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Oct 21, 2015

Panic Is Never a Good Strategy

Samantha McLemore

Opportunity Equity 3Q 2015 Review

What a rocky quarter we just endured. After the worst third quarter since 2011, we’ve had the strongest bounce back through mid-October since that year as well. The S&P 500 declined about 12.5% from its high in July to its low in August. This was the first pullback greater than 10% in over three years. The vast majority of the damage (11% decline) occurred in a mere four days. Prior to the pullback, people complained about how the long duration without a 10% correction signified complacency and presented a risk. It’s true that corrections are a natural and healthy part of a market advance, but they always provoke fear rather than inspire confidence. The psychological damage inflicted by the financial crisis exacerbates this phenomenon.

At the height of the panic, volatility as measured by the VIX index hit 53, a level not seen since the depths of the financial crisis in early 2009. The VIX didn’t even reach this level in 2011 when fears about Europe causing a repeat of the crisis caused the S&P 500 to sell off more than 21%. Likewise, short interest on the NYSE spiked to financial crisis extremes and put-to-call ratios hit the highs experienced in August 2011 and December 2008. Clearly, panic filled the air.

All else equal, we believe this is a good thing. As Sir John Templeton said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” We remain far from euphoria. The market staged a nice bounce after making a double bottom. The September retest of the August lows was on lower volume with fewer stocks making new lows. After selling off significantly after a crummy jobs report, on October 2nd, the market experienced the biggest reversal since October 2011. The market continued its advance over subsequent days, making it appear the bottom has likely been made. The economic picture supports this possibility.

Economic growth appears to be continuing at a moderate pace – a stark contrast from what we saw prior to the financial crisis. Inflation remains contained. Corporate earnings have been solid despite headwinds from foreign currency and energy sector weakness, which have weighed on results. Most importantly, in our opinion, housing is clearly gaining traction. Household formations reached 1.8M units as pent up demand finally spurs action. Starts and permits have strengthened. Housing demand is solid, while supply constraints should make the recovery more steady and stable over the long-term.

There are some risks. Certain economies outside the US have well-known issues, though China appears to be stabilizing. Financial conditions and risk spreads in the US started deteriorating modestly in the middle of last year around the time the Fed talked of tapering. When the Fed finished its taper in October, we experienced further deterioration along with a market selloff and volatility. This year’s action again coincided with talk of Fed tightening. We do believe we are in a higher risk period as its unclear just how much tightening the economy can endure. We are monitoring the situation carefully.

That being said, we believe this investing environment is ideal for managers like us. Our long-term, intrinsic value focus allows us to take advantage of extreme price moves not justified by fundamentals. In the recent selloff, there were a number of our holdings that went in half on the back of no fundamental news. This represents a great opportunity to improve the embedded upside in the strategy. We have employed this tactic over the past few years to improve the strategy’s returns. In addition, we have the ability to hedge or short if we think it will be fruitful. We haven’t done so over the past few years due to our bullishness, but it is something we consider carefully especially as the market continues its advance.

Thank you for your continued support.

Market Commentary

The S&P 500 Index finished the quarter with a total return of -6.44%. The Nasdaq Composite declined -7.09% and the Dow Jones Industrial Average lost -6.98% on a total return basis for the quarter. Utilities were the only sector of the ten sectors in the S&P 500 to post positive returns during the period (5.40%). Large-cap stocks outperformed mid-cap stocks, which beat small-cap names. Specifically, the Russell 1000 Index’s -6.83% loss outperformed the Russell MidCap Index’s -8.01% decline and surpassed the Russell 2000 Index’s -11.92% loss for the quarter. Growth stocks marginally beat their value counterparts, as the Russell 1000 Growth Index lost -5.29% compared to the -8.39% loss of the Russell 1000 Value Index over the same period. The US Dollar Index increased 0.91% and is up 6.74% YTD. Oil (WTI Crude Oil Spot Price) lost almost all of its gains from the second quarter declining -24.18% during the period.

