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Apr 29, 2022

Exploiting Volatility to Outmaneuver the Market

Samantha McLemore

Opportunity Equity 1Q 2022 Letter

The first quarter of 2022 contained “weeks where decades happen(ed)," to paraphrase Lenin. A routine market pullback in January morphed into something different as investors endeavored to understand the ramifications of Russia’s Ukraine invasion in February. The short-term result: a full risk-off panic. The longer-term implications, on the other hand, will take time to sort out. One thing is clear: the world looks quite different than it did just months ago.

Amidst the challenges, Miller Opportunity Equity net of fees declined 7.12% in the quarter, underperforming our benchmark, the S&P 500’s -4.60% return. The Strategy’s long-term performance remains strong. Since inception annualized returns of 7.69% outpaced the S&P 500’s 7.23% by ~46 basis points annually.

We also outperformed the S&P 500 over the long-term although our challenges over the past 9 months resulted in our relative 1-year performance lagging the benchmark. We are never satisfied when we underperform as our entire purpose is to deliver clients excess long-term returns. We emphasize long-term because that is how we manage the portfolio and assess ourselves. Our long-term focus sometimes leads to short-term volatility. In the past, the portfolio bounced back strongly from similar declines.

Annualized Performance (%) as of 3/31/22
  QTD YTD 1-Year 3-Year 5-Year 10-Year Since Inception (12/30/99)
Opportunity Equity (net of fees) -7.12 -7.12 -23.35 13.09 11.81 14.76 7.69
S&P 500 Index -4.60 -4.60 15.65 18.92 15.99 14.64 7.23

Past performance is no guarantee of future results. Please refer to the GIPS disclosure document for important additional information. Returns greater than one year are annualized.

We have great conviction in our process, which is both time-tested and unique. We are patient, long-term value investors. We value businesses and think like owners.  We believe our long-term focus provides us a significant competitive advantage. It allows us to focus on signal over noise, and to position for high long-term, risk-adjusted return potential.

Our style remains highly unique in today’s market. In a market dominated by short-term optimizers, we believe our long-term focus is a significant competitive advantage. As algorithms trade every headline, we conduct careful analysis on business fundamentals and compare those to market expectations. As many prioritize minimizing volatility, we aim to make money for clients above and beyond what index funds can deliver. We like to use volatility in an effort to enhance returns.

These differences mean we can get out of sync with the market during “risk-off” periods. We think it makes sense to hold tight through the inevitable market volatility. The evidence is clear: there’s no reliable way to time markets.

Further, if you hold for the long term, you have great odds of making money. The market only rises a little more than half of days and 63% of months, but it gains 73% of years. On a rolling basis, it’s up 89% of 5-year periods, 93% of 10-year periods and 100% of 20-year periods since 1927!

It’s amazing that investors focus so much attention on the fool’s errand of calling recessions and timing markets! We choose patience. While it may be behaviorally challenging not to be sucked into the vortex of worries, we find such high odds of long-term success quite reassuring!

During the quarter, investors overwhelmingly gravitated to the siren song of concerns. The year began with what we believe was a garden-variety correction. After experiencing only a few 5-6% S&P 500 selloffs in 2021, a larger correction (10%+) seemed overdue. Historically, the onset of a new Fed tightening cycle has triggered just such a correction, which represented a buying opportunity.

When Russia’s President Putin decided to invade Ukraine in February, the world changed. Within days the S&P 500 hit its lows for the quarter. Risks that seemed unimaginable just weeks before – nuclear war, another Cold War, 1970’s style inflation – presented legitimate concerns.

When added to the market’s pre-existing trepidations of rising interest rates, falling liquidity and high inflation, a potent brew of negativity was created. Recession fears exploded, especially as the 2–10-year yield curve inverted. Economist Ed Hyman at Evercore ISI conducted a survey where 100% of participants expected a recession in 2023! Consumer confidence hit lows not seen since shortly after the Financial Crisis. Unsurprisingly, the market sold off in a clear risk-off manner. Dispersions between defense and offense reached extremes.

