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Apr 27, 2021

Learn to Earn!

Samantha McLemore

Opportunity Equity 1Q 2021 Letter

“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.”
– Leon C. Megginson, in paraphrasing Charles Darwin

“Learn as though you would never be able to master it; hold it as though you would be in fear of losing it.”
– Confucius

“He who learns but does not think, is lost! He who thinks but does not learn is in great danger.”
– Confucius

“That is what learning is. You suddenly understand something you’ve understood all your life, but in a new way.”
– Doris Lessing

“The only source of knowledge is experience.” – Albert Einstein

The first quarter of 2021 ranks as one of our top quarters. Miller Opportunity Equity posted solid gains, up 16.16% (net of fees), which ranks it as our 13th best in history. This compares to our benchmark, the S&P 500’s 6.17% gain. That’s not what makes this quarter noteworthy though. We strive to deliver excess returns and, over the long term, that is how we should be assessed. But it’s our investment philosophy and process that determine those outcomes. As part of our approach, we emphasize continuous learning and improvement. This quarter offered many notable lessons and chances for improvement.

Let’s reflect on the extraordinary occurrences of the first quarter. First, the Reddit-fueled short squeeze of perennial shorts, like GameStop, nearly drove successful hedge funds like Gabe Plotkin’s Melvin Capital and even venture company Robinhood out of business. Next, a quick move up in interest rates shocked high growth, high valuation darlings, causing significant drawdowns in growth funds, like Cathie Wood’s ARK Innovation fund, which corrected 33%. As if that weren’t enough, losses on family office Archegos’ over-levered portfolio destroyed owner Bill Hwang’s $20B fortune in only 2 days, inflicting billions of dollars of pain on a number of banks and crushing stocks like ViacomCBS which lost a shocking 60% in merely 4 trading days (our own Farfetch and Discovery were also caught up in the mess). A strong quarter was littered with landmines.

The market provides bountiful opportunities for learning and improvement. The quotes cited above from Nobel Prize winner Doris Lessing and Albert Einstein really drive home the importance of experience in enhancing understanding and changing behavior. People always understood the importance of saving money to financial security, but the Great Depression and the Financial Crisis (so far) permanently altered behavior, leading to more conservatism in savings and investment. We all know about the risk of infectious disease but there’s good reason people expect our recent pandemic experience to leave lasting consequences (though it’s entirely unclear what exactly they will be).

So what exactly can we learn from this quarter? Mostly, it reinforces lessons we know. We always think about risk relative to reward. We haven’t historically shorted much given the poor skew. You can only make 100% but are exposed to unlimited losses. Additionally, as a position moves against you, it becomes a larger part of your portfolio, exactly the opposite of longs!

Historically, this risk mostly remained theoretical. People believed that shorting stocks against long positions lowers risk. It does decrease systematic market risk and volatility to have a part of your portfolio that benefits from falling prices, but at what cost? In our view, shorting can clearly enhance overall risk, which we define as permanent impairments of capital. Shorts have unlimited potential losses, which are dangerous. Additionally, markets mostly rise over time so the trend is not your friend. It’s virtually unheard of for an unlevered, diversified, long equity portfolio to go to zero. The GME situation demonstrated one ugly short has the potential to wipe you out.

In a market where internal mechanics have increased stock specific volatility and extreme moves, the risk from shorting has likely grown. On the other hand, the opportunity to profit from market prices that move in excess of fundamentals (our core approach) has grown. In the quarter, ~31% of the names in Opportunity had peak-to-trough price declines greater than 30%, which compares to 38% of the Russell 2000 (and only 8% of the larger-cap S&P 500).

We try to “monetize volatility”. We think like owners of businesses, because we are, and we invest for the long term. But public markets offer the very valuable option of transacting every day if prices get out of whack. As the Black-Scholes options pricing model clearly enumerates, volatility enhances the value of options. If you compare public market valuations to private market ones, I think public market investors pay little for this valuable benefit. In order to capitalize on it, one must be agile, opportunistic and have a strong sense of when extreme moves are justified versus not. We believe we are qualified to do just that.

