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Jul 14, 2023

On Growth and Change

Samantha McLemore

Opportunity Equity 2Q23 Commentary

"The Struggle"
Edgar A. Guest

Life is a struggle for peace,
A longing for rest,
A hope for the battles to cease,
A dream for the best;
And he is not living who stays
Contented with things,
Unconcerned with the work of the days
And all that it brings.

He is dead who sees nothing to change,
No wrong to make right;
Who travels no new way or strange
In search of the light;
Who never sets out for a goal
That he sees from afar
But contents his indifferent soul
With things as they are.

Life isn't rest- it is toil;
It is building a dream;
It is tilling a parcel of soil
Or bridging a stream;
It's pursuing the light of a star
That but dimly we see,
And in wresting from things as they are
The joy that should be.

What a strange poem to begin an investment letter, you may think. I love this poem and see so many connections to life, personally, professionally and for the markets. Guest writes about the struggle, about striving and the pursuit of goals, about change, about the joy that comes with effort and acceptance. We may think we want it easy, but really, we don’t. Growth requires change (and pain!).

The past quarter, and year, ushered in significant change and transformation. We finalized Bill Miller’s succession plan. Patient Capital now owns and manages what was Miller Value’s Opportunity business, including all supporting employees and infrastructure, bringing our quarter end assets to $1.7B. Our identity changed, but most of how we operate did not. It’s still the same team, the same process, the same office location, etc. Bill remains a mentor, advisor, investor and friend. We’re now fortunate to “toil… (to) build..a dream.”

Markets too faced significant change. A year ago, in the second quarter of 2022, the S&P 500 entered official bear market territory losing 20%+ from the highs (losses peaked at -27.5% in the third quarter). Inflation raged, peaking in June 2022 at 9.1%. The Federal Reserve had just started its aggressive effort to stamp out inflation with the fastest rate increases in 40 years, along with quantitative tightening. Fear and pessimism reigned supreme.

In contrast, in the most recent quarter, the S&P entered a new bull market, conventionally defined as a 20% gain off the lows. Inflation has fallen significantly from the highs. The Fed kept rates flat at its most recent meeting (though another bump is expected in July). First quarter GDP growth was recently revised higher, to 2%, and the job market has remained robust. Skepticism about market prospects remains high.

Relative to expectations a year ago, the economy and the markets have shown remarkable resilience allowing stocks to climb the proverbial wall of worry.  Many risks priced into markets haven’t come to fruition. The debt ceiling was resolved without issue. Rate hikes have slowed. Inflation is improving. We appear to have avoided a recession so far.

Annualized Performance (%) as of 6/30/23
  QTD YTD 1-Year 3-Year 5-Year 10-Year Since Inception (12/30/1999)
 Opportunity Equity (gross of fees) 13.58 25.06  22.11 6.29 3.75  9.72 7.62 
 Opportunity Equity (net of fees) 13.31   24.46  20.91 5.23  2.72  8.64  6.56 
 S&P 500 Index 8.74  16.89  19.59  14.60  12.31  12.86  6.85 

Opportunity Equity strategy performed strongly in this environment, rising 13.31% net of fees for the quarter versus the S&P 500’s 8.74% gain. Over the past year, the strategy, net of fees, grew 20.91% versus the market’s 19.59% increase. Performance improved in the latter half of May as market breadth expanded.

Despite the improvement, people remain concerned about inflation, continued interest rate increases and recession. With core PCE1 stuck between 4-5%, the Fed’s 2% target may seem out of reach2. Yet the market doesn’t see an inflation problem. Five-year inflation break-evens sit at ~2.2%. The St Louis Fed’s 3-month annualized sticky price CPI excluding housing, food and energy fell to 1.4% in June. Truflation’s3 real-time measurement is also in the low 2%’s.

The Fed’s not convinced. Prospects for continued tightening amidst an inverted yield curve keep recession fears elevated. With cyclicals recently breaking out relative to defensive stocks, the market apparently doesn’t share this concern.

At our investor day in May, Bill Miller reminded us of an important lesson: no one has privileged access to knowledge about the future. A year ago, no one forecasted a strong, nearly 20%, gain over the next year. People myopically focused on the significant downside risk we faced to market lows. Several people shared charts noting the similarity between the 2022 bear market and some of the worst in history (2000 and 2008).

While painful, buying stocks in such an environment is often fruitful. When people fear the worst, prospects are the best. It’s important to remember that historically, the S&P 500 has risen more than 70% of years.

