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Oct 26, 2021

Optimizing for Long-term Return Potential

Samantha McLemore

Opportunity Equity 3Q 2021 Letter

The third quarter proved more challenging than we previously anticipated. Miller Opportunity Equity declined 14.2% (net of fees), while the S&P 500 rose 0.6%. While we are disappointed with our results this quarter, these variations are a natural product of a long-term strategy. We strongly believe the portfolio remains well positioned going forward.

Historically, this sort of pullback created a great buying opportunity. We believe this time will be no different.

Annualized Performance (%) as of 9/30/21
  YTD 1-Year 3-Year 5-Year 10-Year Since Inception (12/30/99)
Opportunity Equity (net of fees) 3.44 40.05 11.93 17.22 20.16 8.62
S&P 500 Index 15.92 30.00 15.99 16.90 16.63 7.12

Past performance is no guarantee of future results. Please refer to the GIPS disclosure document for important additional information.

This quarter ranks as our 5th worst on a relative performance basis. The four worst quarters occurred during significant market declines in 2001, 2008, 2011 and 2020. The Strategy has experienced 29, 3-month periods when we were down 15% or more on a rolling basis. The average forward one-year performance for these periods is 35% while the average annualized forward 3-year and 5-year return sits at 17% and 18%, respectively.

Higher prices generally equate to higher expectations. Even when long-term investment potential remains sound, extreme moves can present near-term challenges. Amazon has been our single largest contributor to the strategy over its life. Yet it hurt short-term performance in multiple periods, especially after big moves up. Overall the trend has been up and to the right.

Former market technician John Mendelson referred to this phenomenon as the “rubber band theory.” When stocks get too extended in either direction, there’s a natural gravitational pull towards historical prices as incremental buyers or sellers dry up. Portfolio managers must decide how much to react to these circumstances.

We focus on optimizing for long-term returns. Higher prices typically mean lower future returns so they certainly factor into the equation. Our primary concern always centers on our assessment of long-term, risk-adjusted returns. As patient, long-term investors, we tolerate the natural volatility of stocks as a byproduct of the process.

Volatility can result from any number of concerns. This quarter, economic and earnings growth expectations moderated as we faced another spike in COVID cases. The prospect of rising interest rates on the back of Federal Reserve taper talk added to concerns. US lawmakers’ failure to reach an agreement on raising the debt ceiling raised fears about a US government default. China fears grew as what appeared to be a normal regulatory crackdown morphed into a more threatening attack on foreign capital and culminated in a liquidity squeeze that people feared might be a “Lehman moment.”

Unsurprisingly, market sentiment grew increasingly cautious. The put-call skew index, which measures demand for hedges relative to upside, recently sat two standard deviations above its long-term average.

Markets must continually climb the proverbial wall of worry, and we see recent events no differently. The biggest risks exist when no risks seem apparent. We believe the defensive shift in sentiment and positioning during the quarter bodes well for stocks.

We remain constructive on the long-term outlook for the market and our portfolio. We remain early in an economic recovery. The recent selloff worked off a significant amount of enthusiasm. We own names we believe have the most attractive market prices relative to fundamentals. In aggregate, those prices are lower than a quarter ago. Lower prices often mean higher future returns. We estimate the embedded upside potential in the portfolio at nearly 100%.1

Our primary focus remains on bottom-up analysis, but we often get asked about China since we have some exposure. One of our biggest detractors in the quarter was Alibaba, which we’ve owned for many years but think represents an excellent investment at these levels. We will come back to Alibaba.

We’ve never had high direct exposure to China, but we do tend to invest in stocks that might be controversial. These stocks can show high sensitivity to market risks, which Quantitative strategist Michael Goldstein labels high “arbitrage risk.”

We tend to fish in this pond because high disagreement can increase the likelihood of developing a variant perception, or edge. Financials and homebuilders were a prime example of this over the past decade. The market treated them as though their terrible financial crisis performance indicated greater prospective risk. The underlying fundamentals, with much improved balance sheets, liquidity and risk management procedures, suggested otherwise. Our holdings here have outperformed in aggregate, but that didn’t stop them from selling off more than the market when growth fears emerged. Over time, betas have declined suggesting the market’s growing recognition of the improved underlying risk profile.

