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Jan 30, 2019

Do you know the worst rerun?

Samantha McLemore

Opportunity Equity 4Q 2018 Letter

What a quarter! In so many ways. I welcomed a beautiful baby girl, (Edith, aka “Edie”), to my family on September 23rd, which happened to be a Sunday. My last day in the office was Friday, September 21st, which happened to mark the high in the S&P 500 for the year. At that time, we were up 24.6% YTD, more than double our benchmark’s (S&P 500) 11.1% return. As good a time as any to take maternity leave, I figured. Boy was I wrong. We had our fourth worst relative quarter in the history of the Strategy. Most of the carnage occurred in the last month of the year. On the last day of November, we had given up a lot of ground but were still up 11.1% for the year, still more than double the S&P 500’s 5.1% gain. Then December happened and we ended the year down 9.6% (net of fees)1, twice as bad as the S&P’s 4.4% loss.

The only good news about the terrible month and horrible quarter: it’s a rerun of a show we’ve seen before. Sudden losses of this sort usually lead to strong future returns. I wrote a piece in early 2016 after the market and Strategy tanked on similar concerns highlighting how well it bodes for future returns. We looked at the performance of Opportunity any time it was down more than 15% in a month or 15% over 3 months.

Since we’ve hit those thresholds again, we’ve updated the analysis through the end of December. Basically, when it’s happened in the past, the median forward one-year return has been roughly 30%. That crushes long-term average returns in both the markets and the Strategy. And the results have been great over longer-term periods too, with median 3- and 5-year returns coming in around 20% per year.

The fortunate caveat is that there are not enough occurrences (you need 30) to make the data what statisticians call “statistically significant”, meaning that results indicate properties of the system rather than just randomness. But it’s clear from the data (and understanding market behavior) that buying during panicked selling leads to better long-term returns. The data1 (click on image below) shows that historically you make money between 80-100% of the time if you buy (rather than sell) during extreme short-term sell-offs. Between 70-100% of the time, those gains have been greater than the S&P 500’s long-term historical average return of roughly 10% per year. You can’t ask for better odds in the markets. Yet people mostly do the opposite and sell into weakness (which is exactly why there’s an opportunity)! Opportunity is already up 16% YTD, so thus far history is repeating itself.

We were not immune from the effects of the urge to sell as we had a few days of significant outflows. We were fortunate to be among the minority of actively managed equity strategies to have had net inflows for the entirety of 2018. We opted to take our leverage up modestly to fund the redemptions, rather than selling our companies at depressed prices. Net debt was just shy of 6% of net assets at the end of the third quarter and ended the year just shy of 10%, which happens to be our limit on leverage. We’ve mentioned how we like to try to monetize the volatility in the markets to improve long-term returns. On the margin, this counter-cyclical use of leverage enables us to sell more at higher prices and buy more (or at least sell less) at lower prices.

We added one new company in the quarter, Micron Technology, the semiconductor company. At its low ($28), Micron traded down 57% from its high ($65) earlier in the year on concerns about the end of the cycle. Micron earned almost $12 per share last fiscal year, so the stock currently trades for 2.8x trailing earnings ($33.65). Investors question future profitability prospects due to declining memory prices along with growing inventories. Historically, the company lost money at the trough of memory/storage cycles, but that was before there was major industry consolidation down to 3 players. Micron believes it can earn $6 at the trough. If so, the company trades for only 5.6x TROUGH earnings and the stock will be a major winner. The sell-side forecasts earnings of $7 or more for the next couple fiscal years. The company currently has net cash, rather than net debt as it did during the last downturn in 2016, which lowers risk. A negative sell-side piece earlier this week even noted limited downside given the improved balance sheet and where the stock has historically bottomed relative to tangible book. CSFB Holt, a fundamental valuation tool based on returns on investment, estimates a stock value of $184! That’s not our base case by any means, but it’s certainly a possibility if $6 is the new trough earnings level. We do think the stock could double from these levels given the valuation and improved industry fundamentals.

