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Sep 10, 2019

Navigating Short-term Volatility. An Interview with Samantha McLemore

Having worked in this industry since 2002, Samantha McLemore, CFA is no stranger to market volatility.  Becoming the assistant portfolio manager of Opportunity in 2008 gave her a front-row seat to see the impact of investor behavior. And, as is the case with bull markets, we’ve seen pullbacks throughout the last 10 years that shake investor confidence. How does a value investor navigate the turbulence, especially when your investment style seems out of favor? Samantha discussed in a recent interview. (note the interview has been edited and condensed for clarity)

Q: How are you navigating the recent market volatility?

As everyone knows, no one can predict the future. The S&P is currently 5% off the highs. We know that 5% pullbacks are normal and occur quite often, yet people freak out during a 5% pullback. We think it’s premature to call the end of the bull market and to call for a recession, but at the same time, risks have risen primarily on the trade side and on the possibility for a monetary policy error.

Brian Moynihan, the CEO of Bank of America, was on CNBC at the end of August talking about just how strong the US consumer remains. In just the last week, I heard a CNBC commentator, who has a portfolio of private companies, talking about never having seen the results of those companies be stronger. On the consumer side, we have a good amount of strength, but this is against the backdrop of slowing growth abroad and some weakness on the manufacturing and business side which Brian Moynihan acknowledged and attributed mostly to trade uncertainty.

One headline that’s surfacing over and over and over again is the inversion of the yield curve.  There’s a number of different ways to look at the yield curve, but now mostly all of them have inverted and that can be a signal that a recession is coming. However, it can have quite long lead times and the market can continue going up for a year or maybe even more than a year before the recession comes.

One thing we know is that the Fed has shifted from tightening last December to pausing and now to lowering rates. They lowered rates in July, but the market dropped significantly after that move. Then Trump announced increases in tariffs, which led to more weakness. So, those are the two things that I think will be very important to how things evolve going forward.

Trump is back and forth on this and it is all over the news. I think one thing is clear, which is that he does care what the market does. He’s a tariff man, a self-proclaimed tariff man, but at the same time he knows his election prospects hinge on the market and how the market does is important. So, I think, he’ll be watching both of those things. It’s hard to call which way it goes.

On the other side, the Fed has shifted to loosening rates, which is good. There were a number of regional Fed presidents out in mid-August talking about how they weren’t sure that we needed any more given the strengthening consumer. The market has predicted maybe more recessions than has occurred. The Fed has been consistently wrong in their track record of predicting a recession. The market is now pricing in 100% odds of a 25-basis point cut in September and two-third odds of another one in October. If the Fed disappoints on that, that will not be good. If they deliver what the market expects, that’s not ideal. And whether it’s enough will probably depend on trade. If they do more than the market is anticipating, that would be really good news.

I think the one thing that’s important to keep in mind is overall stocks still look better than all the alternatives. The dividend yield on the S&P500 is now 50 basis points higher than the 10-year Treasury, and it’s now even higher than the 30-year Treasury, which only happened briefly in the financial crisis. Those bond payments are never going to go up, yet, the S&P dividends historically go up 4% to 5% a year. Even bond managers at these levels should be going along the S&P and foregoing bonds because it’s just a much more attractive option. The key is if you can be long term and you can be patient, it makes it much easier. I think the market is attractive here even if we have some volatility in the short term.

So what have we been doing here in this environment where things are maybe a little murkier? We remain focused on companies and on where we can find investments that we think are going to do well over the long term in a variety of scenarios. We always are bottom-up investors. Our average holding period is three to five years and we really do try to think and act like owners of businesses. We focus on making investments at steep discounts to our assessment of what a company or security is worth. We know the future is uncertain, so we focus on probabilistic scenario analysis when we’re looking at the future. What we’re not trying to do, which is what most people do try to do in this market, is time the next news item or trade around a position. We’re trying to focus on the long term and build a diversified portfolio with significant upside. In this environment, we are much more tolerant of perceived risk when we believe the real risk is lower and we think that that’s been quite profitable. And finally, currently the portfolio trades at a deep discount to the market; it’s about 10x forward earnings versus the market closer to 18x. Even as a value investor, the magnitude of that difference surprises me because it’s just so steep.

Q: How does a value investor survive in a market driven by growth names?

I spent a good part of my quarterly write-up discussing how as value managers we’ve been able to do well in a market that’s favored more growthy sort of names. The answer to that is we focus on free cash flow when we’re assessing the value of a business. When building the portfolio, we’ve always focused on having a mix of cyclically mispriced names, so classic value stocks, and secularly mispriced names, so names that actually can sustain growth for a long period of time. Bill is very unique and at the forefront of value managers who were willing to invest like that. I think that focusing on this way of thinking about diversification is a big benefit to the portfolio overall.

