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Apr 23, 2015

Opportunity Equity: 1Q2015 Review and Outlook

Samantha McLemore

Market Outlook

In a quarter where the market went mostly nowhere, Opportunity Equity posted strong results. The strategy gained 6.1% (net of fees)1 vs. the S&P 500’s 1.0%. Since inception of the Strategy (12/30/99), it has earned an average annual return of 7.3%, which is 70% greater than the S&P 500’s 4.3% average annual return over the same period. Any good quarter (or bad) is partially attributed to skill and luck. We attribute the skill portion mostly to our contrarian, long-term value orientation, characteristics that have defined our investment style since the beginning.

Some of our best performers were previous laggards. Amazon, which struggled last year, was a top contributor after the company posted some better profit performance than expected. Since we added a long-term options position to our common stock holdings late last year, Opportunity Equity has reaped additional gains. We have confidence in the long-term strategy and profit potential. We rank management as one of the best we’ve ever known (along with the Harvard Business Review who did likewise) and are happy to hold for the long-term. On the other hand, some of our previous winners detracted from performance. Our three airlines, American, United and Delta, compounded at an average annual rate of 80% vs. the S&P’s 20% from 2012-2014. We knew that pace would not continue forever and their underperformance in the quarter did not surprise us. We still believe that the industry of today will provide much better returns than that of yesteryear. The pullback has brought valuations to the lower end of (and in some cases below) historic ranges. Delta, for instance, offers a 14% free cash flow yield, which it is using to pay down debt, increase dividends and buy back stock. We don’t find many companies offering valuations as attractive as this, especially ones which we expect to continue to grow profits.

The big banks also mostly lagged as interest rate declines pressured the stocks. We met with a strategist from a big Wall Street bank who recently put out a bullish piece on the big banks. He rightly noted that they are the only group still trading below normal historical levels. Even if you adjust for lower returns due to higher capital levels, heightened legal and regulatory costs and lower rates, the discount stands out. Our big banks, Bank of America, Citigroup and JP Morgan, trade at an average of 10.5x this year’s earnings vs. the market’s 17.6x multiple. They benefit from Fed rate increases and should return more capital to shareholders in the future. These names inflicted extreme amounts of pain on holders during the financial crisis. Trauma of this sort is not easily forgotten. As we move further from the crisis and these companies continue to make progress on improving earnings and returning capital, we believe they will get revalued.

After a lackluster 2014 and a rough start to the quarter, our homebuilders actually mostly outperformed (KB Homes was the one exception) for the quarter. Evidence emerged as the quarter progressed that demand was stronger than people projected. Our bullish case remains unchanged. The millennials represent a big cohort of the population numbering over 90M who are just reaching prime marriage, child-rearing and home-buying years. There is ZERO evidence this group doesn’t eventually want to own homes. They are doing it later, but later is starting now. Jobs and household formations drive housing starts. There’s been notable improvement in jobs and now household formations are gaining steam. Estimates call for 8.3M household formations by 2018. That’s an average of more than 2M per year, which compares very favorably with history. Since the mid-1960’s, the highest this has ever been was 1.9M and in the mid-2000’s when starts got over 2M, formations were just over 1.7M. Housing starts so far this year have averaged just shy of 1M units so if we are going to reach formation levels that much higher than historic peaks, housing activity will follow suit. We still really like these stocks. Since they are cheaper than the market, you are not paying for all the growth we expect.

We get really enthused about the potential upside in the strategy when there are major areas of the strategy with so much potential yet to play out. We don’t have the time in this piece to discuss some of the exciting names where we are deploying new capital, but those thrill us too.   If our calculation of the embedded upside in the Strategy is right, there’s still a lot of money to be made. We will continue to work hard to earn returns on your (and as investors in the strategy, our) behalf. Thank you for your continued support.

Market Commentary

The S&P 500 Index finished the quarter with a total return of 0.95%. The Nasdaq Composite beat it rising 3.86% and the Dow Jones Industrial Average rose 0.33% on a total return basis for the quarter. Six of the ten sectors in the S&P 500 posted positive returns during the period. Health Care and Consumer Technology were the biggest outperformers with returns of 6.16% and 4.38%, respectively. Small-cap stocks outperformed mid-cap stocks, which beat large-cap names. Specifically, the Russell 2000 Index’s 4.32% gain surpassed the returns of both the Russell MidCap Index and the large-cap Russell 1000 Index which posted 3.95% and 1.59%, respectively for the quarter. Growth stocks beat their value counterparts, as the Russell 1000 Growth Index rose 3.84% compared to the -0.72% return of the Russell 1000 Value Index over the same period. The US Dollar Index continued its climb increasing 9.0%, while Oil declined another 6.2% during the quarter.

The stock market, while largely unimpressive, was able to stay in the green despite continued geopolitical conflict, harsh winter weather and worries of the Fed tightening. In Yemen, fighting broke out with Houthi rebels seizing control of Sanaa forcing the president to escape house arrest and flee to Aden. In response, Saudi Arabia began air strikes in the region along with a coalition consisting of 10 countries. Also during the quarter, Saudi Arabia’s King Abdullah bin Adbulaziz al Saud died in January and was succeeded by Prince Salman bin Abdulaziz who assured the world that its oil policy will remain unchanged. Israel’s Prime Minister Netanyahu was reelected to his fourth term in office after making controversial remarks about the impossibility of a two-state solution. Nigeria finally held its fifth quadrennial election after postponing it by six weeks in February with Muhammadu Buhari beating out incumbent president Goodluck Jonathan. In January, Greece elected Alexis Tsipras as prime minister sparking the beginning of the conflict between Greece and its creditors over reaching a negotiated debt deal. Mario Draghi committed to a quantitative easing program worth at least 1.1 trillion Euros while China cut its nation’s benchmark interest rate for the second time in three months. In addition, the Fed finally removed the word “patient” from its post-meeting statement in March.

