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Apr 22, 2019

It Pays to Be a Price and Value Investor

Samantha McLemore

Opportunity Equity 1Q 2019 Letter

Opportunity Equity underperformed its benchmark, the S&P 500, by a hair for the quarter. We ended the quarter up 13.56% (net of fees) versus the S&P’s 13.65% gain. We were ahead by far more for most of the quarter; at the end of February, we led the market by nearly 800 basis points. In March when the yield curve inverted, people got more concerned about the end of the business cycle again, which tends to hurt some of our holdings. But if the quarter had ended a day earlier or a day later, we would have beat the index by 94bps and 121bps, respectively.1 A great example of the joys of the calendar in the investment business.

Overall the quarter challenged active managers, as noted in the Bloomberg article titled “Active Fund Managers Get Blown Up Again After Hot Start to 2019.” In this context, our results seem better. Regardless, we don’t tend to pay much attention to short-term results. Our long-term results carry significantly more weight in our minds. Since the inception of the Strategy, it’s grown at an average annual rate of 6.8% (net of fees), which is more than 20% greater than the S&P’s 500’s annual growth rate of 5.5% over the same period.

The broader trend for the quarter entailed a significant recovery from the fourth quarter swoon, as people (mostly) realized that slowdown fears were overdone. The Fed shifted their tone from “gradual tightening” to “patient,” which helped allay fears of the worst and, in our opinion, boosted the odds of a “soft landing,” which means a more prolonged period of economic growth. This would be quite good for our portfolio since we believe many economically sensitive names have been systematically mispriced since the financial crisis lows. People have focused myopically on minimizing risk and volatility rather than on making money. Ironic given we’re in the midst of one of the biggest bull markets in history accompanied by one of the longest economic recoveries in history.

Sir John Templeton, one of the greatest investors of the 20th century, whose Templeton Growth Fund led all mutual funds during his tenure as manager, distinguished between “outlook and trend” investors and “price and value” investors. The former are primarily concerned with the outlook for the economy and the market, and want to understand the current and future trends. The latter primarily are trying to figure out the value of a business and compare that to its current price to see if it is a bargain. Templeton believed that about 90% of those in the market were outlook and trend investors, while a small minority, such as Sir John, Warren Buffett, Charlie Munger and ourselves, focus on trying to figure out what a business is worth and try to buy such businesses only when we can do so at a large discount to our assessment of underlying value.

Given the devastating effects of the Great Recession on people’s investment portfolios, fear of a repeat of something similar has weighed down valuations of names where risk is perceived to be high, including economically sensitive names (especially relative to more defensive areas of the market). When we have periodic market swoons on recession fears, cyclicals fare worse than the broad market. Taking the other side of that wager and focusing on the long term has been a profitable trade indeed, which is a big reason why Opportunity has delivered more than 450 basis points of annual outperformance over the index in the past decade since the financial crisis low.2

We remain very excited about the prospects for the portfolio. Currently, the embedded upside to our estimate of the underlying value of the companies exceeds 100% again, which is towards the higher end of what we’ve seen historically. It has been one of the better buy signals. The portfolio continues to trade at a deep discount to the S&P 500, 9.7x forward earnings versus 17.2x for the market!

We continue to sift through lots of new ideas. One new name, Baidu Inc, made it into the portfolio in the quarter. We funded this by selling Newell Brands, which we exited shortly after quarter end. We didn’t own it very long and it was a mistake that we chose to exit quickly as the turnaround stumbled. We believe Baidu has significant upside and excellent long-term prospects. Baidu is one of the top Chinese Internet companies with a wide range of businesses from search to video-streaming to autonomous driving. It is one of the leaders in artificial intelligence and machine learning. The stock fell from a peak of $284 to a low of $154 as the Chinese economy weakened and Baidu ramped investments to position it well for the long term. The market hates investments that hurt profits, but if successful they can pay off handsomely, as we believe Baidu’s are likely to do. We believe we paid a good price too. When we were buying shares, they were trading at roughly 10x trailing “core” profits (excluding iQiyi’s (mini version of Netflix) losses) despite attractive growth prospects. This is a name that we think has the potential to be both cyclically and secularly mispriced, our favorite combination.

One of the most important ways we think about diversifying the portfolio is between cyclically mispriced securities (classic “value” stocks) and secularly mispriced securities (companies whose underappreciated growth prospects enable them to compound capital over long periods of time). This positioning gives us a shot at doing well in both “growth” and “value” markets.

There’s been a lot written about how growth companies have beaten value companies for an extended run. There are significant deficiencies in how growth versus value is defined. Nonetheless, we’ve managed to do well in a “growth” regime. In a low growth environment, there’s no reason to think this will change anytime soon. However, if we ever finally get inflation, and thus nominal growth, to pick up a bit, that would boost the prospects of classic value stocks. We think many names in the portfolio would do quite well in such an environment, such as airlines, semiconductors, and our financials. Yet, we obviously don’t require such a scenario to do well, as exhibited by our results.

The similarity that runs through all of our investments is a patient, long-term orientation focused on buying securities that trade at significant discounts to our assessment of the underlying fundamental value. This approach has served us over the long term. We expect it to continue to do so. In a world focused on trend and momentum, it pays to be a price and value investor.

