Darling I don't know why I go to extremes
Too high or too low there ain't no in-betweens
And if I stand or I fall
It’s all or nothing at all
Billy Joel, "I Go To Extremes"
An extreme first half of the year capped off a couple years of extremes. Extreme highs, and extreme lows. Extreme changes. The S&P 500 first half loss was the worst in over 50 years, since 1970. The markets challenged even the best managers with many of the best growth investors posting their worst losses in history. Baillie Gifford’s US Fund (BGGSX) was down over 50% in the first half, while Tiger Global Long Opportunities Fund was rumored to be down 60%. Value strategies, which generally fared better in the first quarter, ceded to selling pressure in the second quarter, with the Russell 2000 Value index down more than 15%.
We faced significant challenges in this environment too. Miller Opportunity Equity was down 34.3% net of fees in first half vs. the S&P 500’s 20.0% decline, most of the loss occurred in the second quarter (Miller Opportunity Equity -29.3% vs. SPX -16.1%). Despite the consumer remaining in great shape, knee jerk recession fears pummeled consumer discretionary, where we are overweight with Vanguard’s Consumer Discretionary ETF (VCR) down more than 25% in the second quarter. We think the market’s knee-jerk reaction to simple rules creates opportunities for long-term fundamental investors.
Annualized Performance (%) as of 6/30/22
|Since Inception (12/30/99)
|Opportunity Equity (net of fees)
|S&P 500 Index
The second quarter was the fourth worst in our 20+ year history, only outdone by Q4 2008, Q1 2020 and Q3 2011. All these periods contained markets in freefall. After prior crashes, the strategy rebounded strongly, averaging 96% returns in the next year.
The markets humble you. It’s one of the things I love about markets. Well love-hate really. There’s never a dull moment and you’re always learning. False bravado gets rooted out quickly. Just when you think you understand something, the world changes.
The extreme economic and market conditions of the past few years are little short of astounding, reinforcing the notion that forecasting is an exercise in futility. Our expertise lies in analyzing company fundamentals, and how those compare to expectations we believe are baked into stock prices, which is much more straightforward.
To recap: the new decade began on solid footing with early year gains, only to succumb a devastating pandemic. The Covid crash started in February 2020 and culminated in the fastest 30% decline in S&P 500 history. Entire economies shut down. One could hardly imagine a worse economic environment. Unemployment came close to 15%, the highest since the Great Depression. Oil prices went negative. Bill Ackman warned of a Depression era period saying, “Hell is coming.” A financial apocalypse to be sure.
Who could be bullish in that environment? Yet that was exactly the right position. Prices were way off the highs. Massive monetary and fiscal stimulus saved the day (over $5T in fiscal spending and a Fed balance sheet expansion nearing $5T). Consumers benefited immensely. We experienced a severe recession with virtually no credit losses, a pairing previously unthinkable.
The world completely changed virtually overnight. Third quarter 2020 GDP growth measured a whopping 33%, the highest since the Bureau of Economic Analysis (BEA) started publishing the data in 1947. Had we finally cracked the nut on how to avoid recessions? Pundits discussed the possibility of another “roaring 20’s” with high economic growth and strong markets. People believed elevated spending in areas like ecommerce had experienced a permanent upward shift. It was hard to find much not to like (in hindsight, the biggest warning sign of all and one we wish we heeded).
Dramatic change happened again when the inflation genie escaped the bottle. At first it was dismissed as transitory, but time made matters worse not better. CPI hit a level not seen in 40 years, yet another extreme. A behind-the-curve Fed has been forced to aggressively play catch up. Meanwhile, a market bubble popped in innovative disruption stocks. At the same time, a normalizing economy faced excess inventories as consumer spend shifted to services. Last but not least, Russia’s invasion of Ukraine created the most fraught geopolitical landscape in decades.
This takes us to where we are now: the worst first half market performance since 1970 (SPX down 20.6%), over 50 years ago! Rack up another extreme…enough to give you whiplash. What happens from here? Another dramatic change, or more of the same?
We’ve eaten enough humble pie on macro thinking to avoid any prognostication. Many questions weigh on investors’ minds. Has inflation rolled over? Will we enter a recession or not? Have we entered a new era of geopolitical turmoil and elevated energy costs? Can China sustain its economic recovery while pursing zero-Covid?
No one knows any of these answers. People struggle to understand what a recession is, let alone predict when one will occur. A recession is not two consecutive down GDP quarters as often cited. National Bureau of Economic Research (NBER) defines it as significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
Here’s what we do know. Economic growth has slowed dramatically. GDP growth in the first quarter was negative (mostly due to inventories) and the Atlanta Fed predicts Q2 real GDP growth of -1.2%. The surge in interest rates slammed mortgage demand, which hit the lowest level in 22 years early in June. Refi’s are down nearly 80% year-over-year. Housing activity has slowed.
