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February 12, 2019

February 12, 2019

Bill Miller IV Talks Income Investing with Consuelo Mack

Elizabeth Goodier
Bill Miller IV was recently a guest on the WealthTrack podcast to talk with Consuelo Mack
about our approach to income investing. Here is an excerpt of that interview (note this has
been edited for clarity and brevity). For the full interview, visit the WealthTrack website.

Consuelo Mack: It’s interesting to me that the Income Strategy came out of an
unusual situation which was the depths of the financial crisis. You launched the
Income Strategy in 2009. Define how it’s evolved since then.

Bill Miller IV: The thought process behind the Strategy was the idea that here’s a
basket of securities that are higher up in the capital structure than equity, so
theoretically safer, but they’re also priced to produce a very nice rate of return. Even if
things didn’t recover in 2009 or 2010, we thought we would clip a very nice income
stream while we waited for things to recover, and then potentially earn some return
on top of that.

It’s evolved a little bit, but that’s still the basis of our thought process today. We’re
looking around the world and up and down capital structures for securities that are
kicking off a high level of yield, but also that we think are undervalued.

We build the portfolio on a name-by-name, fundamental value, bottom-up basis, so

we’re not saying, “Our view of the world is X and, therefore, we want to buy securities
that kind of match that view.” We’re looking at everything through screens, all kinds of
systematic processes, then trying to figure out from there what might be undervalued,
and then concentrate within those securities that present what we think will be the
best risk-adjusted returns.

CM: It’s also different, your emphasis on high-yield, in that many income strategies for
instance will say, “We’re going to avoid high-yield securities, number one,” and when
I’m talking about high-yield securities, I’m talking specifically about stocks because if
it’s among the highest yielding stocks, that means that the stock is probably under
pressure for some reason, or the payout ratio is really high, and that means that the
management is not doing proper capital investment back into the company, or there’s
some other problem associated with it. It’s an unsustainable level, but you have some
interesting research about the fact that the performance of high-yielding securities is
actually pretty good over the long term. Can you explain the research, and maybe help
us rethink our attitudes towards high-yield securities?

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BMIV: The more work we ended up doing on higher-yielding securities after we
launched the Strategy, the better we liked it for the risk-adjusted returns aspect. We
happened upon a study that showed that if you had just purchased every single year
the top 30 percent of the stock market just ranked by dividend yield and rebalanced
once per year – this is going back to the 1920s all the way through a year or two ago –
you would have outperformed the equity market by, I think, 130 basis points per year,
with much lower volatility than the market. That’s again a very nice risk-adjusted
return.

I think there are a few reasons for that, and these are hypotheses. First, I think part of
it is the value effect. High-yield securities generally tend to have a low price-to-earnings
ratio, as you just pointed out, and the value effect is a very well-known way to generate
returns. I also think there’s an aspect to it whereby management teams have a much
higher level of capital discipline if they’re paying out a high level of their cash flow to
shareholders. So there’s kind of this implicit agreement that, hey, these cash flows are
yours, and if we want to start a new business or reinvest, we actually have to go to the
equity market or the debt market and validate those plans with someone else. So I
think there’s an element of capital discipline there for management teams. Then finally,
while I have not seen a lot of research on this, it seems to me that there is a very
positive tailwind from carry. So if a security is going to be paying you a dividend every
single quarter – that gets priced into the stock, and there’s kind of this cash flow carry
element to it. So high-yield bonds, at least as an asset class, have historically returned
roughly what equities have but on a much better risk-adjusted or volatility-adjusted
basis, and I think that’s just because of the carry aspect where you get the cash flow
behind you at all times.

CM: How does the Income Strategy differ from a lot of the other traditional income
strategies out there? Again, when I think of the ones that I’ve been covering over the
years, it’s either you’re in an income strategy because you want current income, or
there are some income strategies that focus on companies with growing dividends.
Then there are others that are focusing on total return. I mean how do you consider
yourselves to be different?

BMIV: I think that the unconstrained nature of the Strategy is different from most
things out there. Most investment “products” are slotted into some kind of style box or
narrow set of objectives, whereas with this Strategy we can go anywhere in the capital
structure, anywhere in the world and find what we think are the best risk-adjusted
income streams and put them together in a portfolio. I also think this unconstrained
nature is really important because the more constraints you put on an optimization
problem – and creating a portfolio is an optimization problem – the less likely you are
to get a good result.

