We attribute this to market structure changes that have led to higher risk aversion, shorter time horizons and less liquidity. We have high active share, meaning we differ greatly from the broad market. At the same time, we are patient, long-term value investors who tend to be contrarian and concentrated. When systemic market fears heighten, correlations spike and our performance can suffer (particularly as we’ve been positioned in more cyclical names). When these fears abate, we bounce back.
We believe that over the long-term, our performance will ultimately be driven by the fate of our companies. During these volatile times, the investment merits of our holdings tend to be our guiding force. During our underperformance in 2011 and the first half of this year, our companies did well overall (unlike 2008). This increased our conviction that the market sell-off was a buying opportunity. Despite the rebound in the quarter, we still see significant opportunities across the strategy. We will share a few of those with you.
OneMain Financial (OMF)
OneMain’s performance over the past year illustrates perfectly the broad behavior we’ve seen in the market. We’ve owned this name for years, previously as Springleaf Financial, a subprime consumer credit company built by Fortress Investment in the financial crisis. Springleaf acquired its largest competitor, OneMain Financial, from Citigroup last year making it the leader in the space with no significant competitors. The stock hit $51 last November as the market grew excited about the improved prospects due to the deal.
Then the stock tanked in January and February as fears about a market slowdown caused investors to flee anything cyclical and anything with leverage, a double whammy for OneMain. The stock reached a low of $18 in February on virtually no negative fundamental news (outside of heightened financing costs as high yield spreads widened, but these have since normalized). All the while, fundamentals for the company remained intact. The merger integration has proceeded well and there’s been no deterioration in credit. Since Feb, the stock has rebounded to $30. With the company annualizing earnings at over $4.00, the stock trades at less than 7.5x what it should earn this year. Historically, similar companies have traded closer to 10x earnings. We expect the company to be able to grow earnings per share to $6+ over the next couple years. As earnings and multiples normalize, we believe the stock has the potential to double in the next 12 to 24 months.
Delta Airlines (DAL)
We have written about this one previously, but continue to believe it’s another great example of the values in the market if you are willing to be patient. After massively outperforming for 3 years in a row (2012-2014), the airlines underperformed last year and this year. The market is worried that negative unit revenue trends indicate the cycle is over, and the airlines will lose the capacity discipline exhibited in recent years. We believe capacity rationalization and a change in management incentives to focus on return on capital, rather than growth, will continue to lead to more financial discipline and better equity returns. With the airlines trading at record lows on the favored industry metric (EV/EBITDAR – enterprise value to a measure of profits before interest, taxes, depreciation and airline rents), it’s clear we have a minority view.
Delta is the best example. At ~$39, it trades at 6.9x what it’s expected to earn this year. It earned over a 30% return on capital (ROIC) for the past 12 months. The company has massively deleveraged and improved profitability. At a recent investor event, the company announced that they raised all their long-term profit and free cash flow goals. It now expects to sustain 25%+ ROIC, 15% earnings growth and ~$5B free cash flow annually for the next few years. This means it has a ~17% free cash flow yield. It’s returning lots of this cash to shareholders. It has a 2.0% dividend yield and has increased its dividend by 50% for each of the past three years. It’s buying back a lot of stock and has gotten more aggressive at lower levels, which is both sensible and unusual. It has committed to buy back $3B over the next year, which equates to more than 10% of shares outstanding at current levels.
Clearly the market does not believe the current profitability is sustainable. However, we believe the company will be profitable in the next recession, which is unprecedented for airlines. If it had its current balance sheet in the Great Recession, it would have been close to breakeven excluding merger integration costs. We estimate it will earn ~$2.00 to $2.50 per share at the trough, meaning it trades at a below market multiple even on trough earnings. We don’t foresee a recession, but believe Delta is basically pricing one in here. That gives you a free call on a stable economy.
The company recently announced better than expected unit revenues, which the market liked. If this continues, we could be nearing the end of the current malaise. We believe airlines deserve to trade closer to other high quality industrials at mid-teens multiples implying a value for Delta closer to $80, or roughly twice the current price.
Lennar Corp (LEN)
Lennar is one of the largest homebuilders in the US with arguably the best management team. Since CEO Stuart Miller took over as CEO in April 1997, the stock has compounded at an average annual rate of 12.9%, hugely outpacing the S&P 500’s 7.2% comparable return and also beating the Dow Jones Select Homebuilder Index’ 7.6% return over the period. (You may be surprised to learn housing outperformed the market over the period despite the crash of the housing bubble. I was).
We like housing broadly given the fundamentals of growing demand based on demographics along with constrained supply. New housing starts are still way below a “normalized” level despite great affordability, improving median incomes and credit availability loosening on the margin. These conditions should create long-term growth that’s sustainable for years to come.
Lennar believes it can grow deliveries by 7-10% for the foreseeable future. Add in (moderating) pricing growth, operating leverage and additional value-creating opportunities, like the recently announced acquisition of WCI Communities, and we think you get sustainable earnings per share growth closer to 15%. Lennar is deliberately slowing its pace of volume growth to focus on cash flow production, which will be returned to shareholders in the not-too-distant future.
Yet, the company trades for less than 10x fiscal 2017 earnings, a deep discount to the S&P 500’s 16x 2017 earnings. We think Lennar represents a great opportunity to buy a proven management team who consistently finds innovative ways to make money at a bargain price.
This is just a small sample of the many exciting opportunities we see in the portfolio. With investment opportunities that already seem to price in a very negative economic outlook, we believe the base case argues for superb investment returns. Over the long-term, Opportunity should do very well if we are correct on the investment merits of our companies. There’s a dearth of investors patient enough to hold though heightened volatility. We believe there will be handsome rewards for doing so and we continue to work to earn those for our investors.
Read Opportunity Equity's 3Q 2016 Review
Read the notes from our 3Q 2016 quarterly investor call.
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.
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.
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