inc. were the largest contributors to performance, while Alibaba Group Holdings, Vroom Inc., ADT Inc., Canada Goose Holdings, and Lennar Corp. were the largest detractors.
Relative to the index, Opportunity was overweight the Consumer Discretionary, Financials, Health Care, Energy and Industrials on average during the quarter. With zero allocation to Real Estate, Utilities, and Consumer Staples, the portfolio was dramatically underweight these groups and more moderately underweight the Communication Services, Information Technology, and Materials sector.
We added six positions and eliminated six positions during the quarter, ending the quarter with 44 holdings where the top 10 represented 40.9% of total assets compared to 27.4% for the index, highlighting Opportunity’s meaningful active share of around 88.1%.
- Farfetch Ltd. (FTCH) continued its climb in the quarter, returning 152.7%. The company really took off following the announcement of a landmark global partnership with Alibaba, Richemont & Artemis. The deal gives FTCH access to Alibaba’s platform and its 757M customers while also starting new relationships with Richemont’s brands. The agreement will provide an infusion of $1.15B from their new partners to help them grow out the platform in China and beyond and aligning the incentives of all parties. Later in the quarter, Alibaba’s President Michael Evans joined the board of directors. The company also announced another strong earnings report. For the 3rd quarter, the company posted revenue of $437.7M versus consensus estimates of $369.8M. Gross Margins were above expectations at 48% against estimates of 45%. The result was the company had an Earnings Before Income, Taxes, Depreciation, and Amortization (EBITDA) loss of just $10M, versus expectations for a $22M EBITDA loss in the quarter. Gross merchandise value also beat expectations coming in up 60% versus expectations for 40-45%. The company guided to EBITDA profitability in the fourth quarter ahead of expectations.
- Stitch Fix, Inc. (SFIX) climbed an impressive 116% in the quarter following the release of their Fiscal Year (FY) 2021 first quarter results. Revenue for the first quarter came in at $490M, beating estimates of $481M. Gross margins were higher than anticipated at 44.7% versus expectations of 43.6% and adjusted net income coming in at $9.54M versus expectations for a -$18.5M decline. The company provided stronger than expected full-year guidance, with revenues of $2.05-$2.14B, relative to $2.01B estimates. Stitch Fix finally announced their new CFO, Dan Jedda, who joins the company from Amazon.com. The company is beginning to see uptake in their “direct buy” offering which is allowing them to expand their products to customers that are not current Fix members allowing them to expand their total addressable market. The shift to online purchasing has also further supported the company’s strong momentum.
- It was a busy quarter for Uber Technologies (UBER) who took off in the quarter following the passing of Proposition 22, their ballot initiative that allows them to classify their drivers as independent contractors and not employees. The company also reported 3Q results that was largely in-line with expectations. Adjusted net revenues of $2.81B was slightly below expectations of $2.82B with EBITDA of -$625M coming in slightly worse than expectations for -$623M. The company reiterated their expectation that they will reach EBITDA profitability at some point in 2021, as their Eats business continues to see strong growth as the pandemic continues. The company announced the sale of ATG, their self-driving car unit, to Aurora for $4B, while investing $400M in the business and holding a 26% share of the combined entity. This was followed by the announcement of the company selling Uber Elevate, their air taxi business, to Joby Aviation with Uber investing an additional $75M in Joby. The company’s acquisition of Postmates closed in the quarter and Mexico’s antitrust regulators approved Uber’s acquisition of Cornershop, the Latin American grocery delivery company. The company also announced a joint-venture with SK Telecom, to create a South Korean taxi-share company investing $150M in the start-up.
- Alibaba (BABA) had quite the quarter rising up to a high of $317 in October only to end the quarter down 20% after the delay of the Ant IPO and the announced investigations by the Chinese government into monopolistic practices at the firm. There was additional pressure on the stock as the US House of Representatives passed a bill that threatens to delist Chinese companies from US exchanges unless US regulators are able to inspect their financial audits within three years. During the quarter, the company increased their share buyback program from $6B to $10B. The company report second quarter FY21 results that were largely in-line with expectations. The company reported revs of Rmb155.1B (USD 23.9B) slightly beating consensus of Rmb 153.9B (USD 23.7B) and adjusted EBITDA of Rmb 47.5B (USD 7.3B) versus 41.3B (USD 6.3B). The company maintained full year guidance for revenues of Rmb 650B (USD 100.3B).
- Vroom, Inc (VRM) continued to decline in the fourth quarter following the additional equity raise they did at the beginning of September at a price of $54.50. The company reported 3Q results above consensus with total revenue of $323M versus $311M estimated, gross profit of $25.4M versus $22.3m estimated leading to Adjusted EBITDA of -$35.7M ahead of expectations of -$42.1M. The company guided for revenue of $372M-$414M with the midpoint slightly below consensus of $398M with gross profit of $24-28M versus $27.7M estimated and adjusted EBITDA of -$52M to -$44M versus consensus of -$42.8M. The company is beginning a slow roll out of its last mile delivery and is working to build up its infrastructure to be able to handle the higher demand it is seeing. During the quarter, the company announced the purchase of CarStory, which does AI powered analytics and digital services, for $120mm in a deal split between cash and stock.
- ADT Inc. (ADT) declined 3.5% during the quarter. The company reported strong 3Q results, which showed continued net subscriber growth with record customer retention (attrition of 12.9% versus 13.5% last year). The company reported revenue of $1.30B versus consensus of $1.25B with EBITDA of $564M versus $524M expected. The company updated full year guidance to revenue of $5.20-5.35B versus consensus of $5.24B and EBITDA of $2.15-2.225B versus $2.144B expected and free cash flow (FCF) guidance of $650-725M (raising the lower end by $25m from previous guidance). The company has set 2H21 as the time frame to launch their professionally installed and co-branded offering with Google (ahead of mid-2022 guide) and they announced that they are developing an ADT-owned, next-gen, residential technology platform allowing them to use their own proprietary software.
Bill Miller's 4Q 2020 Market Letter
Christina Siegel's 4Q 2020 Market Highlights
1As of 1/12/21. A proprietary calculation of the central tendency of value for the portfolio based on our assessment of the intrinsic value of individual holdings.
2Apple grew 19% annually on average from a comparable revenue level.
4Source: FactSet as of 1/4/21
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