CM: Give us another example that’s not a private equity firm, that again exemplifies
your approach that when you looked at it you said, “Yes, this is the debt or the stock or
whatever for us.”

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BMIV: Well, one of the pieces I wrote was called “In Search of Uncertainty Discounts,”
and the private equity managers are a great example of an uncertainty discount.
Another uncertainty discount – which by the way is going to be uncorrelated with this
group of stocks – is a company called National CineMedia (NCMI). It’s essentially the
advertising network on most of the movie screens in the U.S.

The dividend yield today on that is about 10%, and that’s on a reduced dividend, by the
way, because they wanted to reinvest in digital and all these other initiatives, so it’s
very well covered by free cash flow. The interesting thing about it is that it’s sort of like
the private equity firms. Movie attendance and how attractive the slate is to
advertisers is very hard to predict in a given quarter, but if you look at movie
attendance over a longer period of time, it’s declining roughly one percent a year.

So what kind of happened for a little while there I think is it was a weak slate of movies.
Attendance was down quarter over quarter, and you string together a couple of these
quarters, and the market starts discounting as though that’s happening into
perpetuity. But if you take a little bit of a longer-term view of what movie attendance is
likely to be, we realized that it’s a hit-driven business and very hard to predict over the
short term. I think that the stock for a while traded in the $12 to $15 range, and I think
that’s probably about fair value, whereas today it trades at seven. So the market is just
discounting this current trend into perpetuity, and I think if you just wait and clip some
dividends, you’ll see some gradual appreciation back to what it’s worth.

CM: Let’s talk about the bigger issue that investors are talking about and that is the
active versus passive approach. At Miller Value Partners, you are very actively engaged
in security selection and investment strategy. There’s a lot of competition from the
more passive approaches which have worked quite well over the last decade in this
bull market. So how do you respond to those who say, “Why don’t I just get a high-yield
ETF?”

BMIV: Well, I think the passive trend is real and for good reason. Active managers as a
group have failed to outperform their indexes, and mathematically that’s going to
continue because active managers as a group are essentially – well, plus the passive
guys – but they are the market, and so you take the market and you deduct fees, and
you’re going to be at a return lower than the market. But I think it’s important to note a
couple things. One, passive strategies don’t actually give you the index’s return. They
give you the index’s return less fees. If you look at the returns to the high-yield ETFs
that are supposed to track those indexes, they’ve historically been much lower than
the “unmanaged” and un-investable index just because you have to pay some sort of
premium for that daily liquidity that you get in the ETF, and it’s in the form of lower
returns than the actual benchmark. So you’re not always going to get the benchmark
returns, and some of the comparisons are not always fair.

With that said, again I think that the shift to passive is going to continue, but despite
that, I think there is still room for active managers, and there are a couple things you
want to look for when you hire an active manager. Aside from the obvious things such
as low fees or reasonable fees and low turnover, I think the most important thing is
something I touched on earlier which is an unconstrained approach, in that if you look
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at the way most institutional money management firms are set up or strategies are set
up, they’re set up in a way that kind of boxes in the managers in a big way. They say
you can’t deviate from the index. You can only deviate from the index in certain ways.
You can’t overweight certain names too much. You can’t underweight certain indices
too much because it’s a business concern, frankly, for a lot of these firms. If you take a
big swing and a big active bet against the index and you miss, well, you’re going to get
fired and you’re going to get paid a lot less money. It’s a survival mechanism that a lot
of people have developed, but unfortunately, it’s also created a huge headwind for
them. So having an unconstrained approach where you can actually take real bets
relative to the index is very important, and the academic research shows that
strategies that have what’s called a high active share are much more likely to
outperform, and so having that unconstrained approach is immensely important in my
opinion.

CM: In fact a high active share means that you’re not correlated with the market, and
in the interest of diversity you don’t want to be and, therefore, you’re not an index
hugger and you’re doing something that’s very different than what an index would do.

For the full interview, visit the WealthTrack website.

Read Bill Miller IV’s 4Q 2018 Income Strategy letter and learn more about the Income
Strategy.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of Miller Value Partners 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 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.

©2019 Miller Value Partners, LLC

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