When macro concerns dominate and correlations rise, this can present a challenging environment for us. We focus on long-term fundamentals. In risk-off periods, macro fears, rather than fundamentals, drive prices. Because we look for disconnections between fundamentally justified intrinsic values and market expectations, we often traffic in dispute. When fears mount, investors run towards certainty and stability. They flee uncertainty and disagreement.

The good news is that over time, this corrects itself. Ben Graham’s old adage rings true: “In the short run, the market is a voting machine but in the long run it is a weighing machine”. We think one of our biggest advantages is having the ability to hold through the noise. We believe we can profit from the periodic swoons. We were buyers during first quarter market weakness.

We think the veer towards defense is way overdone. The economy is still growing, and real rates are still highly negative. Business confidence remains strong, along with corporate earnings growth. High inflation is problematic. Rising interest rates will create challenges, especially for high valuation companies. We’ve already seen some signs of slowing growth, but we don’t believe a recession is likely in the coming year.

Jim Paulsen at Leuthold Group has published some great material on the attractiveness of stocks, particularly offensive ones from similar starting points historically. Current readings of bulls less bears are back to March 2020 levels, and rank in the worst quintile of historical data. When pessimism was at similar levels historically, annualized market returns were much better than happier starting points (+17.4% versus +10.3%).

No surprise at what does best from similar starting points: the most despised segments (cyclicals, consumer discretionary, small caps, etc). We tend to have significant overweights in some of these areas based on our bottom-up assessment of where we identify the greatest opportunities.

Charts Source: The Leuthold Group 1/31/90 to 3/31/22

The worst performing companies in the quarter were the “tech wrecks”. Innovative disrupters, the darlings of the prior decade, nosedived. While we’d long been cautious on highly valued growth companies, we didn’t anticipate how much our early-stage growth companies, which were reasonably priced, would get caught up in the storm.

We believe expensive and unprofitable growth companies will continue to be challenged. We’ve focused on companies that are either profitable or soon to be so. At our core, we remain long-term, fundamental bottom-up investors. We’ve concentrated in companies where we have the highest conviction, and we think current prices represent excellent values for these names.

Farfetch (FTCH), which we’ve added to, exemplifies the opportunity. We see strong competitive advantages, significant growth prospects, attractive business models and no additional capital needs. Importantly, we can make very compelling valuation cases on these companies (and ALL our companies!).

We strongly believe these companies will be worth much more five years from now. Farfetch is a great example. We initially purchased it in late—2019 after the stock had fallen from $30 to $8-10 on concerns about heighted promotional activity and an acquisition (New Guards Group) the market didn’t like (but turned out well!).

Farfetch operates a global luxury marketplace, but we are most excited about the prospects for Farfetch Platform Services (FPS). FPS aims to be the digital technology backbone of the global luxury industry (think a verticalized Amazon Web Services (AWS) for luxury).

Since our initial purchase, Farfetch has made substantial progress. Harrods was the first sizeable company to officially launch on FPS in 2020. That same year, Farfetch announced a strategic deal for their China business with Alibaba and Richemont whereby those companies invested in Farfetch.  Just this month, Farfetch announced a deal with Neiman Marcus Group for FPS. An FPS deal with Richemont, which the company has been negotiating for months, could come as soon as May.

Farfetch is building an attractive technology services business that the market doesn’t seem to appreciate. We expect the company to break out the financials of FPS in the next year or two, which will help highlight the value. Financial results have improved as well. Revenue and gross profit more than doubled from 2019 to 2021. The company reached adjusted EBITDA profitability last year as well. We expect the company will be free cash flow positive in 2023. By 2025, we expect the company to generate ~$1.25 per share in free cash flow (8% implied yield on current $15 price).

Founder and CEO, Jose Neves, is a visionary owner operator. Naysayers have doubted him the entire time, yet he’s continuously proven them wrong. His incentives are well-aligned with shareholders. In his most recent compensation package, announced in early 2021, he only gets paid if the stock is higher than $75 by 2026 (nearly 5x the current ~$15 stock price). Only 5% of his incentives pay off there. He gets paid more at additional increments up to $250 by 2029.

