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Jan 21, 2022

Has the Great Growth Bull Taken Its Last Gasp?

Samantha McLemore

Opportunity Equity 4Q 2021 Letter

We find our 2021 performance quite disappointing. Miller Opportunity Equity ended the year down 4.13% (net of fees) versus the S&P 500’s 28.71% gain. It’s highly unusual for our performance to lag so significantly in a strong market. While we expect periodic underperformance, we are never satisfied when it occurs.

We aim to deliver clients attractive long-term, risk-adjusted returns relative to our benchmark. We’ve met our longer-term objective despite our challenges last year. For the 10 years ending 12/31/21, the Strategy delivered an 18.29% annualized return, 174 basis points above the S&P 500 Index. The Strategy produced average annualized returns of 9.21% for rolling 3-year periods, 8.56% for rolling 5-year periods, and 7.06% for rolling 10-year periods since inception.

We posted strong performance in the first half of the year but gave it all back in the second half. The good news is historically we’ve bounced back strongly after similar selloffs. We used the selloff to opportunistically add to our highest conviction names. We see significant potential in the portfolio and believe it’s well-positioned to deliver on our long-term return objectives.

What happened in the latter half of 2021? Was it typical market gyrations or something more? We believe it was a little of both. Most of the names that got hit the hardest were pandemic winners that surged in the prior year. Reversion to the mean is a feature of markets, so much of this behavior is entirely normal. On the other hand, the market’s tolerance for high growth, high valuation perennial money losers appears to have run out.

Money losing growth stocks posted the biggest losses late in the year. Jim Cramer termed this behavior getting “pelotoned,” as Peloton is the poster child for what we experienced. At recent prices ($31.33 as of close 1/14/22), Peloton is more than 80% off its highs. It’s reversed nearly all its pandemic gains, trading at levels close to the IPO price ($29).

We previously owned Peloton, so we know the company well. We bought Peloton after the IPO based on our belief it was a misunderstood consumer brand pegged as a faddish hardware company.

It benefited enormously from the pandemic as demand surged and customer acquisition costs plummeted. We expected these dynamics to reverse as the environment normalized from stay-at-home. We sold in late 2020 because we thought it was fully valued around $100. Growing risks created a poor risk/reward.

At current prices, it’s interesting once again and we’ve resumed work on it. Market sentiment towards money losers remains quite negative. Peloton’s prospects, like others, ultimately depend on its ability to drive free cash flow over the long term. We reference Peloton because it’s an extreme example of behavior we’ve seen more broadly.

The market reacted very negatively to fundamental headwinds from normalization, especially for unprofitable companies. With the percentage of unprofitable companies near record-high levels, many names could continue to see pressure. It will be interesting to see which companies successfully drive actual profits.

Last year, we also cut back other pandemic winners that had surged, like Farfetch. We maintained positions where we had long-term conviction in the upside, but at lower weights. While Farfetch faced topline headwinds from tough comparables amidst normalization, it’s continued to make steady progress towards profitability. It’s expected to be EBITDA profitable in 2021 and we expect positive free cash flow in 2022. Still, Farfetch currently trades ($27.20 at close on 1/14/22) more than 60% lower than its highs.

As Ben Graham says, in the short term the market is a voting machine, but in the long term, it’s a weighing machine. We remain focused on the long term and have conviction the names we own are attractive on a 5-year time horizon.

We believe we could be early in a market shift away from the disruptive innovation leaders of the past decade towards more classic value. Flows, positioning, and valuation disparities between these market darlings and their more pedestrian value brethren still sit at extreme levels in our opinion. We currently see higher nominal growth and inflation than we’ve seen in decades. If this ultimately flows through to higher interest rates, it will be a game-changer.

If we are right about this potential regime change (which we might not be!), we know the shift won’t be linear. We believe unprofitable growth names are currently quite oversold making a bounce likely. It’s less clear whether this group could sustain any relative outperformance.

People love so-called “growth” companies and “compounders.” It’s understandable why. They’ve driven the market’s historical returns. Hendrik Bessembinder of Arizona State calculated that 4% of companies accounted for the entirety of the market’s wealth creation between 1926 and 2016.

Warren Buffett famously said, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” He’s exactly right. We love those type of investments too, at the right price. That approach has attracted a wide following, which has driven up prices.

It’s certainly not better to buy a wonderful company at a highly inflated price. Buffett’s partner Charlie Munger recently summarized the risk well: “There’s no great company that can’t be turned into a bad investment just by raising the price.”

