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Aug 03, 2021

Fundamentals v Expectations

Samantha McLemore

Opportunity Equity 2Q 2021 Letter

Miller Opportunity Equity gained 3.81% (net of fees) in the second quarter, lagging the S&P 500’s 8.55% return. Performance over the past year was extremely strong as the Strategy rose 84.52% (Net), handily outperforming the S&P 500’s 40.79% gain. A year ago, we were very optimistic about the Strategy’s prospects as we thought the market had yet to recognize the potential of our holdings while the recovery gained steam. We estimated the portfolio’s upside at 87%.1 Interestingly, the performance over the past year was very close to that estimate, which brings up an important point.

Annualized Performance (%) as of 6/30/21
  YTD 1-Year 3-Year 5-Year 10-Year Since Inception (12/30/99)
Opportunity Equity (net of fees) 20.59 84.52 21.89 25.87 17.09 9.51
S&P 500 Index 15.25 40.79 18.67 17.65 14.84 7.18

Past performance is no guarantee of future results. Please refer to the GIPS disclosure document for important additional information.

We always aim to maximize our expected future risk-adjusted returns in the portfolio. All of our activity centers around improving future returns. It’s a dynamic process. At the beginning of 2021, we estimated ~65% upside in the portfolio. Year-to-date through June 30, 2021, we delivered returns of 20.59% (net) and currently estimate the portfolio’s upside potential at 68%. In the middle of our 3-to-5 year holding period, implied average annual returns would approximate ~14%.

We believe the path of least resistance for stocks is higher given we are early in the economic recovery and big drawdowns typically only occur during recessions. Selloffs, such as the minor one we are experiencing now as a result of Delta variant concerns represent buying opportunities. We believe the market is roughly fairly valued, with pockets of under and over valuation. We focus our efforts on the former. While classic value names have had a big rebound, we see more opportunity in those names than higher priced growth stocks.

A strong economic recovery could eventually lead to upward pressure on interest rates. We want to ensure our investments have significant upside potential even if rates normalize. For many higher-priced growth stocks, it’s gotten more difficult to make the math work.

Growth stocks struggled earlier this year as rates rose. Many reflect very optimistic expectations. It doesn’t surprise us that one of the best growth investors, James Anderson from Baillie Gifford, is retiring while another, Dennis Lynch, from Counterpoint Global/Morgan Stanley says it is difficult to find great values.

We agree and it’s reflected in our portfolio positioning. We are selective about investing in names where we believe market expectations don’t properly reflect underlying fundamentals. We must strongly believe the stocks are mispriced even if rates move up significantly. Our growth names still fit the bill. That doesn’t mean their prices won’t be pressured from rising rates, but it does mean we expect fundamentals to offset those headwinds over our 3-to-5 year time horizon.

Alibaba (BABA), one of our largest growth holdings, exemplifies our approach here. The stock ($2062) is down 35% from its highs hit in October 2020 primarily on fears regarding China’s regulatory crackdown. New headlines surface daily on the aggressive new approach by the Chinese government. We believe the worst is behind Alibaba. It has already been fined and agreed to changes in how it operates. The government’s focus has shifted elsewhere, most recently to Didi who just barely IPO’d. Recent press reports suggest the government is partnering with Alibaba to purchase a stake in troubled indicating BABA could be back in the good graces of the government. These concerns have depressed expectations creating a divergence between those and what we believe are very strong fundamentals.

Alibaba is the largest, most dominant ecommerce site in China with a smattering of other interesting businesses, like its cloud and logistics businesses. BABA has historically grown revenues between 32% in poor years (i.e., China’s slowdown in 2016) and high 50%’s in stronger years. It trades at 23x next year’s earnings. We think it should be able to continue to grow 20%+ conservatively implying a similar compound rate of capital if the valuation just holds steady. It’s the perfect holding for patiently compounding capital. It doesn’t surprise us that notable value investor, Charlie Munger, recently bought Alibaba stock.

The top performers of the previous decade were the most innovative digital disrupters, while companies perceived to be at secular risk fared terribly. We track the top performers of each decade and have never seen a trend persist for 2 consecutive periods. There’s a good reason why. Market expectations adjust. The landscape evolves.

Companies today understand the risk of digital disruption and generally have active strategies for prevailing. They won’t all be successful, but some will. We think there are a number of companies where market expectations don’t properly reflect the underlying improvement to fundamentals.