Despite all the fundamental progress, Farfetch almost roundtripped to our initial purchase price of ~$10 this past quarter. At that level, the company traded at ~2.8x Enterprise Value/Gross Profits (EV/GP). Amazingly, it bottomed at the same valuation in the 2020 Covid crash as well. For frame of reference, Amazon bottomed at the same valuation in the financial crisis (side note: Amazon bottomed at 4x EV/GP after the tech bubble burst)! So there’s historical precedent for the lows being in. We will see whether that holds true this time. Regardless, we think there’s significant upside over a 5-year time horizon.

The one other topic I want to briefly address is our volatility. We hope to write something about the topic in more depth in the future, but we want our clients and prospective investors to understand our views on it. We think that volatility is significantly misunderstood. We believe it creates opportunities from which we can profit.

I recently heard the legendary investor Howard Marks speak. He commented that mispricings come from two sources: ignorance and prejudice. He explained that when he started his career, prejudice created a huge opportunity in junk bonds.  People viewed the category as too risky and instituted rules against ownership. Marks built an amazing track record taking the other side of this flawed institutionalized belief, which no longer exists.

We see a similar opportunity in volatility. Two forces have combined to create significant prejudice against volatility. First, the extremely painful losses of the financial crisis heightened people’s focus on and aversion to any volatility. While this myopic loss aversion has always been deeply ingrained, it was exacerbated by the crisis.

In aggregate, hedge funds roughly doubled the market’s return in the decade prior to the financial crisis. In the subsequent decade, hedge funds earned half as much. Why? It’s not because managers became less skilled or smart. People just started prioritizing minimizing drawdowns over making money.

This strong behavioral tendency combined with an appealing academic framework to create powerful institutionalized bias. Markowitz’s Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM) delineated the relationship between a security’s or portfolio’s risk and its return. Intuitively, it makes sense one can achieve higher returns by taking more risk. It seems sensible not to want to pay managers for excessive risk-taking.

Even more alluringly, it allowed the simple calculation of risk. It enabled one to differentiate between return due to additional systematic risk (beta) and return not explained by risk (alpha). It made risk analysis easy!

However, if you’re a long-term holder of an asset, why should you measure your risk based on the worst price on the worst day during the worst period? If we viewed our marriages, children and careers through such a lens, we would surely avoid many of the most fulfilling aspects of life!

If you can hold an asset for 20 years, why do you care where the most fearful fellow sold during the worst of times over the past year or two? We think you shouldn’t! One does need to ensure they have a structure and psychology that allows them to remain invested for the long term.

We mostly agree with Warren Buffett and his partner Charlie Munger. Munger derided modern finance theory as “disgusting”. Buffett has said, “volatility is no measure of risk to us.”

There are many times when volatility and beta give false signals. Banks outperformed in the post-tech bubble bear market of the early 2000s. At the market peak prior to the financial crisis (when risk was the highest in those names!), Bank of America had a 0.9x beta (based on the trailing 5 years) suggesting its “risk” was below the market’s. Wrong! It massively underperformed in the financial crisis. Realized beta over the 5 years from the pre-crisis’ 2006 peak measured 2.3x.

A much better indicator of actual risk, both before and after the financial crisis, was the quality of the balance sheet and risk-taking appetite. Beta is backwards looking and non-stationary. Relying on it underestimated risk going into the financial crisis and overestimated coming out of it (its beta has continued to fall over the past decade).

We care greatly about risk. We spend a significant amount of time thinking about the risks to our investments. We measure risk as permanent impairment of capital, which means the prices and values don’t bounce back. Business fundamentals determine risk.

We believe sound risk analysis can help protect against permanent impairments of capital, but not necessarily temporary drawdowns.  We focus on our risk efforts on the former, and utilize the latter to improve our long term return potential.

Overall, we remain confident and enthusiastic about the prospects for our companies and portfolio. We think we have a sound and proven process that is differentiated, which gives us confidence about the future. We thank you for your continued support.

Samantha McLemore, CFA

April 20, 2022

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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.

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