When we couldn’t find any bulls last year, we examined market history to understand prospects after a 20% selloff. The answer: historically the S&P 500 rose an average of 16% in the following year. Amazingly, the market gained that exact amount the next year (which almost never happens!).

We recently updated the analysis to understand prospects for the second year following a 20% loss. Good news: historical evidence suggests markets should continue up.

A year ago, we also wrote about how we saw a once-in-a-decade opportunity in travel-related stocks. Many had traded back near pandemic lows while demand was booming. We expected pent-up demand to prove more sustainable than expected. It took nearly a year, but the market finally came around to our view.

Carnival Corp (which we don’t own but did mention) was the top performing stock in the S&P 500 in the second quarter (+86%). Norwegian Cruise Line was second (+62%). Delta Airlines also made the top ten (+36%). Meta Platforms made the list too, bringing our holdings to three of the top ten. All were hated a year ago.

Travel has been booming for the last year. Valuations remained depressed and the stocks lagged until recently. The delayed outperformance isn’t unusual. Its why patience is paramount in investing. It’s also why we assess market expectations separately from fundamentals. The former eventually follow the latter. As Ben Graham said, “In the short-run, the market is a voting machine but in the long run, it is a weighing machine.”

We continue to have significant exposure to travel, and believe the names continue to be mispriced. Some of the stocks are overbought in the short term, but spending has yet to normalize to pre-pandemic levels. Aram Rubinson of Rubinson Research, who specializes on the consumer, estimates the category will grow at twice the rate of overall consumer spend next year. Yet the stock valuations remain depressed.

People often question how we can get an edge in relatively efficient large cap stocks. While it’s nearly impossible to get an informational or even an analytical edge on well understood large companies, it’s certainly possible to get a behavioral edge. How else could Meta Platforms, an $800B market cap company, nearly double in a year?4

When Bill was asked at our investor day if it’s gotten more difficult to beat the market, he pointed out that while information is disseminated and reflected in stock prices more quickly than ever before, human nature hasn’t changed at all over his 50-year investing career. People still reach extremes in fear and greed. Losses remain twice as painful as proportional gains are pleasurable. While the market is hyper-efficient at incorporating real time data, it’s much less efficient at longer time horizons.

The best investors prioritize reason over emotion, and patience over immediate gratification. They are willing to endure short term pain for long term gain.

Which brings us back to The Struggle. Often, our biggest challenge is managing ourselves. We are evolutionarily wired to run from pain and loss. Yet enduring these essential aspects of life and investing leads to growth, both personally and financially. In markets, our instincts kick in at the worst times.

I was fortunate to recently meet with Khandro Kunga Bhuma, also known as Khandro-la.  Khandro-la studied with the Dalai Lama for 30 years, reaching rare levels of enlightenment. He instructed her to spread her teachings to the world. William Green, author of the excellent book and podcast, Richer, Wiser, Happier was kind to invite me. Khandro-la had a message to share with the business community.

It’s impossible to effectively convey the experience. Many people say when you’re in the presence of enlightened people, you’re filled with joy, openness, and a calm, loving essence. That’s an excellent description. I experienced an energy unlike anything I’ve previously encountered. 

Khandro-la’s message: the world faces great suffering and risk including pandemics, environmental challenges, the potential for World War 3. The business community can help solve these problems by advocating for the proper solution. The solution: every individual needs to build “a good mind” and a good heart. Khandro-la said taming the mind, through practices such as meditation and understanding the mind, is the path to happiness. She believes it can solve all our problems. When we tame the mind, we feel love and compassion, which positively impacts those close to us, and spreads from there. 

If this sounds out there, it’s not as farfetched as you might think. Famous investors, like Ray Dalio, tout the advantages of meditation. There’s significant evidence that a daily gratitude practice offers myriad benefits, such as improved happiness, sleep, compassion, kindness, immunity, health, longevity and many more[i]. It can even improve our financial prospects!

Northeastern University’s Leah Dickens’ and David DeSteno’s research demonstrates that gratitude improves patience and lowers temporal discounting (our tendency to value future dollars much less than today’s dollars). Gratitude improves self-control, meaning it can be used as a tool to improve investment outcomes.

Self-control was crucial a year ago when the prospect of further losses tempted investors to lower market exposure at the worst time. 