It reminds me of 2011 or 2012 where the market still focused on historical housing problems rather than the signs of fundamental business improvement. Housing stocks bottomed at half their financial crisis lows in late 2011 and rose triple digits in 2012. Value stocks have already had a big move up, but we think the market hasn’t fully reflected the improved prospects of certain names.

The market continues to believe companies like ADT and DXC, two of our biggest positions, can’t sustainably grow going forward. We believe otherwise.

ADT is the leading brand in the home security market. Many believe that it faces secular headwinds from competing do-it-yourself security equipment offerings. The evidence suggests, however, those innovations have grown the total market, not cannibalized managed security offerings. ADT offers both managed and do it yourself solutions. After fixing the core business, ADT is now able to focus on growth. We estimate it is investing to achieve 20%+ returns on capital.

Most notably, it partnered with Google who bought 6.6% of the company late last year. The companies will come out with a fully integrated smart home offering later this year, which has the potential to materially improve the business. ADT also re-entered the commercial business a few years ago. While COVID hurt that market last year, it’s recovering nicely. We expect the company can grow double digits in both the residential and commercial businesses going forward.

At the same time, a number of corporate actions (the sale of its Canadian business and accounting changes resulting from its acquisition of a distribution partner) have complicated financials and made it more difficult to understand the underlying performance of the business. Management has consistently prioritized the economics over accounting, which we love. We expect 2022 to be a clean year that will help the market understand the underlying business performance. We think the stock is worth $16-18, which is significantly more than the current $10.633 price.

While activity slowed down from the heightened levels of last year, we still added five new names in the quarter and exited four.

Our largest new position is Splunk Inc. (SPLK$138.374). Splunk typifies one of our favorite types of opportunities: a company well positioned secularly that is facing short-term business pressures. We believe there’s the opportunity to profit as the business normalizes and then compound capital beyond that. SPLK is a leading provider of security software, a growing market due to exploding cyber threats.

Splunk is in the middle of a multi-year business model transition that has negatively impacted financials and increased uncertainty. We believe we are finally past the worst of the transition with revenues troughing in FY2020. We expect the company to return to positive free cash flow generation in the second half of this year.

SPLK trades at half the multiple of comparables. We believe that gap will close as the market gets more certainty that the transition is working. The stock recently jumped on the announcement that Silver Lake, an excellent tech investor, invested $1B in a convertible senior note and the company announced a $1B repurchase authorization. We believe the stock is worth well more than its old highs ($225) creating significant upside for those patient enough to hold through the transition.

We entered SoFi Technologies Inc. (SOFI) on a PIPE deal earlier this year, and it closed in the quarter. SoFi is a “fin-tech” company offering borrowing, saving, spending and investing offerings. The company has no brick and mortar locations allowing them certain efficiencies. SoFi reinvests savings back into the business by providing customers with higher interest rates on deposits and lower loan rates. It uses data to improve loss ratios and reduce risk.

SoFi is led by Anthony Noto who we’ve known for many years. Most recently he served as Twitter’s CFO and worked at Goldman Sachs prior to that. He’s a thoughtful executive that understands how to drive business value. Overtime, they think they can continue to gain market share from traditional players in the space. We think there’s significant potential in SoFi.

Coinbase (COIN) became a public company in mid-April following their direct listing at a reference price of $250. Coinbase is a cryptocurrency exchange that allows consumers, financial institutions and businesses to transact between fiat and cryptocurrencies and securely store and use cryptocurrencies. We believe over the long term the company has the potential to be the leading technology platform in the growing cryptocurrency space.

COIN’s 2021 revenues are expected to be 4.5x its 2020 revenues as crypto prices and volumes have exploded. It trades at 30x this year’s earnings, which is quite a steal for a quickly growing company in this market. That’s because the market believes this is peak cycle revenues and earnings, and retail margins will be pressured. That all very well may be true, but we see significant potential for the business over the long term as the nascent industry continues to grow and COIN cements its positon as the leading platform.

We started building a position in Biogen (BIIB) following the approval in early June of Aduhelm, their controversial Alzheimer’s drug. The stock initially traded up to an intra-day high of $468.55 and subsequently traded down to a low of $340.27 near the end of June. We believe the significant unmet need will lead to higher than expected demand for the drug. At current prices, we believe you get a free option on the pipeline.

We also began to build a position in Tupperware Brands Corporation (TUP $21.975) at the end of the quarter. Tupperware sells home goods through a direct marketing channel. The stock is well off the 2013 highs of $97. New CEO Miguel Fernandez joined the firm in April of 2020. Previously, he worked on the turnaround of Avon before it was sold to Natura & Co. Over the past year, Miguel has been focused on selling off non-core assets, paying down debt, and rolling out a new growth strategy. We believe there’s significant unrecognized brand value at Tupperware that the company will monetize through expansion into new markets. Overall, the stock is currently trading for less than 5x what it is expected to earn this year.