We’re also very different from the benchmark. We’re benchmark agnostic with very high so-called active share, which academic research (link here and here) suggests correlates with outperformance over the long term. The active share in the portfolio is around 100% now, which means we’re entirely different than the benchmark. Our process and philosophy have allowed us to do quite well over time. The inception of Opportunity was in 1999 and we’ve done significantly better than the benchmark since then, over 20% per year.1

Q: What do you think are some of the challenges over the remainder of the quarter or the year?

Well, there are always challenges and I would say this is a challenging period for us overall. We are long-term investors and, since you can’t predict downturns, it doesn’t make sense to try to do that. We should be patient and we should focus on finding businesses that we really want to own for the long term. So, that’s what we do.

Yet obviously this overall macro environment is murkier and there are some bigger risks than we’ve seen yet in this bull market. That’s always a challenge - appropriately reflecting that in the portfolio while remaining true to your core as long-term, patient, value investors. We’re always back and forth on what do we think, how do we reflect it in the portfolio, what are the best decisions that we could make?

We are fortunate to have the flexibility to do a lot of stuff like hedging, so we’re looking at that, but there’s a definite cost to hedging and an uncertain benefit to hedging. We don’t want to be quick to do something when the best thing to do may be nothing, and sometimes that’s a hard thing to do.

I would say the growth versus value aspect is also a challenge. We’re getting two extremes on divergence in terms of valuations of book value versus growth. The leaders in this market are some of these cloud providers, SaaS darlings, but the valuations there are extremely high and the market currently isn’t placing much weight on valuation.

It’s interesting, the best performing managers have been growth managers. I had a friend the other day who works in the business tell me he’d be surprised if that deep value stuff ever outperforms again. Usually, that is more of a sign that we’re closer to the end of a regime than the beginning.

Empirical does some of the best work and they’re of the belief that it wouldn’t be surprising to see a blow-off top in the growth stuff like you had in 1999-2000 (where the stocks went from expensive to insanely overpriced), but that set you up for one of the best value markets you’ve ever had. That just means we’re looking at a lot of different kinds of names that are “value” names and “growth” names. We don’t distinguish between those two; we look at a wide variety of names and really try to pick the best ones going forward. All of that can be challenging, but it keeps you busy.

Q:  Where you see the best opportunities?

The good news is that we’re finding a lot of interesting names. The market obsesses over certain stuff, like I mentioned, the growthy SaaS names and defensive names in this environment, and it leaves a lot of other stuff sort of thrown to the wayside.  That’s fertile hunting ground for us.

I guess there’s a couple of names that I’ll throw out. One is not a new name, it’s an old name, which I’ve talked about a lot. American Airlines is the name that I think is really attractive. It’s not doing well in the short-term, but you have that stock down 37% over the past year with Delta and United down 1% to 5%. You typically do not see a divergence in the airlines for a good reason. Their fundamentals are highly correlated and their businesses mostly perform pretty closely to one another. American’s numbers have been good lately. They’ve beat and raised. Management has been buying the stock, the CEO’s paid with all stock. That stock’s 5x this year’s earnings; United and Delta are closer to 7x-8x earnings. We think they’re all undervalued. We own them all because we think the airlines manage their business in a much better way than they did historically - better return on capital and better free cash flow generation. But American’s now at the tail end of the Capex cycle from the prior American days. It has the newest, best fleet and it’s going to have the highest free cash flow growth. The market hates the leverage, though, and it has more leverage on its balance sheets than others. When the market gets nervous about potential recessionary scenarios, it will just treat these names with high leverage very poorly. But, I think that that ultimately creates an opportunity. I’ve mentioned Buffett many times, but this is the one airline you can now buy at below Buffett’s price. So, buy when he buys and pay less than him and that’s a good strategy, you’ll do well. So, I think that one’s really exciting.

Tivity Health is another name that is new in the portfolio. It isn’t well known. It built a business partnering with health plans and gyms to incentivize people, particularly older people, to go to the gym and they’re on the forefront of the social determinants of health, physical fitness, and socialization for old people. This was through their SilverSneakers program. It bought Nutrisystem late last year, which is a diet food company. Prior to the deal, those companies had an enterprise value of just shy of $3 billion and today it’s just shy of $2 billion. So, $1 billion knocked off the enterprise value and the market cap has fallen even more. Again, I think what that is due to is the debt that the company has taken on $1.2 billion in debt. The company generates a good amount of free cash flow. I think it’s going to focus all that free cash flow on paying down the debt. They’re already starting to show some benefits of the combined company working together. When they last announced earnings, they lowered guidance a little for the year, because that Nutrisystem piece of business has been a little softer. The health side has been stronger, but typically we don’t see stocks go up on lowering of guidance. This one did. I think that’s a good sign of the bottom of this stock. I think this one has the potential to double.

Overall the upside of the portfolio is close to 95%, so that’s still on the high end of the range. Very attractive upside in the whole portfolio overall if you’re focused on the long term.

1 Performance net of fees from inception (12/30/99) to 7/31/19.  Click here for important information.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

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