The stock market had its first 10% correction in three years declining 12.35% peak to trough. China’s sudden devaluation, fears of the Fed tightening in September alongside lackluster data and continued geopolitical conflict contributed to the negative investor sentiment. On July 14th, Iran and six world powers signed a historic deal to curb Iran’s nuclear program. This was followed in August by China’s announcement that the daily fixing of the renminbi against the US Dollar would be determined by the market which caused immediate devaluation of the renminbi. The migrant crisis reached a peak over the quarter with more than 549,000 refugees arriving in Greece, Italy and Hungary so far this year. The EU approved a plan to relocate 160K migrants which is only a fraction of the 1.3M asylum applications they expect to receive this year. The numbers continue to increase as the conflict in Syria, Iraq and Afghanistan worsen. ISIS destroyed antiquities in the historic city of Palmyra in Syria in August. The Taliban captured Kunduz City in late September and Russia joined the fight against ISIS in Syria while also supporting President Bashar al-Assad’s regime at the end of September adding to the complications in the area. Greece held their second general election in less than nine months with Alexis Tsipras’ left-wing Syriza party winning the elections again. After much apprehension, the Fed did not hike rates in September amongst uninspiring data. This reaffirmed confidence that the Fed will be data dependent and not date dependent.

Every country in the ACWI posted negative returns in the third quarter. China had the largest decline in Emerging Asia, falling 23.2% in local currency terms. Japan reversed its previous gains, returning -14.3% during the period.

Strategy Highlights

During the third quarter of 2015, Opportunity Equity returned -10.27%, net of fees1. In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index, returned -6.44% for the same period.

Using a three-factor performance attribution model, security selection contributed to the Strategy’s underperformance, which was partly offset by interaction effects and allocation effects. The Inc. C300 01/17, Pandora Media Inc., Zulily Inc., Inc. and Delta Air Lines Inc. were the largest contributors to performance, while Intrexon Corp., Platform Specialty Products Corp., Twitter Inc. C35 1/17, Apple Inc. C100 1/17 and Genworth Financial Inc. were the largest detractors.

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

We initiated one position and eliminated five during the quarter, ending the quarter with 57 holdings where the top 10 represented 41.11% of total assets compared to 17.26% for the index, highlighting the Strategy’s meaningful active share of around 95%.2

Top Contributors

    • The C300 1/17 Calls were up 48.99% during the quarter as Amazon beat consensus estimates (20% revenue growth vs Street at 15.8%) and showed continued margin expansion. AWS showed growth of 81% up from 49% in the first quarter. Amazon continued to roll out same-day shipping in 12 new metro areas. Over the period, Amazon announced the acquisition of Elemental Technology.

    • Pandora Media Inc. climbed 37.32% over the quarter. Revenue of $286M beat estimates of $283M as a result of second quarter advertising growing 30% YoY. The CRB decision is still months away but a decision was made by the Registrar to allow 3rd party deals submitted by Pandora to be considered benchmarks for price setting. Many see this as a large positive for Pandora.

    • On August 17th, Liberty Interactive Corp QVC Group announced the acquisition of Zulily Inc. for $9.375 in cash and 0.3098 in QVCA stock for each share of ZU. As a result, Zulily Inc.’s shares returned 33.44% over the quarter. The acquisition was completed on 10/2/2015.

Top Detractors

    • Biotechs were hit hard over the quarter with Intrexon Corp. declining 34.84% over the period. Intrexon reported good second quarter results and announced the acquisition of Oxitec Ltd, which does research and development in biotechnology, in the third quarter.

    • Platform Specialty Products declined over the quarter ending the period down 50.55%. PAH missed on adjusted EPS ($0.25 vs. Street $0.29) but beat adjusted EBITDA at $168M vs the consensus estimate of $153M. In July, Platform announced the acquisition of Alent PLC, which manufactures advanced surface treatment and plating chemicals. Significant changes to management occurred over the quarter, with current Platform CFO, Frank Monteiro, becoming COO, and Sanjiv Khattri, from Covanta, becoming CFO.

    • The Twitter Inc. C35 1/17 Calls were down 59.34% over the quarter. Twitter announced second quarter results that beat estimates and guidance ($502M vs consensus of $482M/guidance of $485M) but missed user targets. At the end of September, Twitter announced that co-founder Jack Dorsey would be named the permanent CEO after holding three months of interviews. Twitter continues to improve their platform with the rollout of Twitter Moments in early October.

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.

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