Inflation has remained stubbornly high, but forward indictors of inflation have rolled over. Commodity prices have broken down sharply leading Ned Davis’ model to issue a sell signal. Monetary growth has plummeted, and financial conditions have tightened dramatically. Both equities and bonds sold off simultaneously, while credit spreads widened. Inflation breakevens have plummeted. In early July, the 5-year breakeven fell back below 2.5% for the first time since September 2021, down from a high of ~3.8%. The 5-year forward rate in 5 years sits at ~2.1%, not far above the Fed’s 2.0% target.
Yet employment, a coincident to lagging indicator, remains strong. There has never been a recession without employment deterioration. Consumer balance sheets remain in great shape with approximately $2.3T in excess savings. Demand for services remains strong, and banks remain upbeat about consumer behavior and demand.
Where do we go from here? The cone of uncertainty about the future is always wide, but it currently seems particularly extreme. A return to the low growth, low interest rate environment of the past decade seems quite plausible, as does the emergence of a new, higher inflation regime. The market will likely remain volatile as it figures out the answer.
Yet, a dramatic market decline has lowered expectations across the board. A peak-to-trough S&P 500 drop of 24.5% ranks as the 12th worst in the post-Depression period. Historically, an investor has earned above-average returns buying after a 20% market decline. The market averaged low-to-mid teens annualized returns over 1, 3 and 5 years whether we faced a recession or not (click here to read our latest blog post). While we could expect more downside to the ultimate low, it hasn’t historically taken that much patience (1 year) to be nicely in the green.
Howard Marks, one of the best contrarian value investors, recently said he’s seeing good values and buying aggressively. Valuations have come down nicely. The S&P 500 currently trades for 16.7x this year’s earnings. The attractiveness of that valuation is highly sensitive to inflation and interest rates. The current multiple is about average for periods when the Fed’s favored measure of inflation (core PCE) sits between 3-4%, which happens to be where the 1-year inflation breakeven lies.
If inflation falls below 3%, as suggested by longer term breakevens, there’s room for multiple expansion to the historical average multiple of 19x+. The reverse is also true. Higher than expected inflation would continue to weigh on market valuations as multiples averaged 13x with inflation above 4%.
In the low-inflation, low-interest rate environment of the prior decade, high growth stocks led. On the other hand, high inflation periods like the 70s benefit value stocks with pricing power. This dichotomy presents a challenge for investors. We see many compelling opportunities we think can do well irrespective of the macro. We’ve constructed a diversified portfolio of undervalued securities that we believe can do well over the long term.
Unfortunately, the current price action is all about the macro. When that’s happened historically, we’ve struggled. JP Morgan recently reported that fundamental trading now represents only 10% of trading flows. The other 90% are a combination of passive, systematic and macro discretionary. That means in the short term, prices can get even more disconnected from fundamentals than they historically did, in our opinion.
While market valuations overall seem reasonable, we believe we are witnessing extreme disconnections in certain areas. Prices can always get more extreme. In the long term, we believe fundamentals will prevail. Based on the fundamentals, we calculate tremendous upside potential for the fund.
The portfolio sits in four broad buckets: travel, reasonably valued compounders, cash-flowing value companies with good capital allocation and high potential earlier-stage growth companies. The commonalities amongst all our holdings: attractive valuations relative to intrinsic value and an attractive risk-reward skew.
Travel represents the biggest disconnect we see between fundamentals and expectations. Unfortunately, we believe were early here, as this divergence has only grown. We expected a strong travel recovery would benefit the stocks and close the valuation gap. Despite record revenues at several airlines, cruise lines returning to service with strong bookings and record summer travel, travel stocks uniformly tanked.
Amazingly, some companies like Carnival Cruise Lines (which we don’t own) made it back to its March 2020 lows when business was shut down with no sign of return. Carnival already resumed positive operating cash flow generation and disclosed stronger than historical bookings for 2023 at higher prices. The market focused on fear of recession and refinancing risk posed by higher rates.
We do own Norwegian (NCLH $11), which is back to levels not seen since May 2020. Norwegian is the boutique, premium brand. It has guided for a return to positive operating cash flow and adjusted EBITDA in the second half. Management expects to earn record adjusted EBITDA in 2023 and to generate enough cash flow to cover all its capital needs, including debt maturities. It trades at 6x 2023 earnings, well below its historical average of 11.8x.
The market fears weakening demand. So far, we do not see evidence to support this fear in the travel space. There’s still significant pent-up demand for leisure, which Rubinson Research estimates to still be over $500B. This provides a cushion for any coming softness. We believe the consumer remains in great shape with excess savings 3x excess inflation (also according to Rubinson). Historically, pricing power has been strong in this group.
