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Jan 29, 2016

Disconnected Fundamentals

Bill Miller

Every quarter, we hold a call with clients to discuss our outlook for the market and review our strategy positioning. Here is an edited version of comments on the market from January 20, 2016. The S&P 500 closed that day at 1859.48.

Bill Miller, CFA

The market really isn't paying any attention to fundamentals at all right now.

If it's paying attention to any fundamentals, it’s paying attention to the fundamental price of oil. We have a situation in the market today where we are repeatedly hitting new lows; I was recently listening to CNBC and they commented that the market has experienced more new 52-week lows than we’ve had in any day even during the financial crisis.

To give you a sense of that, take oil. According to the Dallas Fed, oil is about 13% of the state's income and it's only about 2.5% of the jobs in the State of Texas.

That's the most exposed state there is. So, again, people are thinking dramatically and not quantitatively. For most stocks, prices have become, I think, disconnected from any sort of fundamental reality, which means if you can't buy them here then you probably shouldn’t own any stock because barring a new depression, I think that stocks right here are extremely attractive.

The overall stock market yields around 2.5%, the 10-year treasury yields around 1.95%. The dividend growth rate on the stock market last year was 9%, obviously the growth rate of the coupon on the treasury is zero.

And so, if you were just to say, "Hey, I can buy a 10-year treasury and hold it for pick a number, 5 years to 10 years or I can buy the whole stock market." That I think is an absolute no-brainer in here.

I do believe that the price of many if not most of the companies out there has become disconnected from any kind of fundamentals.

Here are some examples…

Bill Miller IV, CFA

Northstar Realty Finance (NRF) trades at $11/share and has paid a quarterly dividend of $0.75, which just about matches the cash that they generate each quarter and equates to a dividend yield of 25%.

The company has transitioned over the past couple of years from being an opportunistic securities investor to one that actually owns hard assets – property and buildings – yet it trades at a huge discount to other real-estate investment trusts (equity REITs).

The bear case here is that as some of its more opportunistic, higher-yielding securities investments wind down, the company is going to earn lower yields and eventually have to cut the dividend. That is true, and it may imply a dividend cut of one quarter per share, so the dividend could go from $0.75 to $0.50/share, but that would still give them an ample cash cushion on the dividend and imply an 18% yield.

So the valuation doesn't make any sense. Conservatively, the market value for the company's assets looks to be around $20 a share, which is almost 100% upside. And we heard from an analyst today that knows one of the biggest shorts, who has extremely pessimistic assumptions, yet his intrinsic value – this is the short’s intrinsic value – is $13/share. It trades at $11. So we're very optimistic about that one.

Och-Ziff Capital Management Group (OZM), the alternative asset manager, now trades at around $5/share, which is a lower price than where it traded on March 9, 2009, the day the S&P 500 bottomed (using close price) during the financial crisis. Yet, Och-Ziff today manages almost exactly 2x the level of assets that it managed in March of 2009.

Samantha McLemore, CFA

We do see the disconnect in fundamentals versus prices pretty broadly in terms of the companies that we own that have come out with results so far this year.

Delta Air Lines, Inc. (DAL) was a great example. It was another record quarter. They outperformed or achieved all of their long-term goals for 2015. They had EPS growth of 42%, their goal is 15%. They had a return on capital of 28% versus their 20-25% goal.

They generated $3.8 billion in free cash flow, which was just a little bit shy of their $4 billion to $5 billion goal. So the market cap is currently at 35 billion, so that's an 11% trailing free cash flow yield.

They reduced net debt to 6.7 billion - their goal for the end of 2015 was to be below $7B. It's going to $4 billion by 2020. And the company returned $2.6 billion to shareholders in 2015 through dividends and share repurchases. And the share repurchases were at about $45, which is in line with the current level of the stock, so it's not like the stock is down a lot more, so that was a 7.4% trailing owner's yield. Those are really good numbers.

At their Analyst Day in December, they guided for about $5 billion in free cash flow in 2016, so a big improvement over 2015 and a 14% forward free cash flow yield. All of the airlines that we own, United Continental Holdings, Inc. (UAL), Delta, American Airlines Group, Inc. (AAL), they're all trading at five or six times earnings for 2016.

So, obviously, the current stock prices do not reflect the current fundamentals. Delta’s price implies that people believe profits are going down. People believe oil is going back up, that's priced into the oil stocks, so that's hurting the airlines to a certain extent. But Delta said they are planning for $100 a barrel oil so they don't lose discipline and they're going to retain 75% of the benefits of any lower oil prices and they're going to pass that back to shareholders.

We think Delta is a great buy. We do not think the improvements in the industry are reflected in the current price. When we were talking to the CFO a couple of months ago, we talked about how they would perform in a recession. He said he was confident they would be profitable in the next recession and would be able to earn $1-2B. If you assume that they do earn $1.5B, which we think is reasonably likely in a recession and maybe that's what it will take for the market to re-price these things, then it's trading at 23x trough earnings, which, as far as we can see, is not going to happen any time in the near-term.

I can't understand why someone wouldn't rather own Delta when it’s generating a 14% current free cash flow yield and 23x a trough level that may or may not happen any time soon versus ExxonMobil (XOM) at 23x this year's earnings. EOG Resources, Inc. (EOG) is losing money this year. Most of the high quality energy companies are – and they are pricing in future profits dependent on oil returning to $55 to $60 a barrel. Chevron Corporation (CVX) is at 27x – those earnings might actually be too high, yet people seem to want to rather own those than the airlines and I just can't see how that makes sense. I guess that's the opportunity.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM 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.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.