The outlook for high multiple favorites depends to a great degree on interest rates. Warren Buffett likened interest rates to the force of gravity for asset prices. At current low levels, high valuations on long-duration assets can be justified. If interest rates move up, the adjustment will be painful. Market action early in the new year, with the swift moves up in interest rates and down in the Nasdaq, offers a taste of the medicine.

We underwrite all our names to have sufficient upside even if risk-free rates move up to 3% (a scenario, not a forecast!). As we evaluate the opportunity set, we find more attractive prospects in the classic value names. We often hear that people think value investing is dead, which only strengthens our conviction. Our gross exposure to classic value has risen from 44% a year ago to 62% currently.

One new name that illustrates the potential we see is Ovintiv (OVV), an oil and gas producer. We’ve seen a huge shift in the industry away from growth towards returns on capital, cash generation, and capacity discipline. OVV exemplifies the change.

OVV’s new CEO Brendan McCracken says: “We are at the forefront of driving innovation to produce oil and gas from shale both profitably and sustainably. We will generate superior returns and free cash flow by continuously improving capital efficiency and expanding margins while driving down emissions. We will deliver that value to our shareholders through disciplined capital allocation.”

Based on crude at $65 (well below the current $83.82 as of 1/14/22), the company guides to free cash flow generation of $11B over the next 5 years and $21B in the next 10 years. The company’s market cap is currently $10B and its enterprise value is $16B. It’s returning a significant portion of the capital to shareholders. If crude averages $70 in 2022, the company will return $700M to shareholders (in addition to paying down a significant amount of debt), which implies a yield of 7% at the current $39.53 price. In other words, there’s a good shot the company will return nearly its entire market cap to shareholders over the next 5 years.

Many growth companies, on the other hand, are expected to lose money for the next 5 years. The value of any investment is the present value of its future free cash flow. Long-term cash generation potential matters greatly, but so do the time and investment required to generate it. The future is always uncertain. If you can recover your entire investment within 5 years with reasonable likelihood, it makes waiting many, many years to generate any profits increasingly hard to justify, especially if those profits depend on growth that is much less certain.

Moving on to names we added to most aggressively during the selloff late last year, we especially like travel companies hit hardest by the pandemic. The emergence of the Delta then the Omicron variants of Covid-19 in the second half of 2021 pressured re-opening names. This dynamic reminds us of 2011.

After a strong recovery from the financial crisis lows, the market sold off in late 2011 due to fears about a Eurozone debt crisis and breakup. The market’s knee-jerk reaction was to sell off names that did the worst in the financial crisis, like banks and homebuilders.

Some homebuilders, like Pulte Homes (PHM), traded down to half their financial crisis lows despite early signs of housing fundamentals improving. This sharp divergence between the stock prices and the fundamentals created a great buying opportunity. Homebuilders were top performers in 2012, with Pulte gaining triple digits and many others posting similar gains.

I remember writing about the attractiveness of JP Morgan (JPM) right before it lost about a third of its value in the third quarter of 2011 (which didn’t please some of my colleagues!). I believed JPM was a high-quality bank whose prospects were undervalued due to the overhang on the space. It made money every year through the financial crisis.

In the decade-plus since then, JPM has beaten the market nicely (+417% versus SPX +345%) despite significant headwinds for banks (S&P Financial Sector +286%) and value stocks. Low market expectations are a key ingredient to attractive long-term returns!

An earthquake after-shock metaphor helps to explain the situation. Earthquakes relieve tension in physical systems, but aftershocks are common. These aftershocks aren’t as serious as the original event because stresses have been relieved. The financial crisis alleviated tensions in the financial system as weaker players either perished or were shored up with capital. Lessons learned impacted behavior (lower risk-taking behavior and higher propensity for monetary authorities to intervene supportively), which reduced future risk.

Those realities didn’t matter in the short term, but they sure did in the long term.

Since the March 2020 Covid-market crash, we’ve experienced a gradual recovery from the pandemic. While the initial days of the pandemic entailed a complete societal shutdown and an immunologically naïve population, today is different. We have significantly more freedom (at least in the US), the population has immune protection from vaccines and prior infections, and the latest Omicron variant appears more benign than previous strains (which follows the historical pattern of how pathogens evolve).

The actual risk to businesses hit hardest by the pandemic is very different today than it was 12-18 months ago. Yet in the latter half of 2021, airlines and cruise lines traded back down to prices we haven’t seen since before November 2020, before we got the astonishingly strong vaccine efficacy data.