Samantha McLemore, CFA

Strategy Highlights by Christina Siegel, CFA

During the first quarter of 2019, Opportunity Equity returned 13.56% (net of fees) versus the Strategy’s unmanaged benchmark, the S&P 500 Index, return of 13.65%.

Using a three-factor performance attribution model, selection effect contributed to the Strategy’s performance but was offset by allocation and interaction effects. Avon Products Inc. (AVP), Bausch Health Companies Inc. (BHC), Celgene Corp. (CELG), OneMain Holdings Inc. (OMF), and Inc. (AMZN) were the largest contributors to performance, while Genworth Financial Inc. (GNW), RH (RH), CenturyLink (CTL), Newell Brands Inc. (NWL) and Intrexon Corp. (XON) were the largest detractors.

Relative to the index, Opportunity was overweight the Consumer Discretionary, Financials, Health Care, Communication Services 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, and Consumer Staples sector. In terms of sector allocation, the overweight position in the Health Care sector, which underperformed the index, detracted the most from the Strategy’s relative performance. On the other hand, the overweight in Consumer Discretionary, which outperformed the index, contributed the most to relative performance.

We added one position during the quarter, ending the quarter with 40 holdings where the top 10 represented 41.9% of total assets compared to 21.3% for the index, highlighting Opportunity’s meaningful active share of 99.9%.

Top Contributors

    • Avon Products, Inc. (AVP) increased 93.3% over the quarter. The company announced a 10% reduction in global headcount, a 25% reduction in SKU count and a 15% reduction in inventory. Their 4Q results showed signs of progress but were below consensus with sales of $1.40B versus expectations of $1.43B with adjusted EBITDA of $107M below consensus of $127M. The company did see progress in their price mix, average rep sales and average orders which were up 6%, 4%, and 5%, respectively. Near the end of the quarter, Avon gained after it was reported that the company is considering a sale to Brazil’s Natura.

    • Bausch Health Companies Inc. (BHC) gained 33.7% over the period. The company reported 4Q results which beat expectations but disappointed on guidance. The company reported 4Q Revenue of $2.12B beating consensus of $2.08B, EBITDA of $858M compared to the Street at $824M and EPS of $1.03 versus $0.84 expected. The company guided for 2019 revenue of $8.3-8.5B below consensus at the midpoint ($8.4B versus $8.47B), EBITDA of $3.35-3.5B (consensus $3.43B), and operating cash flow of $1.5-1.6B. The company reiterated long-term guidance of a 3-year revenue CAGR of 4-6% and EBITDA CAGR of 5-8%. Bausch paid off $100M of its outstanding debt balance helping to reinforce its commitment to debt reduction.

    • Celgene Corp. (CELG) was up 47.0% after Bristol-Meyers Squibb (BMY) announced their proposed acquisition of Celgene for $50 in cash per share and 1 share of the combined company for an approximate total value of $102.43 per CELG share (based on BMY closing price 1/2/19). There is potential for an additional $9/share if ozanimod, liso-cel and bb2121 are approved by the FDA by stated deadlines. The acquisition is expected to close later this year. The acquisition proposal gained ISS backing, which stated the proposed transaction has “sound strategic rationale and the valuation appears reasonable”.

Top Detractors

    • Genworth Financial Inc. (GNW) declined 17.8% after its acquirer, China Oceanwide, disclosed its auditor resigned. The company also announced disappointing 4Q18 results. The company reported an operating loss of $0.58 compared to consensus of $0.26 due to significant charges in the life insurance division. The company is still waiting on approval from Chinese and Canadian regulators and FINRA for their acquisition by China Oceanwide.

    • RH (RH) declined 14.1% over the period after releasing mixed 4Q results and disappointing on 2019 guidance. The company reported 4Q EPS of $3.00 ahead of consensus of $2.86 driven by lower expenses and share buybacks. The company’s FCF generation disappointed coming in at $163M in 2018 below guidance of $260M due to lower than expected 4Q sales. For 2019, the company expects revenue growth of 3-5% lower than the 8-10% previously guided. The company is guiding for EPS of $8.41-$9.08 lower than previous guidance of $8.97-$9.90 and lower than expectations of $10.12. The company is pushing back the opening of their RH Guesthouse in NYC to Spring 2020 and they have pushed back the debut of RH Color to 2020. RH will no longer report comparable sales going forward. The company announced the promotion of Jack Preston, currently senior VP, finance and chief strategy officer, to CFO while current CFO, Ryno Blignaut will step down for health reasons.

    • CenturyLink Inc. (CTL) declined 19.3% after reporting 4Q results and cutting the dividend to $1/share from $2.16/share, a yield of 8%. The company reported an EPS of $0.37 ahead of consensus of $0.32. The company guided for 2019 adjusted EBITDA of $9.0-9.2B versus consensus of $9.08B and free cash flow of $3.25B at the midpoint versus consensus at $3.28B. The company is focused on bringing its leverage down to 2.75-3.25x over the next three years. Later in the quarter the CEO, Jeffrey Storey, and CFO, Indraneel Dev purchased $991K and $587K of stock, respectively.

View our 1Q Infographic and read our 1Q 2019 Market Highlights for a recap on what drove market performance.

Past performance is no guarantee of future results. 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.

1Opportunity Equity representative account performance, net of fees.
2Opportunity Equity representative account performance, net of fees for the period 3/9/09 - 3/31/19.

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