Despite the recent gains, we continue to have confidence in our portfolio’s prospects. Portfolio activity has fallen, with annualized turnover of 29% in the past quarter. Our activity picks up during times of volatility when the opportunity set shifts dramatically. This happened during the volatile pandemic years. Now it’s fallen back to lower levels.

We initiated two new positions in the quarter and exited one. Interactive Corp (IAC) is our most material new position with a 2.5% weight. The market gave us the opportunity to buy a company with an excellent capital allocation track record around the price of its liquid securities, MGM Resorts International (MGM), Angi Inc. (ANGI) and cash. This means we got the rest of the company, including Dotdash Meredith, and Turo, and all future value creation nearly for free. At $69, the stock remains well below the 2021 highs ($179) and our assessment of what it’s worth. We like the collection of businesses, see significant opportunity in each one and believe management will continue to grow shareholder value.

We also bought Western Alliance (WAL $41). We initiated the Western Alliance position during the second bank selloff in May. The stock reflected the risk of a bank run. We thought these concerns were overdone since the company published frequent positive deposit updates. We were able to buy the stock at 3-4x earnings believing it should normalize at least back to its April price in the $40s.

Though we think they are undervalued, we exited ADT and Teva Pharmaceuticals to fund new ideas.  Both names have disappointed, and we took some losses.

We believe having a mix of different types of misvalued securities makes sense, specifically what some label growth and value. We view growth as an input in the value equation, as Warren Buffett says, and don’t divide the world this way. Yet the market has tended to favor one group over the other during different periods, which makes diversification beneficial.

Much has been made of the narrow market this year. Early in the quarter, people noted the top 7 “growth” stocks generated 90% of the S&P 500’s gains (Tesla, Apple, Microsoft, Amazon, Nvidia, Alphabet, Meta Platforms). This return concentration isn’t unusual. This year’s gains mostly just recoup 2022’s losses. Over the 18-month period, only 3 of the companies (Nvidia, Apple and Microsoft) made money and outperformed. Their median return (-15%) remains well below the market’s (-4%). Recently, gains have broadened out to other stocks.

Many technicians and quantitative strategists expect growth stocks to continue to outperform. There’s a good shot that’s right but longer term, we remain more optimistic on classic value. People remain enamored with growth investing. Value stocks trade at a discount to historical valuations unlike growth stocks, which trade at a premium.

Take two high quality stocks as an example, Costco (“growth”) vs. JP Morgan (“value”). Costco has a long history of excellent performance, earning attractive returns on capital with consistent growth. Over the past 30 years, it’s grown earnings per share at 9% per year, but it’s compounded capital at better than 16% annually as the P/E multiple expanded from ~12x to 37x this fiscal year’s5 earnings. Sell-side consensus expects EPS growth to continue at roughly the same rate for the next 5 years. If it sustains the current multiple, the 9% implied return would be solid. But with valuations near all-time highs, and interest rates on the rise, there’s clear risk to that valuation.

JP Morgan has also posted excellent performance. It was profitable even during the financial crisis. Since Jamie Dimon took the reins in 2005, it’s grown earnings per share 11% per year (almost exactly the same rate as Costco over the same period). The stock’s annualized gains of roughly the same rate. Its P/E ratio has fallen from 12x in 2005 to 10x today. It guides for a normalized 17% return on tangible capital but earned 23% in the most recent quarter.

Costco’s P/E grew from 18x to 37x during the same time JP Morgan’s fell from 12x to 10x. This makes sense to a certain extent because while both companies delivered improving returns on capital, Costco’s improved more. Valuations are sensitive to interest rates. Since JPM experienced no valuation expansion, it also seems to have less valuation risk.

We can calculate the justified P/E based on return on capital, cost of capital and growth rate. For companies with very high returns on capital and strong growth (like Costco), very high P/Es can be justified, especially in a low interest rate environment. We also analyze market implied expectations by calculating the implied growth rates. For Costco, it’s about 5.3% - in perpetuity! That seems elevated to us! For JP Morgan, it’s less than 0.5%. Way too low in our opinion.

That’s emblematic of the opportunity set we see in the market. The market is paying a hefty premium for quality, growth and stability while shunning cyclicality and “boring” value stocks.

We’ve recently been adding to Citigroup (C). After perennially disappointing for decades, even the most bullish financial investors aren’t interested (a good thing in our view!). CEO Jane Fraser is making all the right moves: exiting underperforming consumer businesses, investing to improve the tech and operating infrastructure, returning capital to shareholders. These actions should result in improving returns on equity. The market reaction is a giant shrug.

