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Jul 20, 2015

Seeing More than the Gorilla in Our Midst

Samantha McLemore

Opportunity Equity 2Q 2015 Review

We attended a fantastic conference at the end of June. Our former colleague, Michael Mauboussin, now works at Credit Suisse First Boston and still hosts the annual Thought Leader Forum. It covered many interesting topics, including perception and attention. The bottom line: we pretty much fail miserably at accurately observing our world.

Many people may be familiar with the gorilla experiment where most people fail to notice a black gorilla waltz across the screen when they are focused on counting basketball passes of other participants. At the conference, they asked those of us who were already familiar with it to play along. We did, and most of us noticed the gorilla (awareness of what you’re looking for really boosts your ability to detect it). However, most of us failed to pick up on a number of other new changes, like the background curtain changing to an entirely different color and one person leaving the stage. Even when you know you should be alert to changes, your mind just doesn’t function in a way that allows you to notice, particularly when you’re focused or when the change is on the margin.

So what does this have to do with the markets, and our Strategy? Well, everything. Markets are all about marginal change. As a result of the financial crisis, risk dominates investment thinking, even though we’re 6 years off the lows. During those extreme days, we found a quote that we loved, and still do, by Arthur Pigou, an English economist. “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.” The giant lives on.

Birinyi Associates publishes a monthly piece on the markets. Laszlo Birinyi, one of the few to get bullish near the lows, has consistently produced better market forecasts than others. His most recent piece started,

"The Nasdaq hit multiple all time highs this month while the other major indices were within hailing   distance of theirs….We mention this as it was generally ignored by the media and by mid-month one might have thought we were in a bear market. We continue to find it disturbing when good news, big days are relegated to the interior of the financial section while the latest regulatory issue or scandal is the apparent highlight."

It is amazing that this black cloud still hangs over our head with the market more than triple its 2009 low. From February 28, 2009 through the recent quarter end, the S&P 500 achieved a 221% total return, and our Opportunity Equity strategy doubled the market’s return (443% total return net of fees).

The pervading culture of risk management reinforces this psychology. Stereotypes always have exceptions. We found one that may not have any, and certainly doesn’t have many. Risk managers (and there are many more layers of them now) believe one thing: if something is falling in price, you should own less of it, not more. We bought a little Sberbank, the dominant Russian bank, last fall when the crisis heightened and the ruble-dollar exchange rate hit 69 (up from 34 a few months earlier), an extreme level. We spoke with an analyst who used to work with Bill and now works for a large mutual fund complex and asked if anyone in her shop did anything in Russia then. She said that at the peak of the crisis, her risk managers put a halt on buying any Russian securities. Another value investor told us a similar story. The Micex index, which consists of Russia’s 50 most liquid stocks, is up 17% year-to-date in rubles and 22% in dollars. Risk mitigation equaled return mitigation in this case (and many others).

With all this focus on risk, what aren’t people noticing? My good friend, and former colleague, who is Chinese, told me that the Chinese word for risk/danger is 危机, which is made up of two words, with the left one meaning risk and with the right one meaning opportunity. This seems very wise. We find many scenarios where perceived risk exceeds actual risk leading to an investment opportunity.

Bill has been doing this professionally for about 35 years and recently said that the period since the financial crisis ended has been among the most fruitful for active managers he has seen in his career. People hyper focus on timing their trades perfectly. Virtually no one looks past the next quarter. The premium placed on low volatility trumps most other things so there’s little willingness to buy when prices are falling (and values are improving). This means a long-term contrarian value investor can find great opportunities.

When discussing the Opportunity Equity’s longer-term track record with some clients, they expressed surprise that they didn’t know just how well the strategy had done over its life. The strategy was launched in December 1999. Since then, it’s up an average of 7.35% per year (net of fees)1 vs. the S&P 500’s 4.21%. Given the low return environment, the 314 bps of annual outperformance is 75% higher than the market.

We believe the path of least resistance for the market is higher. First quarter GDP should mark the bottom, meaning growth is accelerating. We’ve maintained housing is the key to the economy and market. Those numbers keep strengthening. The first time homebuyer is back and household formations keep growing nicely. Outside of energy, earnings keep growing. With the market flat, multiples are contracting. The real earnings yield of the market, which we believe has the best forecasting ability of any metric, is still above historical averages. Since monetary tightening and recession usually harken the end of a bull market, we track both carefully. Of 14 recession warning signals, none indicate a problem. The Fed continues to emphasize a slow, gradual path higher for interest rates. Consequently, we believe patient investors should earn solid returns.

We continue to see attractive opportunities in the market. This risk-averse, short-term market discards names in decline despite superb valuations and a solid outlook. Airlines represent the best illustration currently. Industry rationalization and a new return on capital focus have improved the economics. Companies are posting record profits, but valuations are below the low end of historical levels, meaning they get no credit for structural improvement. Delta, for example, looks great on the fundamentals. It’s earning record profits and cash flow. It has paid off a ton of debt. It had $17B of debt in 2009 and it will be $6B by the end of this year and $4B by 2017, according to the company. Its return on capital over the past 12 months is 20%. It aims to produce $7-8B in operating cash flow and $4-5B of free cash flow annually from 2015-2017. At current market levels, the midpoint implies a 14% free cash flow yield. It’s using excess cash to buy back stock and it buys more at lower prices, which is rational and rare. It’s paying and growing its dividend. You just can’t find many opportunities like that in the market. Yet no one wants to own it. Our ability to look past some ugly near-term headlines and stock charts helps us as we seek to earn attractive returns.

We thank you for your support. We will continue to work hard to pursue attractive returns.