This is why we like to distinguish between market volatility and underlying risk. These are two distinct (but related) concepts. If your time horizon measures in days, months or quarters, volatility is a good proxy for risk. If you’re long term, like us, it’s not at all. Over the vast majority of 10-year time horizons, the stock market is up. Underlying business fundamentals drive the performance of individual stocks. We focus on managing real risk, not market volatility.

This explains why some of our holdings can be sensitive to macro concerns. As it relates to China, the market’s focus on this risk is understandable. Bank of America recently published a report highlighting that up to a quarter of revenues in US ETFs are derived from China. In addition, China represented 30% of global GDP growth over the past two decades. The report concluded: “What happens in China, doesn’t stay in China.”

The main problem in China is an unsustainable economic growth model. Debt has exploded, but unfortunately much of that debt isn’t fueling economically productive activity, as Martin Wolf excellently details here. Total property related investment is estimated to represent up to 30% of Chinese economic activity. The Chinese must shift their economy and it won’t be easy.

The Chinese instituted a number of regulatory changes to deal with this problem (and others). Regulatory risk exists everywhere and markets can deal with it. However, when investors can suddenly be wiped out without any forewarning - as happened when China changed online tutoring companies’ status to not-for-profit - it changes the equation. Capital flees. That’s exactly what we’ve seen.

George Soros issued a public warning on investment in China, Cathie Wood liquidated a number of Chinese equities, and private capital is taking a pause as the exit prospects for investments have suddenly deteriorated significantly.

The unforeseen government wipeout reminded us of the financial crisis. The moment the US government seized the government-sponsored entities (GSEs), Fannie Mae and Freddie Mac, while they still met all required capital standards, our CIO and my co-PM Bill Miller declared that financials were uninvestable because risks were impossible to assess.

He was exactly right. A max exodus of capital began as investors and depositors fled. For financials, as levered institutions dependent on liquidity, there’s a special type of feedback loop where human behavior (panic) creates immediate fundamental survival risks. One company after another (Lehman, Wachovia, AIG, etc) failed.

What stopped the panic? The government. Through the TARP program (Troubled Asset Relief Program), the government stepped in as the buyer of last resort.

What can we learn about this regarding China? The government is mostly able to mitigate and manage these risks. It’s an internally controlled economy with manageable external debt, which explains why people aren’t more concerned. China intervened aggressively with calls to US banks after the tutoring company wipeout suggesting a recognition of the dangers of certain actions and a desire to contain the damage. China has always been sensitive to capital outflows, which should provide it some incentive to treat capital fairly (and possibly explains the recent clampdown on cryptocurrencies).

In the long run, China’s growth and investment prospects will benefit from reforms to shift their economy towards consumption. In the short run, it’s painful. Anatole Kaletsky summarized the risk well when he wrote about how severe crises emerge during the 2016 Chinese growth scare: “weak economic data leads to financial turmoil which induces policy blunders that in turn fuel more financial panic, economic weakness and policy mistakes.”

No one knows what the future holds. But there’s some reason for optimism. In a recent Wall Street Journal article, Kevin Rudd, the former prime minister of Australia, put it best: “And in China, as with all countries, ultimate political legitimacy and sustainability will depend on the economy.” Xi Jinping plans to stay in power for a third term next year. He needs to show positive outcomes.

Sir John Templeton, one of our investing heroes, talked about investing at “the point of maximum pessimism.” This is a helpful concept, but how do you know you’re there? You don’t!

We love the story relayed about him in Richer, Wiser, Happier: How the World’s Greatest Investors Win at Markets and Life by William Green. Templeton invested in hundreds of companies (including bankrupt ones!) in the depths of the Great Depression believing they would benefit from the War. He ultimately proved right and made many multiples on his investments. But stocks took years to bottom and turn up. It took courage and conviction to make money, not prescient foresight. Holding required equal, if not more, fortitude than buying.

Fortunately for us, our primary job consists of bottom-up investing and not macro forecasting. We do attempt to understand the macro environment in which we’re operating. We think it’s easier to analyze companies, understand ranges of potential outcomes, and invest where we see good risk-adjusted returns.