Many travel names already seem to have priced in a recession. The airlines are more than 50% off their highs. JP Morgan recently noted that a 40% decline has historically been a good buy signal. Airlines gained more than 70% on average over the next year, subsequently. The legacy US airlines are generating record revenues and significant free cash flow, which can be used to repair their balance sheets. They also have record liquidity.
The market gives airlines no credit for being better businesses than their historical bankruptcy-prone record suggests. Consolidation of US legacy players led to a decade-plus of more capacity discipline and better returns on capital. Pilot shortages will enforce capacity restraint, which should lead to better pricing power…a big deal for profitability given high operating leverage. We already see signs as Delta and United earn attractive margins despite higher fuel costs.
Delta (DAL $30) trades below 4x next year’s EV/EBITDAR, the favored industry valuation metric that incorporates aircraft leases and debt balances. That’s only happened one other time in the past 20+ years, in June 2016. Delta gained 50% in the following 12 months from that point. United (UAL $38) trades at a similarly depressed multiple, 3.6x. Outside of two months prior to the pandemic, it’s also only been below 4x in Jun 2016 as well. It rose ~80% over the next year.
Travel company stock prices seem to be caught in the vortex of simple rules that drive many systematic and macro discretionary strategies. Recession equals sell consumer discretionary. High oil prices mean sell transportation. The facts don’t matter, at least in the short term. We believe they absolutely will in the long term, which is why we’ve added to our exposure.
We bought Expedia (EXPE $89) in the quarter. It’s fallen 50% year-to-date despite expectations for record EBITDA this year. Expedia made significant improvements to both its cost structure and its technology infrastructure during the pandemic. This year Expedia’s EBITDA margins (21%) are expected to surpass 2019’s (16%) by more than 30%.
It’s also gushing free cash flow. EXPE should generate ~$16/share this year, which is a ~18% yield on the current $91 stock price. Most of this year’s free cash flow stems from working capital, but the prospects for operating free cash flow are also strong. Consensus has Expedia earning ~$11/share next year, a 12% yield. Add in working capital benefits and it should generate more than ~$18/share (20% yield). Barry Diller, who has one of the strongest capital allocation track records around, chairs the Board and recently exercised some options. We expect the company to reach its deleveraging targets later this year, then to deploy its cash flow in value accretive ways, such as share repurchase.
In March 2020, Expedia bottomed at 6.4x 2019 EV/EBITDA. There could hardly be a more dire business outlook than what it faced then. A similar multiple on current year EBITDA would equate to $78, 12% downside, which demonstrates the dire outlook already priced in. We believe the stock is worth more than double the current price, an attractive risk-reward skew. It’s unusual to find a company with a 10-20% free cash flow yield that can sustainably grow topline high-single digits, as we believe Expedia can do.
I recall only one other instance where fundamentals diverged so sharply from stock prices. In late 2011, markets sold off on fears that a Eurozone debt crisis would lead the world back into recession. Homebuilders and financials, the worst losers during the Financial Crisis crash, plummeted. Some homebuilders, like Pulte, traded down to half their financial crisis lows despite reporting housing improvements for the first time. Fear ruled in the short term, but fundamentals ultimately prevailed. Homebuilders were top performers in 2012 posting triple-digit increases in some cases. Opportunity Equity was a top performer that year.
This raises the question: are we witnessing a once-in-a-decade opportunity?
We started to see this parallel late last year when travel names sold off sharply in the face of a looming travel recovery, which we believed would lead to significant gains. Unfortunately, the disconnect has only grown more extreme, something you can never rule out in markets.
From here, we need to see significant deterioration in fundamentals to justify current prices. That can always happen, but we find it unlikely. We think recency-bias is again rearing its ugly head as the market anchors on pandemic-like outcomes unlikely to recur. As fear recedes, we expect strong gains from these stocks. Sir John Templeton famously advised to invest at the point of maximum pessimism. We may be getting close.
We also like reasonably valued compounders, like Amazon (AMZN $111), Google/Alphabet (GOOGL $2207) and Facebook/Meta (META $158). GOOGL trades for 16.5x this year’s earnings excluding net cash, while META trades for 13x. Given the quality of these businesses, their dominance in online advertising and the great returns on capital, we think these are very attractive valuations.
AMZN looks more expensive on this year’s earnings, but we believe it is massively underearning its long run potential. We expect it to close that gap over the coming years. Consensus earnings estimates for 2027 are ~$10 per share so it trades at less than 11x 4.5 year out earnings. Costco trades at close to 39x. A multiple in the low 20’s seems conservative in most scenarios, which would imply a doubling. That may understate the potential as you can easily argue that Amazon Web Services (AWS) is currently worth the entire value of the business. Either way, we think these compounders are undervalued. In contrast, there are still many quality companies that appear expensive.