Other activity in the quarter included a private investment in Ziopharm Oncology, a company we’ve owned for years, to help fund some clinical trials on innovative new cancer treatments. We view the company as a real option on a scalable immune-oncology play, led by one of the most highly respected cancer researchers, Dr. Laurence Cooper. We also exited Eventbrite, which we bought on the IPO. The position was too small to be meaningful, so we exited it when it traded up. Lastly, we also sold Pandora, which Sirius XM agreed to buy out (at a bargain price right as fundamentals started to improve!).

The selloff made me even more excited about Opportunity’s prospects. At year-end, the Strategy traded at only 8.7x forward earnings, a deep discount to the S&P 500’s 15.1x, while at the same time having estimated long-term earnings growth that’s slightly better! (see chart below) The amazing thing is that Opportunity trades at only 8.7x when we own so many great companies earning fabulous and sustainable returns on capital. Our calculation of the upside to the intrinsic value of our holdings surpassed 100%! The “return to Sorrento” (all stocks at 52-week high) yields 48% upside.

Valuation Characteristics Opportunity Equity S&P 500
Price-to-Earnings Ratio* (P/E) 8.7x 15.1x
Price-to-Book Ratio (P/B) 1.9x 3.0x
Price-to-Sales Ratio (P/S) 1.1x 2.3x
Estimated 3-5 Year EPS Growth 12.9% 12.8%
Weighted Avg Market Capitalization $85.6B $201.0B
Weighted Median Market Capitalization $12.9B $99.1B

*Forward 4 quarters
Source: FactSet

There’s lots more in the portfolio to get enthusiastic about. The airlines are back below long-term historical valuation levels despite clear evidence that things are different (in the form of significant and sustainable free cash flow). The homebuilders had a rough 2018 as rising mortgage rates along with federal tax changes slowed activity some. Our builders now trade for less than 8x this year’s earnings and we believe they will continue to grow earnings for many years due to favorable demographics. The banks are posting returns on equity and tangible equity that no one would have expected a decade ago and are returning most of their earnings to shareholders, yet trade between 8-10x earnings. Our “growthier” names like Amazon and Facebook have had significant pullbacks that set them up to do well going forward, in our opinion. There are many other names that excite us at these levels too.

We promise to work hard to do as well as possible for our investors and we appreciate your support.

Samantha McLemore, CFA

Strategy Highlights by Christina Siegel, CFA

During the fourth quarter of 2018, the Opportunity Equity returned of -26.5% (net of fees)1, while the Strategy’s unmanaged benchmark, the S&P 500 Index, return of -13.5%.

Using a three-factor performance attribution model, allocation, selection, and interaction effects contributed to Opportunity’s underperformance. Genworth Financial Inc. and Pulte Group Inc. were the largest contributors to performance, while Endo International, Intrexon Corp., Mallinckrodt, Inc. and Bausch Health Companies Inc. were the largest detractors.

Relative to the index, the Strategy was overweight the Consumer Discretionary, Financials, Health Care, and Industrials on average during the quarter. With zero allocation to Energy, Materials, Real Estate and Utilities, the Strategy was dramatically underweight these groups and more moderately underweight the Information Technology, Communication Services, and Consumer Staples sector. In terms of sector allocation, the underweight position in the Utilities sector, which outperformed the index, detracted the most from the Strategy’s relative performance. On the other hand, the overweight in Health Care, which outperformed the index, contributed the most to relative performance.

We added three positions and eliminated two positions during the quarter, ending the quarter with 39 holdings where the top 10 represented 45.0% of total assets compared to 21.0% for the index, highlighting Opportunity’s meaningful active share of around 101.6%.