We’ve owned Alibaba for years. It’s much easier to analyze than China. With hindsight, we added to it too early. At current prices, we think it’s an excellent investment opportunity.

We always assess investments through the lens of expectations relative to fundamentals because expectations’ revisions drive stock prices. All fundamental analysts pay close attention to fundamentals (as do we!), but there’s much less explicit attention devoted to expectations.

Michael Mauboussin and Al Rappaport detail how to calculate price implied expectations in their book Expectations Investing and on their website. This enables the quantification of expectations baked into a stock, namely how many years of growth you’re paying for at the current stock price. According to our assessment, for Alibaba, the answer is less than one! For a company that has grown revenues at a 50% average annual rate over the past decade and pretax profits even faster, that’s astounding.

If competitive or market threats had completely impaired Alibaba’s future growth prospects, this might make sense. There’s no evidence this is true. Analysts expect the company to grow bottom line 15-20% per year going forward. If it can do that, we believe the stock is worth significantly more the current $165 stock price. Even the most bearish analysts expect high-single-digit growth rates.

The market appears to be pricing in the possibility that the government or competition will completely impair Alibaba’s ability to grow. Yet every analyst we’ve spoken to incorporates these factors into their estimates. So the situation reminds us of another great Templeton quote: “absolutely nothing will make a stock go down to an extremely low price except for other people urgently trying to sell.”

We think Alibaba remains a dominant ecommerce platform in China. As the economy shifts more towards consumption, ecommerce should grow and Alibaba should benefit. The rapid growth of other commerce platforms have eaten into Alibaba’s market share. We think additional competition is a good thing in the context of anti-monopoly policy. We still see solid growth prospects as Alibaba expands into lower-tier cities, continues to build out logistics and grows new categories like groceries. At current prices, we don’t believe the market is pricing in the cloud computing franchise, which remains the strongest in China.

We think there are many ways to win, but they require patience. As far as we can tell, there’s only one way to lose: the government completely impairs Alibaba’s prospects. We don’t believe that will happen because it’s not in the government’s interest to impair one of its most innovative, consumption-led companies. We can always be wrong, but we believe the odds are on our side and the risk-reward potential is incredibly attractive over the next 3-5 years.

Another name we’ve recently purchased and have grown incredibly excited about: General Motors (GM). GM is interesting on many levels. We see it as an attractive investment opportunity and it might be a microcosm of current markets, both past and prospective.

Tesla trounced GM over the last decade. Tesla rose 15,797% crushing GM’s 238% increase, which lagged the S&P 500’s 365%. Tesla came out of nowhere creating what many said was the best car ever made. A decade ago, no one saw that coming, including GM. GM’s historical strength led to arrogance. It completely dismissed the threat of any newcomer.

Where are we now? Expectations are entirely different. Tesla’s current price embeds 18 years of growth while GM embeds under one year (see a pattern in what we like?!). Tesla’s expectations look even loftier when you consider that in that 18th year, Tesla would be projected to earn $1.35 trillion revenues at very high, Ferrari-type margins. The largest automakers today generate roughly $250 billion revenues at less than half those margins.

Tesla’s priced to go where no man (or woman!) has gone before. It’s impossible for Tesla to meet these expectations with auto manufacturing alone. It requires something more. Bulls believe Tesla can dominate an autonomous driving future and make significant money on software subscriptions. We don’t have a view on this other than that Tesla needs to do so to be attractive at the current price.

Market expectations for GM, on the other hand, are muted. There appears to be no innovation or growth priced into the stock. Yet GM plans to launch 30 EV (electric vehicles) models globally by 2025 (Tesla has launched a total of 4). GM’s new electric vehicles, like the Hummer and Cadillac Lyric, are extremely impressive. It’s revamping its manufacturing production to be modular, allowing greater speed and adaptability. The entire culture has transformed from a stodgy, bureaucratic old manufacturer to a speedier, more innovative software-enabled automaker. GM currently employs 25,000 software engineers.