Europe excluding UK and Japan were the strongest regions in the ACWI posting gains of 14.81% and 9.49%, respectively. All fourteen countries in Europe posted gains with twelve out of the fourteen posting gains above 11%. The United States had the lowest return of the group. Emerging Markets rose 4.56% supported by Russia’s 15.71% gain over the period.

Strategy Highlights

During the first quarter of 2015, Opportunity Equity generated a total return of 6.1% (net of fees)1. In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index, returned 0.95%.

Using a three-factor performance attribution model, security selection, interaction effects and allocation effects contributed to the portfolio’s outperformance. The Intrexon Corp, Amazon C300, Fiat Chrysler Automobiles, Apple Inc. C100 and NXP Semiconductors were the largest contributors to performance, while Inc., Zulily Inc., Monitise PLC, Seagate Technology and Genworth Financial Inc. were the largest detractors.

Relative to the index, the Strategy was overweight the Financials, Consumer Discretionary, Industrials, Information Technology and Materials sectors on average during the quarter. With zero allocation to Utilities and Consumer Staples, the Strategy was dramatically underweight these groups and more moderately underweight the Energy, Health Care, and Telecommunication Services sectors. In terms of sector allocation, the underweight position in the Health Care sector, which outperformed the index, detracted the most from the portfolio’s relative performance. On the other hand, the overweight in Consumer Discretionary, which outperformed the index, contributed the most to relative performance.

The Strategy initiated four positions and eliminated two during the quarter, ending the quarter with 58 holdings where the top 10 represented 43.58% of total assets compared to 16.94% for the index, highlighting Opportunity Equity's meaningful active share of around 96%2.

Top Contributors

    • Intrexon Corp increased 64.08% over the quarter, supported by its announcement of an exclusive licensing agreement with partner Ziopharm Oncology (ZIOP) and MD Anderson Cancer Center related to the CAR T therapy. Intrexon added to this announcement by entering into an exclusive collaboration with Merck Serono for development of two candidates from their CAR T program. In addition, at the end of March Intrexon signed a cooperative R&D agreement with the National Cancer Institute for development of adoptive T cell therapies. These agreements will help Intrexon become a key player in the CAR T cell world. Intrexon’s fourth quarter results beat expectations, topping Q4 revenue forecasts of $26M by $5M.

    • The C300 1/17 Calls were up 52.63% during the quarter as Amazon’s stock rebounded from its lows seen at the beginning of 2015. Amazon’s improvement was supported by the positive surprise of the fourth quarter’s results. In the fourth quarter, Amazon showed record Q4 gross margin (29.5%) leading to operating profit that beat the street by 58%. The improved performance was supported by growth in AWS and Prime membership. Over the period, Amazon announced its expansion of PrimeNow into Baltimore and Miami and the addition of the Dash Button for Prime subscribers.

    • Fiat Chrysler Automobiles continued its climb ending the quarter up 40.85%. Fourth quarter results were mixed with EBIT missing forecasts as a result of NAFTA margin weakness and APAC pricing headwinds. Sales were up over the period and EMEA showed improvements in profitability. The market is still largely anticipating the Ferrari IPO which is planned for mid-2015.

Top Detractors

    • Inc. had a rough first quarter declining by -33.86%.’s fourth quarter results missed on revenues but beat on EBITDA. Revenues were lower than expected as a result of expected CPG campaigns not materializing. Over the period, announced a new e-circular product and launched its targeted coupon capabilities for CPGs. Management also announced a $50M share buyback along with disappointing guidance for FY15 with both revenue and EBITDA coming in below the Street at the mid-point.

    • Zulily Inc. continued to decline ending the period down 44.49%. Fourth quarter results were disappointing as revenue growth decelerated over the period to 52% versus 72% in Q3. Gross margins missed as a result of expected cost savings not materializing from investments in fulfillment automation. Over the quarter, Zulily announced that CFO Marc Stolzman will be leaving the company at the end of March but did not announce a replacement. Zulily also announced a $250M share repurchase program.

    • Monitise PLC had a volatile quarter ending the period down 48.51% as it continues to try to recover from its transition into a subscription based model. At the beginning of the quarter, Monitise initiated a strategic review. The strategic review was concluded at the end of March with the decision to remain an independent company. The strategic review also resulted in Elizabeth Buse becoming the sole CEO with a new focus on key geographies and products. During the quarter, Montise announced disappointing earnings showing a drop in license revenue with the impact of renegotiated contracts still being felt. The launch of the Monitise Central Platform in early April is widely anticipated to create a strong boost in growth.

1Since inception, Opportunity Equity outperformed the S&P 500 net of fees for 10 calendar years. A complete record of Opportunity Equity’s annualized one-year performance history can be accessed by clicking here. For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity Composite Performance Disclosure. Past performance is no guarantee of future results.

2Active share represents the share of strategy holdings that differs from the benchmark index holdings. The greater the difference between the asset composition of the strategy and its benchmark, the greater the active share.

Contact LMM 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.

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

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s 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 LMM 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.

©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.