Here’s an example of how we benefit from volatility. We own Rocket Companies which we think is a great mortgage finance company with a successful history of innovation, growth, and cash generation. We think Rocket has several competitive advantages, including its technology and marketing platforms. One way this manifests is retention rates far superior to the rest of the industry (client and refinance retention rates of 80%+ versus less than 20% for the industry).

Rocket went public last year amidst record low interest rates that led to record revenues, margins, and profits. Rising interest rate concerns have kept a lid on the stock. We bought it last year after doing work on what the longer term potential looked like, as well as what earnings might be in a more normalized environment. We think Rocket is a great example of “time arbitrage.” We are taking the long view when others focus on the coming quarters.

The stock is in the $20s, and we believe it could be worth many multiples of that over the next decade. We intend to be long-term owners. This quarter, the price surged 70%+ in one day and more than doubled over 3 days. This brought it close to our estimate of its present value. Given our assessment of the risk (downside in scenarios of quickly increasing rates) relative to our upside, we exercised our liquidity option, so to speak, and sold 21% of our position during the surge. We don’t love to trade around our positions, but we do intend to capitalize on volatility to create value when we get the chance.

Discovery, Inc. was one of the top performers in our portfolio, and the market, for much of the quarter. In the middle of March, it was up nearly 160% year-to-date. We sold almost half of our position in the quarter, which was a good move since it dropped 56% in a matter of days. On the other hand, we added to Farfetch after it got caught up in the Archegos liquidations and traded down over 40% from the highs.

Volatility creates opportunity (and in certain situations risk as well, although we do not equate volatility with risk). We view risk as permanent impairments of capital, or the possibility one won’t meet their investment objectives over their time horizon.

Our disciplined process of thinking carefully about fundamentals relative to market expectations helps us identify opportunities and risks. Our contrarian and long-term orientation enables us to optimize for long-term returns, rather than short-term volatility. We think that makes us distinct. Since the financial crisis, we’ve grown fond of saying that volatility is the price you pay for excess returns. This may not always be the case, but we will use it as we seek to enhance long-term returns as long as the opportunity exists.

We do not contend we know how to time stocks or markets. We see it much the same as Warren Buffett. After he wrote his noteworthy piece, Buy American, I Am, in October 2008 at the depths of the financial crisis, someone asked him how he knew it was the right time to buy stocks. His response: he didn’t know time, he knew price. No one knows the future, including the most noteworthy prognosticators out there. We aspire to something simpler: finding divergences between prices (expectations) and intrinsic value (fundamentals). We look at long-term discounted cash flows in a variety of scenarios. We are patient in allowing the fundamentals work in our favor over time.

As a young analyst, I remember being shocked when I first heard my boss, Bill Miller’s response to the question, “what is investment success?” and he replied that over the long term it was simply “survival.” Isn’t that the lowest possible bar, I wondered, full of youthful ambition and naivety. As Bill explained and I’ve come to know firsthand: not at all! Investment management is exceedingly competitive. To survive, one must perform well in a variety of environments. Outperforming the market net of fees is extremely difficult. Doing so through various market environments is almost impossible.

The very same attributes that lead to outperformance and success in one market sow the seeds of demise in the next. To outperform in the late 90s, you needed a technology-focus and growth orientation. When the tech bubble burst, those who didn’t adjust were crucified. During the 2000s, global cyclicals led the pack, but this attracted vast amounts of capital that drove down returns in subsequent years. Again, one needed to pivot to do well.

During the extreme losses of the financial crisis, those positioned conservatively with defensive and stable securities fared much better. Since those market lows, we’ve experienced one of the strongest bull markets in history (S&P 500 +18%+ per year off the March 2009 lows) where those same traits have caused many funds to seriously lag. One must continuously learn and adapt to stay ahead, but must also avoid learning the wrong lessons.

According to a recent Bloomberg article, from 1990 through 2008, hedge funds earned average annual returns doubling the S&P 500. They justified their high fees. The same article notes that the same hedge fund index annualized 8% per year through February, roughly half the market’s return. Why? The painful financial crisis experience led investors to prioritize minimizing volatility over earning high returns. This environment creates the opportunity to profit from going the other way. Demand for volatility has been exceedingly low while supply continues to grow. We think this has created a mispriced “asset”.