GM believes it can double revenues by 2030, and improve margins through software and services. GM currently earns $2 billion of high margin software and services revenue, which is more than Tesla. Cruise, GM’s majority owned autonomous company, recently detailed why it sees the potential for $50B in revenues within 6-8 years of its 2023 launch of the Origin vehicle. BrightDrop, its autonomous commercial vehicle unit, looks promising as well with the potential for $10 billion in revenues. We don’t think this optionality is reflected in the current price. Investors started to see the potential after GM’s recently analyst day. We can easily get values for GM more than double its current price of $58.

The contrast between GM and Tesla illustrates what we see more broadly in the market, which is why we see more opportunity in classic value names than in the secular growth names. After a decade of dominance, expectations for innovative and disruptive companies are quite high. Many classic value companies were caught flat-footed, but have invested heavily to catch up. Muted expectations don’t reflect their improved prospects.

We do still see some higher growth companies with reasonable expectations. Farfetch is a good example. Most high growth darlings trade at much higher valuations than they have historically. This isn’t true of Farfetch, which trades inline with Amazon’s historical valuation, which is a good comparable due to business model similarities. Both companies have commerce marketplaces (though Farfetch’s is high margin and Amazon’s is high asset turns) and technology services businesses. Amazon’s web services (AWS) is now well recognized. Similarly, Farfetch’s strategy is to build the operating system for luxury goods companies who have been notoriously bad at technology. The market doesn’t yet reflect any value for this business, in our opinion.

Farfetch sold-off dramatically, recently trading at less than half its peak earlier this year. Fundamentals have performed strongly. The company has been able to maintain high growth on the top of difficult comps from last year, and recently reached adjusted EBITDA breakeven.

We think the company will continue to drive both growth and incremental profits over the coming years. The company’s nascent platform services and advertising businesses represent sizeable opportunities. Cost rationalization in shipping and logistics should create efficiencies. People who focus on Farfetch’s historical losses don’t properly distinguish between investments and operating losses (a common problem in a world of intangible assets). We believe Farfetch has the potential to be a multi-bagger over a multi-year period.

Long duration assets like Farfetch are more sensitive to movements in interest rates. We evaluate all our investments for adequate upside even with higher interest rates. Yet rising rates does represent a legitimate risk. Warren Buffett equated interest rates to gravity for financial assets.

To hedge this exposure, we bought TLT (long duration Treasury ETF) puts in the most recent quarter. Hedges typically are costly. We think this one is unique as we anticipate return potential in our base case as well as preservation potential in more extreme cases. It would offer sizeable gains in a more inflationary scenario that required more extreme moves in interest rates.

Overall we remain very excited about the prospects for the portfolio. We continue to think this is a timely entry point. We thank you for your continued investment and we will continue to work our very hardest to do well for our shareholders.

Samantha McLemore, CFA

Strategy Highlights by Christina Siegel, CFA

During the third quarter of 2021, Miller Opportunity Equity returned -14.22% (net of fees), compared to the Strategy’s unmanaged benchmark, the S&P 500 Index, return of 0.58%.

Using a three-factor performance attribution model, selection, interaction, and allocation effects contributed to the portfolio’s underperformance. Grayscale Bitcoin Trust, Matterport Inc., TLT P140 Jan. 2023, Alphabet Inc., and Capital One Financial Corp. were the largest contributors to performance, while WW International, Alibaba Group Holdings Ltd., Vroom Inc., Metromile Inc., and ADT Inc. were the largest detractors.

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

We added seven positions and eliminated ten positions during the quarter, ending the quarter with 47 holdings where the top 10 issuers represented 36.0% of total assets compared to 28.1% for the index, highlighting Opportunity’s meaningful active share of around 88.5%.

Top Contributors

    • The Grayscale Bitcoin Trust (GBTC) rose 14.34% during the period following the path of Bitcoin higher. Bitcoin rebounded during the period, recovering from the low of $29,865 in July to end the quarter at $43,436. Bitcoin continued to gain traction in a number of areas with Coinbase announcing Board approval to invest $500M of the company’s balance sheet into Bitcoin while Wells Fargo became the latest bank to register a private Bitcoin fund to serve their wealthy clients. Finally, a job posting from Amazon looking for a Digital Currency and Blockchain Product Lead for its Payment Acceptance & Experience Team spiked interest in the space.