Top Contributors

    • Genworth Financial Inc. (GNW) increased 11.75% over the quarter as the company moved closer to gaining approval for their deal to be acquired by China Oceanwide Holdings Group. Their deal was approved by the Delaware Department of Insurance over the quarter, as well as Fannie Mae and Freddie Mac. In January, the company received approval by the state of New York finishing all necessary sign-offs by U.S. insurance regulators. Approvals are still pending in Canada and China but the company expects the deal to close in early 2019.

    • Pulte Group Inc. (PHM) gained 5.4% over the period after announcing strong third quarter results. The company reported 3Q EPS of $1.01 ahead of consensus of $0.95. The outperformance was driven by better than expected EBIT coming in at $385M versus expectations of $369M. Revenues came in ahead of consensus ($2.65B versus $2.62B) due to higher average selling prices, but net orders slightly missed at 5,350 homes compared to 5,431 expected along with closing at 6,031 versus 6,145. The company raised full year cash flow guidance by $100M to $1.1-1.2B.

    • Ziopharm Oncology Inc. (ZIOP) warrants returned 11.7% despite the overall stock return for the quarter of -41.6% due to timing. The company made a number of announcements during the quarter as it worked to re-align its strategic relationship with Precigen moving developmental and commercial control to Ziopharm. Ziopharm will now be focused on IL-12, CD19 point of care CAR-T and TCR platforms, as well as assuming exclusivity and full development rights for the existing Cooperative Research and Development Agreement with NCI. The company successfully closed a private placement in November raising $50M which should extend their cash runway to mid-2020. The company also announced expansion plans for its Sleeping Beauty (SB) CAR-T program in specific Asia territories through a joint-venture with TriArm Therapeutics.

Top Detractors

    • Endo International plc (ENDP) declined 56.6% over the quarter. The company released results from their P3 Cellulite study, which met its primary endpoints and showed statistical significance against placebo; however, analysts were disappointed by patient satisfaction scores. This was followed by the release of 3Q earnings which beat expectations and raised full year guidance. The company reported revenue of $745.5M ahead of $692.8M with EPS of $0.71 beating expectations of $0.59. The company raised full year adjusted EBITDA to $1.32-1.34B from $1.27-1.33B and adjusted EPS to $2.65-2.75 from $2.50-2.60.

    • Intrexon Corp. (XON) declined 62.0% over the quarter. The company announced 3Q results which missed on both the top and bottom line. The company reported revenue of $32.4M below consensus of $42.5M with an EPS of -$0.44 versus -$0.27 expected. Intrexon’s Precigen gained exclusive rights to Merck KGaA’s Chimeric Antigen Receptor T-cell (CAR-T) in exchange for $150M in stock for Merck. By regaining control of CAR-T development, XON is moving towards its 2018 goal of moving away from exclusive channel collaborations to full control of its pipeline portfolio. The company also announced the formation of Intrexon Bioinformatics Germany GmbH a bioinformatics company based in Munich. Oxitec, a subsidiary of XON, announced an expanded collaboration with Bill & Melinda Gates Foundation to develop a self-limiting Anopheles stephensi strain to help combat malaria in India, Middle East and the Horn of Africa.

    • Mallinckrodt plc (MNK) declined 46.1% over the quarter. The company announced a plan to spin off of its specialty generics business to shareholders in 2H19. The current CFO, Matthew Harbaugh, will become CEO of the specialty generics business which will maintain the Mallinckrodt name and ticker. Mallinckrodt announced 3Q results which beat consensus. The company reported revenue of $640M ahead of consensus of $636M with EPS of $2.10 ahead of expectations for $1.80. Acthar revenue came in ahead of consensus with $290M versus $287M, and management expects Acthar revenue to be greater than $1B in both 2018 and 2019. Management raised full-year EPS guidance to $7.00-7.20 from $6.50-6.90 previously.

View our 4Q Infographic and read our 4Q 2018 Market Highlights for a recap on what drove market performance.

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.

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.

©2019 Miller Value Partners, LLC