We should start to see serious cost improvements in late 2024 accompanied by improving returns on equity. The stock trades at ~$46, 55% of its $85 tangible book value. The company is confident it can reach 11-12% return on tangible common equity by 2025 when it’s tangible book should be greater than $100. If it reaches its return target, as we believe, Citi should trade back to tangible book, implying a more than double over the next couple years. Meanwhile, you collect the 4.5% annual dividend, which is currently a better yield than long-term treasuries.

We like other names mostly ignored by the market for similar reasons. Names like Expedia, General Motors and Delta Airlines. These companies have strong returns on capital (14%+), good competitive positions, cheap valuations (all double-digit free cash flow yields), and are returning capital to shareholders. We trust the managements to take advantage of their depressed stock prices and create long-term shareholder value.

Those aren’t the only names we find compelling. The CEOs of Mattel (MAT), OneMain Financial (OMF) and Farfetch (FTCH)all spoke at our investor day. We encourage you to listen to the fireside chats to understand why we see attractive investment opportunities in these names.

In early July as we write this, we see nearly 90% upside in the portfolio. The embedded potential gains have normalized as the fund rallied, but still sit at the high end of our historical range. We have high confidence in our long-term performance potential. As always, we know it won’t be a smooth ride.

That’s fine because growth requires change, and challenge. We maximize our chance of success with patience, perseverance, and acceptance. To maximize returns, we endeavor to remain rational, especially during times of extreme emotion. As always, we look forward to the toil required to outperform and we appreciate all the support and interest during these transformative times. Please let us know if we can help you.

1PCE: Personal consumption expenditures
23-month annualized
3Measurement of 10 million data points real-time
4 As of 7/13/23
5 Fiscal year ending August 31

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Christina Siegel's 2Q 2023 Market Highlights

Stock prices as of July 13, 2023

Source: Bloomberg

CPI: Consumer Price Index measures the monthly change in prices paid by U.S. consumers.

PCE: Personal consumption expenditures includes a measure of consumer spending on goods and services among households in the US.

PCE, CPI, and inflation rates based on available data at the time the piece was written and are not guaranteed to stay the same in the future.

The S&P 500 Index (SPX) is a market capitalization-weighted index of 500 widely held common stocks.

Portfolio Upside to Central Tendency of Value (CTV), is a proprietary calculation based on our assessment of the intrinsic value of individual company holdings currently in the portfolio. Portfolio Upside to CTV refers to the weighted average expected return from each individual company reaching our estimate of intrinsic value fromits current trading price. CTV is a probability-weighted estimate of what we believe is the intrinsic value per share for each individual company currently in the portfolio. As part of this process, we build detailed, long-term company models for a variety of scenarios and use multiple valuation methods, such as discounted cash flow (DCF), comparable company analysis, private market analysis, historicals, liquidation, and LBO analysis. These different valuation methodologies are probability weighted to create our CTV. The analysis embeds both risk and return features and allows comparison across securities. Upside to CTV refers to the expected return from a stock reaching our estimate.

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. References to specific securities are for illustrative purposes only. Portfolio composition is shown as of a point in time and is subject to change without notice.

Portfolio holdings and portfolio discussion are for a representative Opportunity Equity account. Holdings discussed may or may not be included in all portfolios subject to account guidelines.

Investors should carefully review and consider the additional disclosures, investor notices, and other information contained elsewhere in this document as well as the Offering Documents prior to making a decision to invest.

All historical financial information is unaudited and shall not be construed as a representation or warranty by us. References to indices and their respective performance data are not intended to imply that the Strategy’s objectives, strategies or investments were comparable to those of the indices in technique, composition or element of risk nor are they intended to imply that the fees or expense structures relating to the Strategy or its affiliates, were comparable to those of the indices; since the indices are unmanaged and cannot be invested in directly.

The performance information depicted herein is not indicative of future results. There can be no assurance that Opportunity Equity's investment objectives will be achieved and a return realized. Returns for periods greater than one year are annualized.

The views expressed in this commentary reflect those of Patient Capital Management portfolio managers as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Patient Capital Management disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. Any data cited herein is from sources believed to be reliable, but is not guaranteed as to accuracy or completeness

Click for more information on Opportunity Equity and the Opportunity Equity Strategy Composite Performance Disclosure.

©2023 Patient Capital Management, LLC