    • Matterport Inc. (MTTR) took off during the quarter climbing 78.90% following the company’s de-SPAC in July. The company announced they have expanded ‘Matterport Capture Services’, their on demand digitization service, to 22 new US cities and added four in the United Kingdom. This will allow customers to schedule a technician to digitize any commercial or residential property and is now available in 51 US cities in total. The company also announced a beta version of its Notes collaboration tool, a conversational, real-time team collaboration, communication and file sharing tool inside the Matterport digital twin.

    • TLT 1/23 P140 was a hedge position we initiated in the quarter against rising interest rates given our exposure to some long duration stocks that could see headwinds from rate increases. We did this by buying January 2023 TLT (long duration Treasury ETF) Puts with a strike of $140, giving us protection if long-term interest rates (+20yr) rise, which we are already starting to see.

Top Detractors

    • WW International Inc. (WW) fell 48.75% during the quarter. The company reported 2Q results with revenues of $311M below consensus of $337M, with adjusted operating income of $65M below expectations of $82M. The miss came from the fact the company expected there to be a rebound in demand for weight loss as the economy started to open up but it turned out people were more focused on being social. The company guided for 2021 revenue of $1.3B near consensus of $1.28B with GAAP EPS (generally accepted accounting principles earnings per share) of $1.10-1.25 ($1.63-$1.78 excluding impact of early extinguishment of debt) versus consensus of $2.05. The company ended the quarter with the announcement that Mindy Grossman would be stepping down as President and CEO after the first quarter of 2022. The company is the process of searching for her replacement.

    • Alibaba Group Holding Ltd. ADS (BABA) dropped 34.22% during the quarter, along with most Chinese stocks as increased regulatory scrutiny pressured the market. Chinese regulators asked all companies in the industry to stop blocking links from competitors, rumors circulated that Alibaba, and Tencent would be opening up their platforms to one another. During the period, Alibaba reported mixed 1Q Fiscal Year 2022 (FY22) earnings with revenue coming in below expectations due to slower core commerce growth while adjusted earnings before income, taxes, depreciation and amortization (EBITDA) beat. Total revenue of Rmb 205.8B (34% YoY), came in below consensus of Rmb 209.4B with Alibaba Cloud revenue growing 29% YoY to reach Rmb 16.1B. Adjusted EBITDA margin came in at 23.6% versus consensus of 22.5%. The company announced an increase in its share buyback program to $15B from $10B previously while reiterating their original FY22 guidance of revenue of Rmb 930B (30% YoY). Alibaba also announced its plans to invest Rmb 100B by 2025 to support the government’s goal of “Common Prosperity”. Their investments will include tech investments in underdeveloped areas, overseas expansion, agricultural investments, high-quality employment for young adults, and facilitating digital equality between urban and rural areas among others.

    • Vroom, Inc. (VRM) was down 47.31% after reporting earnings that beat expectations but disappointed on guidance. Revenue of $761.9M beat consensus of $647.4M with EBITDA of -$60.7M slightly beating consensus of -$60.9M. The company guided for total revenue of $858-$891M versus consensus of $699M, but both gross margins and EBITDA disappointed. The company’s gross margin guidance of 6.2% was well below expectations of 8.8% leading to EBITDA of -$100M to -$92M against expectations -$59.4M as the company continues to invest for growth. The company also announced the appointment of Robert Krakowiak as CFO effective immediately, with David Jones remaining with the company through the end of November.

Top Contributors and Top Detractors
Top Contributors Ticker Return Contribution (basis points)
Grayscale Bitcoin Trust GBTC 11.7% 34
Matterport Inc MTTR 16.6% 30
TLT 1/23 P140 TLT 1/23 P140 23.3% 30
Alphabet Inc. GOOGL 9.49% 28
Capital One Financial Corp. COF 5.49% 12
Top Detractors Ticker Return Contribution (bps)
WW International Inc. WW -49.3% -132
Alibaba Group Holding Ltd. BABA -34.3% -131
Vroom, Inc. VRM -47.2% -127
Metromile Inc. MILE -61.6% -101
ADT Inc. ADT -24.6% -90

Performance Attribution
Click on image to view larger.

The data provided is from FactSet Research Systems 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. Parenthesis indicate a negative number.
*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 3Q 2021 Market Letter

Christina Siegel's 3Q 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