Investing is always a mix of art and science. Thinking carefully about how the future will resemble the past and how it won’t is part of the art. We study behavior, both institutional and individual, to help us. It’s a fine balance to stay true to your process while being adaptable. It helps to have principles one believes can endure the test of time. For us, that’s an emphasis on intrinsic value.

We believe that when market prices diverge from intrinsic value, we can invest to drive excess returns. Buying mispriced businesses with good fundamentals helps you compound capital over time. We have strong conviction in our process. Yet, we always try to learn, improve, look for the places where we are wrong.

One quick last thought before I move onto the portfolio. This quarter I read an article about this fabulous study on siblings. I love it because of its lessons on how to maximize learning and success. The study looked at why younger siblings fared much better at competitive sports, reaching the highest levels of competition at a much higher rate. The answer: younger siblings are more challenged since they play with older siblings, operating at the “optimal challenge point.” Being challenged just beyond our abilities leads to the most improvement. Essentially, you need to make many mistakes for maximal progress!

As an investor, erring comes with the territory and the key is to learn from it. As a parent, I preach about the benefits of “failing” to my children who really hate messing up. As much as we hear about the benefits of a “growth-mindset” that truly embraces the advancement opportunities that failure represents, humans are wired to do the opposite.

On to the portfolio. We continue to like the diversification in the portfolio between classic value names and long-term growth compounders. The balance between the two buckets will be driven by our bottom-up assessment of the opportunity set.

In a quarter where growth names struggled, ours didn’t escape the pain. Some of our bigger names, such as Farfetch, Stitch Fix and Amazon were down in the quarter. High valuations combined with rising rates generated by a strong economic recovery provided headwinds to growth names in the quarter. We would expect this to continue and have adjusted our weights accordingly. On the other hand, our value names broadly did well and this more than offset the growth weakness.

Overall, our outlook for the Strategy remains positive, and we still see significant upside potential. After such a strong trailing twelve months (+160% net of fees), we’d typically expect the portfolio to take a pause as the market digests the huge move up. The pandemic recovery is behaving like a natural disaster normalization. We expect strong economic growth and corporate earnings growth and a continuation of fiscal and monetary support. These circumstances are anything but normal, and our base case is for the market to continue to advance.

We’ve already seen rolling corrections with the NASDAQ, the Russell 2000 Index, and the Russell 2000 Value Index all pulling back more than 10% in the quarter, peak to trough. The Russell 2000 Growth Index corrected 17% in the quarter. The larger, more stable S&P 500 Index fared better, losing less than 6%. Opportunity pulled back just less than 10% from its highs as well. We think this sets us up well going forward. Based on our internal central tendency of value (CTV) assessment1, we calculate there’s ~70% upside in the Strategy, which implies double-digit annualized returns over the next 3-to-5 years.

We had a number of buys and sells in the quarter, entering five net new names and exiting three names (with a couple new issuances we both entered then exited shortly thereafter). Our largest new position is General Motors (GM). General Motors is the leading US auto manufacturer, but what makes it unique is its aggressive plans to shift the business to electric vehicles by 2035. GM owns many interesting assets in the electric and autonomous space, from its battery technology platform to a majority investment in Cruise (autonomous company valued at $30B in the quarter) and BrightDrop, its electric commercial van. Trading at only 11x this year’s earnings and 9x next, we don’t think GM reflects much of this value, especially relative to companies like Tesla that trade at 168x earnings! Our sum of the parts analysis yields values well above $100 per year, more than 70% above the current $58 stock price.

We’ve owned Amazon for decades, but increased our position in the quarter through some long-term call options (Jan 2023 $3050 calls). Amazon has been trading around $3000 per share since last July, significantly lagging the market’s nearly 30% gain. We think Amazon has the potential to double over the next 3-to-5 years as growth continues and margins improve.