Our cash-flowing value stocks are an eclectic mix of businesses. For much of the past decade, the market ignored value (or worse!) and the stocks languished. When managements allocate capital well by returning it to shareholders, the favorable cash-on-cash returns can take care of themselves. We own some energy companies, like Ovintiv (OVV $40) and Diamondback (FANG $107), with high free cash flow yields that are returning significant amounts of free cash flow to shareholders. Ovintiv, for instance, has a 33% free cash flow yield next year with oil in the $90s, and a cash return of over 20%.
We own OneMain Financial (OMF $38), a subprime consumer credit company, that trades for 4x earnings with a 10% dividend yield, which should be sustainable in a recession. Credit losses are normalizing from abnormal pandemic lows, but it sees no sign of a coming recession. It expects to generate capital through the cycle. It also has enough liquidity to last for 2 years without accessing the capital markets.
We own Teva Pharmaceuticals (TEVA $7), the largest generic pharmaceutical manufacturer, that trades for 3x earnings with a 24% free cash flow yield. Prior management overlevered the balance sheet doing acquisitions. Current management has paid down net debt from $34B to $20B. Assuming it hits its leverage target at the end of next year, that free cash flow can come back to shareholders, or be used for other value accretive purposes.
We own a couple of turnarounds. At Mattel (MAT $22), CEO Ynon Kriez has led a stunning improvement in operations, margins, growth and returns on capital. At 11x next year’s earnings, the market isn’t yet crediting the company for the magnitude of improvement. For this reason, there’s been rumored private equity interest in the company. Later this year, we expect it too will get its balance sheet to a place where it can allocate capital in additional shareholder-friendly ways.
At DXC (DXC $28), CEO Mike Salvino has massively improved the topline, margins and free cash flow. At 7x, the company believes its undervalued (we agree!) so it’s buying back a significant amount of stock. Next fiscal year it expects to generate $1.5B in free cash flow, which equates to a 24% yield at the current $6.3B market cap.
I’d be remiss not to mention Alibaba (BABA $104), our largest position. We could place it in the value bucket or the reasonably priced compounders. It got crushed over the past year but was one of only two stocks we had up in the quarter, which is how it ended up at the top spot. With the Chinese government fully committed to zero-Covid, you’d hardly call the operating environment good. It is getting less bad as the economy reopens. With low enough expectations, that’s all it takes. A harbinger of what’s to come more broadly for markets?
BABA trades for only 12.5x next year’s earnings excluding net cash. The perfect storm of malign economic conditions, government pressures and a sizeable investment that weighed on the stock over the past year appears to be dissipating. It remains an ecommerce and cloud leader with good growth prospects. We think it’s significantly undervalued.
The last bucket in the portfolio is high-potential, early-stage growth companies. This group has been slaughtered. Nothing was spared from pain. It’s likely some of these companies will prove to be the best values over the next decade. We’ve concentrated in the names where we have the highest conviction, and exited names where fundamentals have been more challenged.
Here, too, we see some extreme valuations. We’ve written about the potential we see in Farfetch (FTCH $7), a luxury goods marketplace and aspiring technology platform for luxury. FTCH has also acquired several traditional luxury goods companies over the years, the largest being New Guards Group (NGG), a collection of brands. It also owns Stadium Goods, a stake in Neiman Marcus group, Browns and several other assets. Many of these businesses are already profitable. We calculate their value alone to be worth more than the entire company today! At the current price, you get a free option on the whole marketplace and platform services business.
While we are disappointed with our performance, we remain confident about the portfolio’s prospects. We wish we’d better foreseen the risks presented by the euphoria of 12-18 months ago. Mr. Market has now reversed that sentiment entirely. We believe the current environment is characterized by extreme pessimism. We maintain high conviction that our securities are mispriced because we see firsthand how deeply disconnected the stock prices are from the underlying fundamentals.
In a market driven by fear rather than fundamentals, we think the rewards for being long term will be outsized. We think extreme times in extreme markets call for extreme patience. We have a diverse mix of businesses that should help us do well in a variety of environments. We have high confidence in our process, which offers the unique combination of a long-term focus, a flexible approach and valuation-centricity.
We have deep gratitude and appreciation for our supportive clients. As significant investors alongside our clients, we’ve felt the pain of recent performance. We remain fully committed to delivering excellent returns going forward.
Samantha McLemore, CFA
July 15, 2022
Christina Siegel's 2Q 2022 Market Highlights
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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