To fund these new positions, we exited Flexion Therapeutics (FLXN) and GTY Technology Holdings Inc. (GTYH) allowing us to realize some tax losses in names that were less liquid. We also opportunistically exited Discovery Inc. (DISCA) following the run-up of the stock into the $70s as the market became excited about the direct-to-consumer opportunity. Roblox (RBLX) and Workday (WDAY) were smaller positions that we also used as a source of funding as we saw greater near-term upside in other opportunities.

We will continue to work our hardest to deliver returns to our investors. We appreciate your continued interest and support.

Samantha McLemore, CFA

Strategy Highlights by Christina Siegel, CFA

During the second quarter of 2021, Miller Opportunity Equity returned of 3.81% (net of fees) compared to the Strategy’s unmanaged benchmark, the S&P 500 Index, 8.55% return.

Using a three-factor performance attribution model, selection, allocation, and interaction effects contributed to the portfolio’s underperformance. DXC Technology Company, Energy Transfer LP, ADT Inc., Diamondback Energy Inc., and Capital One Finance Corp. were the largest contributors to performance, while Quotient Technology Inc., Desktop Metal Inc., Teva Pharmaceutical, UBER C32 1/22, and Taylor Morrison Home Corp. were the largest detractors.

Relative to the index, the portfolio was overweight the Consumer Discretionary, Financials, Energy and Industrials on average during the quarter. With zero allocation to Real Estate, Utilities, and Consumer Staples the fund was dramatically underweight these groups and more moderately underweight the Communication Services, Information Technology, Health Care, and Materials sectors.

The portfolio added five positions and eliminated four positions during the quarter, ending the quarter with 50 holdings where the top 10 represented 34.4% of total assets compared to 27.9% for the index, highlighting Opportunity’s meaningful active share of 88.5%.

Top Contributors

    • DXC Technology Company (DXC) continued to climb higher during the quarter gaining 24.57%. The company reported solid Fiscal Year 4th quarter (FY4Q) results with revenue of $4.385B beating consensus of $4.29B and earnings per share (EPS) of $0.74 ahead of expectations for $0.70. The company guided for fiscal 2022 revenue of $16.6-$16.8B, below the Street at $16.9B and adjusted EPS of $3.45-3.65, ahead of the consensus of $3.43. By FY2024, the company expects organic revenue growth of 1-3%, adjusted earnings before income and taxes (EBIT) margin of 10-11%, adjusted diluted EPS of $5.00-$5.25 and free cash flow (FCF) of $1.5B. Later in the month, the company held an investor day where management highlighted their confidence that they can hit all of their targets while also stressing the progress they have made on their turnaround to date.

    • Energy Transfer LP (ET) rose over the period along with the price of oil climbing 40.59% over the period. The company received positive news that the Dakota Access Pipeline project would not be shut down while the Environmental Impact Statement by the US Army Core of Engineers is drawn up. Energy Transfer reported strong 1Q results with revenue of $17B surpassing expectations for $11.8B with adjusted earnings before income, taxes, depreciation and amortization (EBITDA) hitting $5.04B ahead of consensus of $2.77B. The company raised full year adjusted EBITDA guidance to $12.9-13.3B from $10.6-11.0B previously, with the increase largely related to the benefits realized from Winter Storm Uri. The company paid down $3.7B in debt during the quarter, using strong cash flow to reduce leverage. The company also announced the issuance of $900M in 6.5% Series H perpetual preferreds with the company using the proceeds to repay debt and for general purposes.

    • ADT Inc. (ADT) was a top performer over the period returning 28.12%. The company reported 1Q21 results that beat expectations with revenues of $1,305M, a Year-over-Year (YoY) decline of -4% versus the -7% expected, and EBITDA of $542M beating consensus of $525M. The company maintained full year guidance of revenue $5,050M-$5,250M (versus consensus of $5,189M), adjusted EBITDA of $2.1-2.2B (versus consensus of $2.16B) and Adjusted FCF of $450-550M (versus consensus of $447M). The company reiterated that they expect full year RMR (recurring monthly revenue) to grow in the mid-teens while they expect to spend an additional $150-250M on SAC (subscriber acquisition costs) with the majority of the spend hitting in the first half of the year. The company expects the commercial business to reach pre-COVID levels by the end of 2021. The company will continue to invest in their own internal IP spending ~$50M this year on next-gen solutions.