We also purchased Vontier, a spin-out from Fortive, which itself was a spinout from Danaher. Danaher’s unique approach to managing its business and acquiring companies created massive value over the years. Fortive pursued the same path. Vontier uses the same business and acquisition systems and offers similar potential. Vontier’s main businesses are gas station software and hardware and auto repair tooling. The market doesn’t value it similarly to the other two companies due to near-term business headwinds from passing a regulatory-led demand surge for its equipment and concerns about electric vehicle disruption. Management has already made some smart investments in the space and we believe it will deploy the same rational capital allocation policy that drove so much value at its predecessors.

Karuna Therapeutics is a biotech company we got to know through our holding in PureTech Health, which founded Karuna. Karuna is unique in that the main asset it has developed is largely de-risked since it’s a reformulated drug where there’s ample historical data. The company has a Phase 3 trial in schizophrenia psychosis. This indication has a large unmet need, with about two-thirds of patients either inadequately treated. We think the company has the potential to be worth about double where the stock is trading ($117).

We entered Metromile on a PIPE deal for a SPAC. Metromile is an “insure-tech” company with big plans to disrupt the auto insurance market. The company offers pay-per-mile pricing along with an AI-led, integrated approach to underwriting and claims management. The auto insurance market is very large and highly fragmented. Roughly two-thirds of people overpay for car insurance, subsidizing the one-third of people who drive the most. The management team is great and opted to focus on fix the unit economics before pursuing growth. The company just started marketing and, if it’s successful, we believe it will be worth much more.

We will continue to work our hardest to do well for our investors. Thank you for your interest and support.

Samantha McLemore, CFA

Strategy Highlights by Christina Siegel, CFA

During the first quarter of 2021, the Miller Opportunity Equity returned 16.16% (net of fees) versus the Strategy’s unmanaged benchmark, the S&P 500 Index, 6.17% return.

Using a three-factor performance attribution model selection and allocation effects contributed to the portfolio’s outperformance while interaction effects detracted slightly. Quotient Technology, Discovery, Bausch Health Companies, DXC Technology Company, and Diamondback Energy were the largest contributors to performance, while Precigen Inc., Farfetch Ltd., Genworth Financials Inc., Flexion Therapeutics and Vontier Corp. were the largest detractors.

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

The portfolio added seven positions and eliminated four positions during the quarter, ending the quarter with 50 holdings where the top 10 represented 33.7% of total assets compared to 26.3% for the index, highlighting the Opportunity portfolio’s meaningful active share of around 89.0%.

Top Contributors

    • Quotient Technology Inc. (QUOT) took off in the first quarter gaining 74% following the announcement of 4Q results, which beat expectations. The company reported revenue of $142.5M exceeding estimates by $21.5M, but gross margins disappointed coming in at 35% versus expectations for 46%. Earnings Before Income, Taxes, Depreciation, and Amortization (EBITDA) of $17.9M still beat expectations of $14.4M. The company issued long-term revenue growth guidance of 15-20%, with a more modest guidance for 2021 of 13%.

    • Bausch Health Companies (BHC) climbed 55% during the period. Glenview (6% owner) sent a letter to the company in early February arguing the company has not acted to unlock shareholder value and urging the company to sell its eye care business. Shortly after, activist investor Carl Icahn disclosing a 7.83% stake in the company. The company responded to the filing saying that they remain committed to splitting the business into two parts, but are open to pursuing all opportunities. The company reported strong 4Q results with better-than-expected 2021 guidance. 4Q revenue came in at $2,213M slightly ahead of consensus of $2,165 and EPS of $1.34 beat consensus of $1.12. The company guided for 2021 revenue of $8.6-8.8B coming in ahead of expectations of $8.55B with EBITDA of $3.4-3.55B ahead of $3.46B estimated. The company announced the transition of Paul Herendeen to an advisory role to be succeeded by Sam Eldessouky, previously senior vice president, controller and chief accounting officer. Finally, the company announced the sale of Amoun for $740M, which was relatively in line with estimates and should help support debt reduction targets ahead of the planned spin-off of Bausch + Lomb eye care business.

