Out Of Jail And Into Malls – Bill Miller Income Strategy 2Q 2017 Commentary

 

The second quarter was a good one for our Income Strategy, as we outperformed the primary benchmark, the BofA Merrill Lynch High Yield Master II Index, for the fourth consecutive quarter. The Strategy also declared and paid a $0.15 dividend, implying a 7.2% annualized current yield. Compare this to the high-yield index, which ended the quarter with a 5.7% yield-to-worst, representing the fifth percentile of yield going back to 1994. Put differently, the diversified high-yield market has been less expensive on an absolute basis approximately 95% of the time over the past 23 years. This is partially why the majority of the Strategy remains in equities, which look to be a far better value proposition for the long-term investor. One advantage of running a flexible, concentrated strategy is that we can wait for what Warren Buffett has called “fat pitches.” We ended the second quarter with only 44 individual positions. Five of those positions are in overlapping issuers, so we own securities of just 39 issuers. In the paragraphs below, we will review our thinking around some of the more significant changes in the Strategy in the past quarter.

The most significant change was the liquidation of our largest position, corrections operator GEO Group (GEO). We invested in the company shortly after the previous administration’s Department of Justice announced in August of 2016 that they intended to phase out the use of private prisons, cutting the stock by almost 40% in one day. After reviewing facility contract details in company filings, we determined that the extent of the stock’s move was far too large in relation to what was practical. We thought the cratered stock was an attractive value proposition even if the government did phase out private operators, and while a Trump victory was not our base-case scenario, we thought it could be another way for GEO owners to do even better. After the election and rescission of the phase-out order, the stock rallied to an all-time-high price, which we did not believe would allow us to generate a risk-adjusted return substantially above our benchmark, so we sold the stock. We eliminated several other smaller positions, though this was the most significant sale.

The proceeds of the GEO sale went into a handful of new positions, the most controversial of which are probably our shopping center REITs (real estate investment trusts), Washington Prime Group (WPG) and CBL & Associates (CBL). The ongoing narrative is that Amazon is fundamentally changing the retail business as we know it and killing many traditional retailers in the process, which is true. However, we think the narrative reflected in current prices has outpaced reality. The stocks now trade near a low-teens dividend yield, and the ample free cash flow coverage of the dividends, combined with what we think is the most likely path for the cash flow, means the dividends are likely safe for the foreseeable future. Seasoned management teams run these companies, and this is not the first time consumer preferences have changed. The firms are using the excess cash flow above and beyond the dividends to redevelop their properties, and such investments thus far appear to generate compelling incremental rates of return.

We will continue to stick to our valuation-driven approach to finding undervalued, income-generating securities. As always, we welcome your questions and comments.

Top Contributors

  • Private equity firm Carlyle Group LP (CG) soared in second quarter after reporting Q1 EPS of $1.09, handily surpassing the consensus estimate of $0.38. Performance was strong across segments, helping drive a 34% bump in the firm’s net accrued carry; the market also cheered commentary around accelerating fundraising. Minimal harvesting activity caused the company to declare a dividend of $0.10/unit (2.0% annualized yield).
  • Valeant Pharmaceuticals International Inc. 6.75% 8/21 rose 11.8% over the period. The company reported Q1 adjusted EBITDA of $861M versus analyst estimates of $858.9M. Management also raised FY adjusted EBITDA guidance to $3.60-$3.75B, up from $3.55-$3.70B. The company completed the sale of Dendreon ($819.9M) in June and announced the sale of iNova for $930M. If successfully completed by year end, the company will have paid down ~$5.4B in debt, meeting their goal to pay down $5B by February 2018.
  • Apollo Global Management LLC (APO) continued its climb in the second quarter after reporting 1Q EPS of $0.82, which easily surpassed analyst estimates of $0.64. Management declared a distribution of $0.49/share (7.3% annualized yield), representing the highest distribution in two and a half years.

Top Detractors

  • Frontier Communications Corp. (FTR) common stock and Frontier Communication Corp. 11.125% Preferredwere the top two detractors falling 44.0% and 35.9%, respectively. The company declined after reporting Q1 EPS of -$0.11, below analyst estimates of -$0.05. The company also slashed its dividend 62% to $0.04/share (16.0% annualized) and continued to see elevated customer churn. The company launched a seven-year $1.5B term loan to improve liquidity and lower debt costs, but Moody’s still downgraded the firm’s corporate family rating to B2 from B1 based on weak operating results and subscriber losses.
  • Medley Capital (MCC) declined -14.7% during the quarter. The company reported fiscal 2Q adjusted net investment income of $0.17/share versus analyst estimates of $0.20 and cut their dividend -27.3% to $0.16/share (10.1% annualized yield) as credit challenges persisted.
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Laughing Water Capital Q2 2017 Investor Letter

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Alternative to What?

