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Jan 26, 2016

Opportunity Equity: Looking Back at 2015

Samantha McLemore

Market Commentary

The S&P 500 Index crawled along returning 1.37% for the year. The Dow Jones Industrial Average followed suit returning a meager 0.21% for the year with the Nasdaq Composite surpassing both, closing out the year with a rise of 7.11%. Five out of the ten sectors in the S&P 500 posted positive returns at year end, with Consumer Discretionary and Health Care gaining the most with returns of 10.18% and 6.58%, respectively.  On the other hand, Energy and Materials did the worst posting returns of -21.12% and -8.48% respectively. Large-caps outperformed mid-caps, which beat small-cap names. Specifically, the large-cap Russell 1000 Index returned 0.91%, staying in the green ahead of the Russell MidCap Index’s -2.44% return for the year. The small-cap Russell 2000 Index posted a -4.41% return. Growth stocks outperformed value stocks with the Russell 1000 Growth rising 5.67% compared with the Russell 1000 Value Index’s decline of 3.84% over the year. Stocks marginally outperformed bonds, with the Barclays U.S. Aggregate underperforming most equity benchmarks with a 0.55% return.  Long dated US Treasuries underperformed with the Barclays Long-Term Treasury Index declining 1.64%. Gold continued to decline in 2015, decreasing by 10.77%. The US Dollar Index continued its appreciation, increasing 9.26%, while oil prices fell by 30.47%. Major developed country equity markets ended the year flat, with Japan being the top country with a rise of 10.96% in local currency terms.

The U.S. stock market picked up speed in the fourth quarter after the first 10% correction in three years seen in the third quarter.  The Nasdaq Composite led the charge with an 8.76% quarterly gain while the Dow Jones Industrial Average gained 7.70% and the S&P 500 rose 7.03%. The market started the quarter strong with the best month for stocks in several years occurring in October. In December, the Fed raised interest rates for the first time in almost a decade.  All ten sectors in the S&P 500 posted positive returns for the quarter, with Materials and Health Care gaining the most with 9.69% and 9.22% returns, respectively.  Energy and Utilities performed the worst with returns of 0.20% and 1.07%, respectively.

At the start of 2015...

Opportunity Equity was positioned to take advantage of the rebound in growthier technology names that were hit hard in 2014. Over the course of the year, the broad positioning of the Strategy remained consistent, but we did opportunistically take new positions and scale back others as they worked.

We initiated 9 new positions throughout the course of the year and eliminated 7.  The activity was driven by bottom-up stock picking, as opposed to a wholesale shift in strategic portfolio positioning.  The Strategy continues to seek to monetize volatility in the market by paring back winners and adding to names where we think the market doesn’t appropriately reflect the embedded intrinsic value.  Overall, market conditions did not change significantly in 2015.  Therefore, turnover in the portfolio was relatively low at 16%.

Opportunity Equity remains positioned primarily in four areas: housing, financials, airlines and technology.  The weight in Consumer Discretionary increased from roughly 34% at the end of 2014 to about 43% at the end of 2015.   The Amazon C300 1/17 call options accounted for 809 bps of this increase and we consider this name to be more a technology play than a consumer discretionary one.

During the fourth quarter of 2015...

Opportunity Equity generated a total return of 3.35%, net of fees.1 In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index, returned 7.04%.

Using a three-factor performance attribution model, interaction effect and sector allocation contributed to the Strategy’s performance, which was offset by security selection. Inc. C300 1/17, Inc., Delta Air Lines Inc., Boyd Gaming Corp. and Angie’s List Inc. were the largest contributors to performance, while Pandora Media Inc., Apple Inc. C100 1/17, Gamestop Corp., Twitter Inc. C35 1/17 and Endurance International Group Holdings Inc.  were the largest detractors.

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

We initiated one position during the quarter, ending the quarter with 58 holdings where the top 10 represented 42.3% of total assets, compared with the 17.7% for the index, highlighting Opportunity Equity meaningful active share of around 96.2%.2

Top Contributors

    • Inc. C300 1/17 Calls were up 68.8% over the quarter with the Inc. common stock gaining 32.0%. Amazon beat on 3Q results, announcing revenue growth up 30% YoY along with a 450bps increase YoY in margin. In addition, AWS revenue grew 78% YoY. Strong Q3 results were followed by the announcement that CyberMonday 3P sales increased 40% YoY and fulfillment by Amazon items shipped during the holiday season increased 60% YoY.

    • Delta Air Lines Inc. finished out the fourth quarter with an increase of 13.27%. The third quarter EPS of $1.74 were in line with consensus.  In June, Delta increased its annual dividend by 50% to $0.54 per share. The company also introduced a new $5B share buyback program following the completion of the previous $2B repurchase plan.

Top Detractors

    • Pandora Media Inc. had a rough fourth quarter decreasing by -37.16%. Pandora dramatically declined after announcing third quarter results which met consensus estimates. Third quarter revenue was up 30% YoY while mobile ad revenue was up 40% YoY. Sluggish growth in users and hours disappointed the market. The Copyright Royalty Board’s (CRB) Web IV ruling came in better than expected. The 2016 non-subscriber rate was announced at $0.0017 vs. $0.0014 in 2015 with a subscriber rate of $0.0022 vs. $0.0025 in 2015. These prices will be increased annually in line with CPI. Over the quarter, Pandora also announced the signing of a multi-year licensing agreement with ASCAP and BMI, with a combined catalog of 20 million works.

    • Apple C100 1/17 Calls declined 34.24% over the period while Apple common stock was only down 4.16% for the period. Apple announced third quarter results that beat estimates on both the top and bottom line with revenue growing 22% despite serious FX headwinds. Later in the quarter, a few of Apple’s suppliers pre-announced negative fourth quarter results which has weighed heavily on AAPL’s shares. Over the period, Apple announced that Jeff Williams will be the new COO. Jeff was previously the SVP of Operations.

    • Gamestop Corp was down -31.25% for the quarter as third quarter EPS came in at $0.56 (5% below consensus estimates). The underperformance was driven by lower comps (down 1.1% vs. guidance of flat to +4%) and lower EBIT. Breaking from a previous trend, GME announced Holiday comps up 4.4% versus the -3.1% seen in 2014. The collectibles and Tech Brand segments continued to show strong performance up 300% and 60%, respectively.

For recent investment commentary, check out A Silver Lining in the Dark Cloud of Volatility and ‎Tough Start of 2016, but Don’t Panic Yet

1For 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. 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.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.