Stan Druckenmiller, another master of investing, talks about how he always envisions the world in 18 months when selecting investments. That strategy works because it’s virtually impossible to predict the future with any accuracy. It is possible to extrapolate some trends, especially when they feature reversion to the mean from an extreme.

We’ve healed greatly from the worst days of the pandemic, and we expect that to continue going forward. We see the greatest disconnects between current market expectations and 18-months-out fundamentals in names like Norwegian Cruise Lines (NCLH) and Delta Airlines (DAL).

Delta is a quality airline with shareholder-friendly management. It was the only one not to issue equity during the pandemic. It was also the only profitable airline in the second half of 2021. It generated positive operating cash flow despite business and international travel weakness. When earnings finally normalize, which the company doesn’t expect until 2024, it should earn more than $7/share. After bouncing significantly off the lows, DAL currently trades at $41.99 or less than 6x those earnings.

We’ve believed for over a decade that the US airlines are better businesses than they’ve historically been. Consolidation led to a more rational industry. These companies shifted from growth at any cost to a return on capital mindset, the importance of which can’t be understated. We previously believed a recession would finally demonstrate the group’s improved resilience.

Unfortunately, a global pandemic did exactly the opposite. Buffett, who bought the airlines after being a critic of their historical capital destruction, sold his airlines early in the pandemic due to the risk. The government offered support to the industry due to their national strategic importance, which we believe offers protection against another worst-case scenario. We still believe Delta is a better business than the market gives it credit for and one whose prospects will be materially different 18 months from now. As patient investors, you can expect us to hold tight.

Norwegian is in a similar boat (pun intended). The pandemic battered cruise lines more than any other industry. Cruises were halted and have been slow to resume. The companies burned capital and took on debt. We initially invested in late-2020 after we had clarity on vaccines. At that time, we believed we could analyze the ultimate damage to the balance sheet and the implications for valuation.

Norwegian plans to return all its ships to sea by late this spring. Business should normalize over the coming years. Given the mRNA vaccine producers indicated they could produce specialized vaccines for Omicron by March, we didn’t see significant risk to our outlook of normalization. We like Norwegian the best because it’s the smallest operator with the best long-term growth potential, which we think this just-in-time market ignores. Classic time arbitrage!

We believe business will normalize over the coming years. We believe Norwegian can continue to grow earnings per share roughly in the mid-teens beyond that. We think the most likely scenario is for it to return to profitability later this year. If we look out 3-5 years, we think the company can earn $3 in early years and has the potential to earn over $6 per share in later years in some scenarios. Historically, the company has traded at multiples in the mid-teens or higher. If we use the low end of its historic range of 13x, we still get values double or triple the current price ($23.20) in a few years. Our discounted cash flow scenario analysis supports this view.

As of this writing, the market is coming around to our view with NCLH up 12% year-to-date and DAL up 7%, while the market (SPX) is down 1.5%. The market discounts the future, which is why these stocks act well despite the surge in coronavirus cases. We still see much more potential for these names.

One phenomenon that we’ve continually noted over the past decade: the unique juxtaposition of cautious sentiment with such extremely strong market returns. From the lows in March 2009, the S&P 500 has gained 18.6% per year on average – well above the 9.7% average since 1927.

People have bemoaned the poor return and heightened risk prospects nearly the entire time. Until recently, equity flows were negative. They still aren’t as strong as bond flows despite very low (and sometimes negative!) interest rates. This created a prosperous investing environment for anyone whose primary concern was making money. Those primarily focused on risk and volatility have been missing a great opportunity.

We think the general calculus remains the same. We always refer to Sir John Templeton’s famous saying: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” We’ve mentioned previously our belief that we’ve moved into the later stages of optimism. However, there’s ample evidence that skepticism remains abundant (especially in certain areas of the market).

Historically, market returns remain strong after a 20%+ return year. Strategas calculates the S&P 500 averages returns of 11.3% the following year, with positive returns 69% of the time. Yet according to Birinyi Research, Wall Street firms forecast 2022 returns of only 3.8%. We know these forecasts are worthless, but they do speak to the prevailing sentiment.

Barron’s recently noted that the University of Michigan Index of Consumer Sentiment dropped 13% to 70.6 in 2021 – the worst end-of-year reading since 2008, the deepest, darkest moments of the financial crisis!