Top Detractors

    • Grayscale Bitcoin Trust (GBTC) reversed a large portion of the gains seen in the first quarter, declining 41.48% during the second quarter. A pullback is normal after such a strong move in the first quarter (up 103%) but a number of headlines assisted in the decline. Telsa reversed course in the period, removing Bitcoin as a payment option citing environmental concerns as the reason for the change of heart. China reiterated their crypto-mining bans from 2013 and 2017 that bar financial and payment institutions from providing any services related to cryptocurrency transactions. China also imposed new restrictions on energy-intensive mining ordering cryptocurrency miners to shut down their operations. The cryptocurrency did not move higher despite El Salvador passing a new law that makes bitcoin legal tender in the country.

    • Quotient Technologies Inc. (QUOT) fell -33.90% over the period after reporting first quarter results. The company reported revenue of $115.3M ahead of consensus of $110.7M and EBITDA of $6.84M beating consensus of $6.11M. The company raised full year guidance on revenue to $505-$525M with the midpoint ($515M) coming in below consensus of $518M, and EBITDA of $50-$65M with the midpoint ($57.50M) coming in below consensus of $61M.

    • Desktop Metals Inc. (DM) declined 21.29% during the period. The company reported their first quarter results with revenue of $11.3M beating consensus of $9.9M with adjusted EBITDA coming in at -$19.4B slightly ahead of consensus of -$20.6M. The company reaffirmed full year 2021 guidance with revenue expected in excess of $100M exiting the year at a revenue run rate of $160M but lowered adjusted EBITDA guidance to -$60M to -$70M from -$50m to -$60m previously. Over the period, the company announced a number of new processes and materials adding a process for wooden parts, the qualification of 316L stainless steel, qualification of 4140 low alloy-steel and the CE (Conformite Europeenne) mark for their Flexcera resin for use in 3D fabrication of dental prosthetics. By the end of the period, the company filed to sell 2.49M shares from existing shareholders.

Top Contributors and Top Detractors
Top Contributors Ticker Return Contribution (bps)
DXC Technology Co. DXC 24.4% 104.0
Energy Transfer LP ET 40.5% 87.5
ADT Inc. ADT 28.2% 83.3
Diamondback Energy Inc. FANG 28.3% 73.9
Capital One Financial Corp. COF 21.8% 49.7
Top Detractors Ticker Return Contribution (bps)
Grayscale Bitcoin Trust GBTC -41.5% (106.2)
Quotient Technology Inc. QUOT -33.9% (86.4)
Desktop Metal Inc. DM -22.9% (45.8)
Teva Pharmaceutical TEVA -14.2% (45.6)
UBER C32 1/22   20.6% (31.8)

Performance Attribution
Click on image to view larger.

The data provided is from Miller Value Partners, LLC and is believed to be reliable, but is not guaranteed as to its timeliness or accuracy. Percentages and returns may not sum to 100% due to rounding effects. A three-factor attribution consists of the allocation effect, selection effect, and the interaction effect, which sum to the portfolio's performance relative to the benchmark.
*Returns based on underlying portfolio equity long holdings for each sector.
• The allocation effect represents the portion of the portfolio's excess return attributable to differences in sector weights between the portfolio and the benchmark index.
• The selection effect represents the portion of the portfolio's excess return attributable to differences in the weights of individual securities within each sector between the portfolio and the benchmark index.
• Most complex and sometimes counterintuitive, the interaction effect represents the portion of the portfolio’s excess return attributable to combining sector allocation decisions with security selection decisions, and is often thought of as measuring the accuracy of manager’s convictions.
Please note that the methodology used by our independent third-party attribution software vendor will at times present sector allocation effects that are counterintuitive. For example, the software may calculate a negative sector effect even when the portfolio, on a weighted average basis for the period, was overweight an outperforming sector. Under the vendor's methodology, allocation effects in recent months may overwhelm the allocation effects from earlier in the period, particularly over longer time frames.

Related Posts

Bill Miller's 2Q 2021 Market Letter

Christina Siegel's 2Q 2021 Market Highlights

1A proprietary calculation of the central tendency of value for the portfolio based on our assessment of the intrinsic value of individual holdings.
2Price at close on 7/9/21
3Price at close on 7/9/21
4Price at close on 7/9/21
5Price at close on 7/9/21

For 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.

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.

©2021 Miller Value Partners, LLC