    • Discovery Inc. (DISCA) had a wild ride over the quarter rising 157% until it peaked in mid-March where it then preceded to fall 44% over the final 8 days of the quarter for a total period return of 44%. The company reported 4Q results with revenue coming in at $2.89B ahead of consensus of $2.83B, with operating income before depreciation and amortization (OIDBA) coming in at $1B above consensus of $934M leading to adjusted Earnings Per Share (EPS) of $0.76 versus $0.72 expected. The real surprise came in the strength in their DTC offering which ended the period with 11M global subscribers ahead of consensus, which was estimating 8M subscribers by this point. The company took a hit late in March having the largest one-day drop in the company’s history. Investors speculated the move was the result of the liquidation of positions of Archegos Capital Management resulting in the sales of $30B of stock.

Top Detractors

    • Precigen Inc. (PGEN) declined 30% following a strong gain in the fourth quarter of 2020. The company presented at the JPMorgan Healthcare Conference where they highlighted their plans to begin development and validation for an UltraCAR “off-the-shelf” library of non-viral plasmids targeting various tumor-associated antigens across a range of hematologic and solid tumor indications. The company noted that they expect to complete dose-escalation and initiate the expansion portion of the phase 1 study in 2021. The company reported preliminary data suggesting their Phase I study of PRGN-2009 immunotherapy for HPV associated cancers showed increased immune response on repeated administration of the therapy. The company raised $112.5M in new capital selling 15M additional shares at $7.50. The new capital will be used to rapidly accelerate their UltraCAR-T program into the clinic. In March, the company announced that they had received orphan drug status from the FDA for PRGN-2012 to treat recurrent respiratory papillomatosis. Finally, the company closed out the quarter by announcing the departure of CFO, Rick Sterling, effective April 2nd. The company has begun an executive search for a successor.

    • Farfetch Ltd. (FTCH) declined 15% during the period following a strong performance in 4Q20. The company reported 4Q results that showed strong platform GMV growth of 49% Year-over-Year (YoY) while also hitting EBITDA profitability for the first time. Management guided for 1Q21 GMV growth of 50-55% versus 49% expected with adjusted EBITDA of -$20M at the midpoint versus consensus of -$5M. For the full year, the company expects GMV growth of 30-35% slightly below consensus of 38% with EBITDA margin coming in at 1-2%. The company does not expect any meaningful contribution from their Tmall launch in 2021 and announced plans to launch beauty in Fiscal Year 2022 (FY22). The big announcement was the official launch of E-concessions as a Service, which has been a long-term goal of the company. While the stock saw some declines earlier in the quarter, it was further pressured by block trades that were associated with the liquidation of Archegos Capital Management.

    • Metromile (MILE) declined 33.7% during the quarter as the company completed its reverse merger with special purpose acquisition company (SPAC) INSU Acquisition Corp. II. The company hit a high of $19.97 on February 17 and then proceeded to follow the rest of the SPAC market down to finish the quarter at $10.29. The company reported 4Q and 2020 results ending the year with 92,635 policies in force (5% YoY growth) and guiding to end 1Q21 with 95,500-96,000 policies in force and to end the full year with 125k-133k (growth of 39% at the midpoint). In 2020, the company generated direct earned premiums of $99.7M below 2019 levels of $102.2M resulting from a reduction in driving due to the COVID-19 pandemic.

Top Contributors and Top Detractors
Top Contributors Ticker Return Contribution (bps)
Quotient Technology Inc. QUOT 73.5% 130.4
Bausch Health Companies Inc. BHC 43.5% 117.0
Discovery Inc. - A DISCA 52.5% 113.1
DXC Technology Company DXC 21.4% 93.5
Acuity Brands, Inc. AYI 48.7% 77.5
Top Detractors Ticker Return Contribution (bps)
Precigen Inc. PGEN -29.4% (76.9)
Farfetch Ltd. FTCH -16.0% (57.6)
Metromile Inc. MILE -33.6% (48.8)
Flexion Therapeutics FLXN -22.4% (24.7) Inc. AMZN -5.0% (18.9)

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 1Q 2021 Market Letter

Christina Siegel's 1Q 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.

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