The S&P 500 lost 38% that year in sharp contrast to last year’s 28% gain. Until now, we’ve never before had back-to-back double-digit declines in sentiment with double-digit gains in markets.

This skepticism is confirmed elsewhere. The American Association of Individual Investors sentiment survey shows only 45% bulls, and the CBOE Skew Index, which tracks the cost of tail-risk protection, remains elevated. Under the market surface, signs of caution abound, with defensive names outperforming offensive ones last year.

Given the inverse relationship between market returns and sentiment, we find these readings encouraging. Bull markets typically don’t die under such conditions.

Truly, no one knows what the future will bring. What we do know is that our approach has a long history of delivering returns. We’ve successfully delivered annualized excess return against our benchmark, the S&P 500, since the Strategy’s inception in December 1999. Our process is based on an approach that has worked for 40 years. We strongly believe holding a portfolio of attractively valued companies with improving prospects during a strong, but much-maligned, recovery is a recipe for success. Not linear success, but long-term success.

We thank you for your support and interest, especially during our more challenging times. We have high conviction in our current portfolio and will work our hardest to deliver on the return potential we see for our investors.

Samantha McLemore, CFA

Strategy Highlights by Christina Siegel, CFA

During the fourth quarter of 2021, Miller Opportunity Equity returned -7.32% (net of fees) versus its unmanaged benchmark, the S&P 500 Index, return of 11.03%.

Using a three-factor performance attribution model, selection, interaction, and allocation effects contributed to the portfolio’s underperformance. Taylor Morrison Home Corp., Matterport Inc., Diamondback Energy Inc., Tivity Health Inc., and Acuity Brands Inc. were the largest contributors to performance, while Stitch Fix Inc., Splunk Inc., Norwegian Cruise Line Holdings Ltd., iShares 20+ Year Treasury Bond ETF P140 1/23, and Teva Pharmaceutical 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, and Utilities, the portfolio was underweight these groups. The portfolio was moderately underweight the Communication Services, Consumer Staples, Health Care, and Materials sectors and more dramatically underweight the Information Technology sector.

The portfolio added five positions and eliminated nine positions during the quarter, ending the quarter with 43 holdings where the top 10 represented 38.2% of total assets compared to 29.3% for the index, highlighting Opportunity’s meaningful active share of 89.6%.

Top Contributors

    • Taylor Morrison Home Corp. (TMHC) rose 35.6% during the quarter benefitting from a decline in interest rates early in the quarter which reversed in December. Taylor Morrison reported solid Q3 earnings with orders of 3,372 beating consensus expectations of 3,265 with homebuilding revenue coming in at $1.77B versus $1.73B expected. Gross margins ex-charges came in at 21.2% ahead of consensus of 20.3% leading to Earnings Per Share (EPS) of $1.34 versus $1.20 expected. The company expects gross margins and community count to continue to increase in Fiscal Year 2022 (FY22). Lou Steffens was named as successor to current CFO Dave Cone who is set to retire at the end of calendar 2021. The company renewed its $250M share repurchase program through June 2024.

    • Matterport Inc. (MTTR) continued to be a strong contributor during the quarter after Matterport’s ability to contribute to the building of the metaverse was brought to light. The company reported 3Q results that missed consensus due to unexpected supply constraints and labor shortage in its capture services. The company reported total sales of $27.7M below consensus of $29.1M but with gross profit beating coming in at $15.2M versus $15.1M expected leading to an EPS loss of -$0.06 slightly better than consensus of -$0.07. The company lowered full-year revenue guidance to $107-110M down from $120-126M previously while also lowering FY22 topline guidance to 50% growth from 65% at the time of the PIPE transaction due to continuing supply constraints and labor shortage.

    • Diamondback Energy (FANG) returned 14.4% in the quarter as oil price rose and fell during the quarter ending the period largely in the same place that it started. The company reported strong 3Q results beating on the top and bottom line. The company reported revenue of $1.9B beating consensus of $1.5B with EPS of $2.94 beating expectations for $2.79. The beat was driven by a combination of higher volumes, higher realizations, and efficiency gains. The company increased its total production guidance for the year to 370-372mboe/d1 (up from 363-370mboe/d) while lowering Capital Expenditure (CAPEX) guidance for the second time this year to $1.49-1.53B. The company raised the dividend for the third time this year to $2/share annually while authorizing a new $2B share repurchase program. Starting in 4Q21, the company plans to return 50% of Free Cash Flow to shareholders through the base dividend and a combination of buybacks and special dividends. Finally, the CEO Travis Stice announced plans to reduce methane emissions by 70% as part of the firm’s ESG initiative.