  • Market action in the first half has been unusually calm, with the market doing a good job of ignoring the negative headlines and drifting upwards almost without interruption
    • This environment has made it unusually easy for investors to stick with passive strategies, much to the detriment of active or alternative strategies
  • SP500 is market cap weighted and float adjusted
    • Market cap weighted means that if there were 2 companies that were completely identical except that one was more expensive than the other, SP500 would own more of the expensive company: if you are keeping score, this is equivalent to “buying high”
    • Float adjusted means that if there were 2 companies that were completely identical except that at one company, the management team owned a lot of shares, SP500 would own less of this company: this means that the more confidence the management team has, the less stock the SP500 owns
  • At present, SP500 is trading at LTM P/E of 25x with margins above their normal level and its growth will ultimately be linked to inflation
    • Even Jack Bogle (founder of Vanguard) has opined that SP500 returns over the next decade are likely to be 4%/year
  • Over longer periods of time, our results will be predicated on the ability of our incentivized management partners to unlock the value we see in their temporary hindered companies, and by our ability to remain rationally focused on fundamentals in a world that is irrationally obsessed with headlines

A Word on Volatility

  • Over the last 6 months, every one of our starting top 5 investments declined by at least 15% from high to low at one time or another, and 2 of those investments are no longer in our top 5
  • Any sizeable divergences are decision points, and we faced several in the first half
  • Even the best businesses in the world like Berkshire Hathaway have seen their stocks suffer short term declines in excess of 50% as they continued their march forward
  • Our investment in Iteris which suffered five declines of 15% or more during the last 6 months – if we had tried to avoid them, likely would have missed out on owning a very good business that is executing at a very high level

Comments on Selected Investments

  • EZ Corp (EZPW): traded off substantially in the first half, despite executing at a very high level and continuing to drive improving fundamentals
    • On 6/28, company announced they would be refinancing their debt and potentially acquiring a LatAm operation, as we had hoped
    • News led to sell-off in the market as refinancing is taking the form of a convertible bond
    • Equity capital is precious, and should not be used lightly, and have adjusted down our upside price targets as well as our faith in management’s ability to steward our capital
    • Despite our general disagreement with dilutive capital raises during a period when equity is undervalued, case can be made that it makes sense to sell cheap equity to purchase cheaper assets and we are withholding final judgment on the convert until we learn more about company’s acquisition plans
    • EZPW is under-scaled in Mexico and LatAm and it is possible that inclusive of synergies we will be able to buy LatAm pawn assets at an absurdly low multiple
    • Longer term, EZPW has multi-bagger potential through a return to growth and the eventual dissolution of the dual share structure and we are happy to own a defensive business that should benefit if the economy softens as the economic recovery continues to age
  • Gaia (GAIA): has impressed the market by growing faster than expected and spending less money on growth than forecast
    • Only recently started to expand its foreign language offerings and management has indicated they have received inbound interest from potential foreign customers, eager to gain access to GAIA’s offering
    • Given that Netflix recently made headlines as international subscribers became a larger % of the total than domestic subscribers, foreign language offerings should aid Gaia in their continued pursuit of new customers
    • Recently organized a social gathering for some of its “Truth Seeking” customers which was an enormous success
    • Continues to march toward 1.6M subscribers, and $2.50/share in earnings which would likely lead to upside of several hundred percent
  • Iteris (ITI): despite its considerable appreciation over the last 1.5 years, remains under-valued
    • Extrapolation suggests that transportation businesses are now producing in excess of $12M in FCF
    • If the transportation businesses are viewed as a simple consulting business, absent corporate expenses they would deserve a valuation in excess of current market prices, meaning that the fast-growing agricultural business is currently free to investors
    • In the coming decades, intelligent transportation market and autonomous vehicles could be worth trillions of dollars
    • To date, market attention has been focused almost exclusively on autonomous vehicles and their ability to communicate with each other
    • Iteris is not only the leading player in the sensor market, they are literally leading the development of the Architecture Reference for Cooperative and Intelligent Transportation under the US DOT
    • Continued to make progress with several notable customer wins in recent months in agriculture business
    • Management has also created a new, separate legal entity to house the agriculture/weather business, which suggests that an eventual sale of this business is somewhere on their radar
  • Now Inc (DNOW): been a laggard during the first half as the market is worried that increasing Western oil production is more than offsetting production cuts from OPEC
    • Day to day, DNOW treated as a proxy for oil prices – but the reality is more complex
    • In the intermediate and longer term, DNOW is dependent on oil volumes, not price
    • Investment has been predicated on the belief that as a dominant player in the distribution of parts for energy-end-users with a rock solid balance sheet and ample liquidity, any difficult times would allow DNOW to gain market share as they acquired struggling independent operators
  • Revlon (REV): started the year with gains of 20% but later sold off as domestic sales suffered, largely due to a channel shift from mass to specialty
    • Much of our thesis has been focused on the successful integration of Elizabeth Arden and international growth, but success in these areas have been over-shadowed by the domestic difficulties which I failed to fully appreciate
    • As inventory overhangs in the mass channel clear, pricing will come back, and controlling shareholder Ron Perelman has been aggressively buying shares of late, seemingly putting a floor beneath them
    • Open market purchase has increased the likelihood that the business will be taken private before ultimately being sold to a strategic buyer
  • Points International (PCOM): Canadian company focused on consumer loyalty market which entered our portfolio as a mid-sized position
    • Main business is providing the software and know-how to airlines and hotels to allow consumers to “buy, gift, transfer” loyalty points
    • Few short years ago, PCOM was a growth-crowd darling and traded at 100x EPS – however, a series of bumps in the road and a re-focusing of their business toward lower margin, longer term contracts, as well as investments in 2 not-yet-profitable business lines led to a ~75% decline in share price
    • Asset light nature and long-term contracts – attracted to the investment by its misleading GAAP financials, a pending change to the way the company reports segment earnings, and the complete turnover in the shareholder base as panicked growth investors threw in the towel
    • With 75% of revenue-partners locked in for 3 years, 3 growing business units, a management team that conceded they would likely be better served outside of public markets, strategic value that could be quite high, and a noted activist likely to push for a sale, it is unlikely that the 10 year future will matter in this case
    • A sale is not necessary for a successful investment as the company continues to strengthen its offering and the core business produces plentiful cash flow, which the market should recognize as the newer businesses reach break-even levels in 2018
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