Market Commentary

The S&P 500 Index finished the quarter with a total return of 0.28%. The Nasdaq Composite beat it rising 2.06% and the Dow Jones Industrial Average lost -0.29% on a total return basis for the quarter. Five of the ten sectors in the S&P 500 posted positive returns during the period. Health Care and Consumer Discretionary were the biggest outperformers with returns of 2.84% and 1.93%, respectively. Small-cap stocks outperformed large-cap stocks, which beat mid-cap names. Specifically, the Russell 2000 Index’s 0.42% gain surpassed the return of the large-cap Russell 1000 Index’s 0.11% return and outperformed the Russell MidCap Index’s -1.54% loss for the quarter. Growth stocks marginally beat their value counterparts, as the Russell 1000 Growth Index rose 0.12% compared to the 0.11% return of the Russell 1000 Value Index over the same period. The US Dollar Index declined 2.92% but is still up 5.78% YTD. Oil (WTI Crude Oil Spot Price) rebounded 24.94% during the quarter.

The stock market moved sideways despite continued geopolitical conflict, worries of the Fed tightening and fear of a Grexit. In April, Iran agreed on a framework for its nuclear program with the final agreement set to close on June 30th. The deadline was not met but talks are expected to close in early July. Sepp Blatter stepped down as FIFA President after the US Justice Department charged 14 people, including nine FIFA officials, in a 47-count indictment. Ireland became the first country in the world to legalize same-sex marriage through popular vote. This was followed in June by the US Supreme Court making same-sex marriage legal in the United States. On June 30th, Greece became the first developed nation to default on its payment to the IMF after talks broke down earlier in the week. On July 5th, the Greek people voted “no” to a referendum to accept international creditors’ proposals for more austerity in exchange for rescue loans. This sparked fear of a Grexit; however, Greece accepted austerity measures in return for a three-year bailout worth up to $96B on July 13th. From June 12th to the end of the quarter, the Shanghai Composite lost 17.01%. The Chinese government reacted by suspending IPOs, banning shareholders with more than 5% of a company’s shares from selling, providing cash for more people to buy on margin, all while half the companies listed on China’s two major exchanges have suspended trading. After much apprehension, the Fed did not hike rates in June.

Japan was the strongest region in the ACWI, posting gains of 5.19% in local currency terms. Two out of the fourteen countries in Europe posted gains with the other twelve posting losses in local currency terms. Emerging Markets rose 0.70% supported by Russia’s 3.99% gain over the period.

Strategy Highlights

During the second quarter of 2015, Opportunity Equity generated a return of 2.44% (net of fees). In comparison, the strategy’s unmanaged benchmark, the S&P 500 Index, returned 0.28%.

Using a three-factor performance attribution model, security selection, interaction effects and allocation effects contributed to the strategy’s outperformance. The Inc. C300 01/17 call options and our Netflix Inc., MGIC Investment Corp., Cigna Corp. and Intrexon Corp. investments were the largest contributors to performance, while American Airlines Group Inc., United Continental Holdings, Nationstar Mortgage Holdings Inc., Groupon Inc. and Fiat Chrysler Automobiles were the largest detractors.

Relative to the index, Opportunity Equity was overweight the Financials, Consumer Discretionary, Industrials, Information Technology and Materials sectors on average during the quarter. With zero allocation to Utilities, Consumer Staples and Telecommunication Services, the strategy was dramatically underweight these groups and more moderately underweight the Energy and Health Care sectors. In terms of sector allocation, the underweight position in the Health Care 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 three positions and eliminated one during the quarter, ending the quarter with 60 holdings where the top 10 represented 37.79% of total assets compared to 17.28% for the index, highlighting Opportunity Equity’s meaningful active share of around 96%2.

Top Contributors

    • The C300 1/17 Calls were up 54.1% during the quarter as Amazon beat consensus estimates (3.1% operating margin vs Street at 1.9%) and showed significant profit outperformance. AWS was broken out for the first time and showed margins that were +17% surpassing expectations. Amazon continued to roll out same-day shipping into 6 new metro areas and is gearing up for “Prime Day”, which is a global shopping event for Prime members with more deals than Black Friday.

    • Netflix Inc. (NFLX) continued to climb over the quarter increasing 57.66% during the period. The company beat its guidance of total new subscriptions by 800K in the first quarter alongside improvement in both content and international markets. Netflix launched in Australia and New Zealand in the first quarter and in Japan in the second quarter. The company reiterated its goal of being in 200 global markets by the end of 2016. In the second quarter, Netflix announced the approval of a seven-for-one stock split to take place on July 14th.

    • MGIC Investment Corporation (MTG) continued its strong performance ending the quarter up 18.17%. First quarter results beat expectations with EPS of $0.26 vs. consensus of $0.22. Strong credit performance along with improved NIW and lower notices of new delinquencies helped improve investor expectations. The market is hoping for the potential deployment of excess capital going forward.

Top Detractors

    • Airlines were hit hard over the quarter with American Airlines Group Inc. (AAL) and United Continental Holdings Inc. (UAL) becoming two of the largest detractors declining -24.18% and -21.17%, respectively. American had a good first quarter beating on EPS of $1.73 vs. consensus of $1.71. In addition, American generated $1.1B in free cash flow during the first quarter. United beat on first quarter EPS of $1.52 vs. consensus of $1.44, as well. Overall weaker RASM in the industry drove the story for the negative performance of the airlines.

    • Nationstar Mortgage Holding Inc. (NSM) declined over the quarter ending the period down 32.18%. Nationstar reported a first quarter EPS loss of -$0.53 versus consensus forecasts of $0.77. Servicing income had the largest miss while originations and Solutionstar segments were in line with expectations. While servicing revenue was higher, larger expenses drove the miss.

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.