Top Detractors

    • Stitch Fix Inc. (SFIX) fell 53.8% during the quarter after providing weaker than expected guidance. The company reported Q4 earnings that beat with revenue of $581.2M (+18.5% year-over-year (Y/Y)) coming in above consensus of $571M (versus guidance for $560-575M) while adjusted Earnings Before Income Taxes Depreciation and Amortization (EBITDA) of $38.2M exceeded consensus expectations of $18M. Active clients grew 11% Y/Y to 4.18M missing expectations with the company guiding for active subscriptions to go negative in 2Q. Management guided for F2Q22 revenue of $505-520M (0-3% Y/Y), below consensus of $585M while also lowering its FY22 guidance to “high-single-digit” Y/Y growth from >15% previously. While the stock hit a low not seen since the beginning of COVID, the company recently announced a new $150M share buyback program in early January.

    • Splunk Inc. (SPLK) declined 20.3% following the announcement that CEO Doug Merritt is stepping down and will be replaced on an interim basis by Graham Smith, Chair of the Board of Directors and previously Executive VP of Finance at Salesforce. The company reported FY3Q total revenue of $664.8M vs $645.2M expected with operating margins coming in at -9% versus consensus at -16.3%. The company provided 4Q guidance which disappointed with total revenue expected to be between $740-790M below consensus of $825M with non-GAAP operating margins of -2% to -8% worse than consensus of 1.9% due to continued investment in customer satisfaction as they work to move their legacy customers to the cloud. For the full year the company expects revenue of $2.51-2.56M vs consensus of $2.544M with non-GAAP operating margins of -15% to -17% worse than expectations of -14.9% and operating cash flow of $100M vs consensus of $116M. Finally, the company also provided 2023 preliminary guidance of Cloud annual recurring revenue (ARR) of at least $2B versus consensus of $2B and Total ARR of $3.9B versus $4.06B expected.

    • Norwegian Cruise Line Holdings Ltd (NCLH) continued to get hit from worsening headlines in relation to the Omicron variant. The stock declined 21.5% during the quarter following worse-than-expected 3Q results. The company reported revenues of $153M below consensus of $247M with EPS coming in at -$2.17 versus expectations for -$2.04. The company reported that 40% of its capacity was operating by the end of 3Q and they expect 75% to be operating by the end of 2021 with the full fleet back up and running by April 1, 2022. They also highlighted that they expect to be operating cash flow positive in late 1Q22 and profitable for the second half of 2022. The company announced a refinancing transaction, issuing $1Bn of new 1.125% exchangeable notes due 2027 and raising another $1.1Bn through the sale of 46.8M new shares at $23.64. Proceeds are being used to redeem up to $1.215Bn of debt with a blended interest rate of 8.1%, implying annual interest savings of $88M. The company was hit later in the quarter following CDC commentary that even vaccinated travelers should avoid cruises in addition to negative headlines around a new proposed carbon dioxide emission fee on ship owners. Based on Norwegian’s 2019 emissions, the proposed fee would be equal to 20% of NCLH’s Earnings Before Income and Taxes (EBIT) in 2019. The decision is not final and could take up to 2-years before countries decide to adopt the decision.

Top Contributors and Top Detractors
Top Contributors Ticker Return Contribution (basis points)
Taylor Morrison Home Corp. TMHC 35.0% 75
Matterport Inc. MTTR 20.9% 61
Diamondback Energy Inc. FANG 14.2% 45
Tivity Health Inc. TVTY 14.6% 41
Acuity Brands Inc. AYI 16.1% 32
Top Detractors Ticker Return Contribution (bps)
Stitch Fix Inc. SFIX -52.4% -9
Splunk Inc. SPLK -20.1% -73
Noewegian Cruise Line Holdings Ltd. NCLH -22.3% -69
iShares 20+ Year Treasury Bond ETF P140 1/23 TLT 1/20/23 P140 -34.9% -57
Teva Pharmaceutical. TEVA -17.8% -52

Performance Attribution

Click on image to view larger.

The data provided is from FactSet Research Systems 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. Parentheses indicate a negative number.
*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

Christina Siegel's 4Q 2021 Market Highlights

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.

1mboe/d means thousand barrels of oil equivalent per day.

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.

©2022 Miller Value Partners, LLC