Ruminations on Returns, Prices, and the World’s Biggest Buyer
the Miller Income Strategy returned 2.13% (net of fees) in the fourth quarter of 2021, compared to 0.66% for its benchmark, the ICE BofA US High Yield Index. From the beginning of the strategy, we have designed it to provide a functional advantage, namely a high level of income, while maintaining the flexibility to navigate a variety of investment environments. Although the lack of constraints around asset classes presents a hurdle for investors wishing to operate within carefully constrained style boxes, it is proving particularly important today with inflation hitting a 40-year high of 7% in 2021.
In previous letters to investors, we have often noted that diversified fixed income is not a good place to hang out in the face of macro data and valuations. Last year’s returns confirm this outlook. In 2021, the high yield index achieved a total return of 5.36%. However, it is not possible to invest in the index, as it represents a collection of 2,123 different bond issues, many of which do not trade frequently enough to buy. The two most liquid high-yield passive ETFs posted returns between 3.75% and 3.99% last year. Not only are these returns significantly lower than those of the index, but these ETFs, as well as the index, all returned less than the rate of inflation in 2021, meaning those who invested in these assets lost the purchasing power of owning them last year; for most people, losing purchasing power in a supposedly “safe” asset – bonds – is not the name of the game.
Investors seem to be waking up to the fact that the fixed income environment hasn’t improved that much. On the first trading day of 2022, more than $1 billion exited the iShares long-term Treasury ETF (TLT), or almost 7% of the entire fund, which was the third lowest exit. largest in its nearly 20-year history. High-yield ETFs are also seeing very large outflows. Yet neither government bonds nor diversified high yield are assets we want to hold. The 10-year US government bond is yielding only 1.74% today, so if you own the 10-year bond and its valuation doesn’t change over the next year, your buying power will fall by around 5% if inflation remains at the current level. . Our high-yield benchmark is valued at 4.5%, so if there are no defaults or fees, a holder will lose about 2.5% per year in purchasing power if inflation remains at 7%.
The key question now is, “Will inflation be transitory or will the Federal Reserve still be able to control it?” The best starting point to consider this is the bond market’s current expectations, which are that the Fed will indeed stick to the landing; in other words, the market thinks that inflation should decline over the next few years and be closer to 2% per year in five years. Perhaps it is the huge collection of assets on the Fed’s balance sheet that reassures the market that there is a pathway to quickly eliminate liquidity if needed.
Although the market thinks the Fed has everything under control, it is possible that the Fed is underestimating the reflexivity of demand response to all monetary and fiscal stimulus. They have signaled their intention to continue pouring liquidity into the market for a few more months, even if inflation hits a 40-year high and unemployment nears previous lows. The flip side of the Fed’s unprecedented assets is that the Fed is not an economically driven buyer, meaning its massive leverage in the bond market is likely skewing price signals.
Why do we pay so much attention to the Fed? Because they are the driving marginal influence on the “risk-free” rate, or the cost of capital from which asset prices derive. Monetary policy is an extremely powerful and flexible tool that helps set the course of the economy. We focus on the Fed so our shareholders don’t have to because our strategy provides the flexibility to find what we believe are the most attractive income opportunities across capital structure based on valuation . This means that it is important to understand not only the mechanisms that underlie changes in capital costs, but also how the mechanisms are likely to impact the cash flows that our holdings are likely to generate. In recent quarters, we have reduced bonds whose investment thesis had a lot to do with relative valuation mismatches and replaced them with holdings whose cash flow and distributions we believe are likely to grow with the economy.
As always, we remain the biggest investors in the Income Strategy and we welcome the support, questions and feedback from our fellow investors.
Bill Miller IV, CFA, CMT
Strategy Highlights by Tyler Grason, CFA
- Preferred Apartment Communities (APTS) was the top contributor during the quarter, growing 49.5%. The company announced third-quarter funds from operations (FFO) of $0.28, well ahead of consensus of $0.17, and quarterly dividend of $0.175/share (4.0% annualized return). ), driven by higher net operating income (NOI). Same-store multi-family sales increased +7.5% year-over-year (Y/Y) with same-store NOI of +8% and occupancy improving to 97 .1%. Management raised FFO guidance for fiscal year 2021 (FY21) by 8.9% mid-term to $1.00-$1.07. The company continued its asset recycling strategy over the period with the announced sale of an office building in Alabama for $55 million.
- Chemours Company (CC) grew 16.4% in the period after posting Q3 revenue of $1.68 billion, +36% YoY and +4% ahead of consensus, driven by volume growth by 25% while prices added +11%. Earnings before income, taxes, depreciation and amortization (EBITDA) of $372 million rose 77% and beat estimates by 9%, as higher net income more than offset additional cost headwinds. Chemours raised its guidance for FY21, including EBITDA of $1.3 billion to $1.34 billion (from $1.1 billion to $1.25 billion), earnings per share (EPS) of $3.93 to $4.13 ($2.84 to $3.56) and Free Cash Flow (FCF) of at least $500. M (from > $450 M). Additionally, Chemours announced the closing of the previously announced sale of the Mining Solutions business for $520 million.
- Apollo Global Management (APO) increased by 18.4% during the quarter. The company reported distributable earnings (DE) of $1.71 in the third quarter, well ahead of the consensus of $1.10 and the quarterly dividend of $0.50/share (annualized yield of 2.8%) . Commission-related revenue of $300 million beat 7% while net realized performance fees of $312 million beat estimates by 23%. Total assets under management (AUM) of $481.1 billion and earning assets under management of $361.3 billion both increased +2% sequentially on strong capital raising with 18.1 billion dollars in admissions over the period. Additionally, Apollo hosted its 2021 Investor Day, outlining long-term financial goals, including more than $9/share in distributable earnings by 2026 (14% compound annual growth rate (CAGR) from $5.50 pro forma 2022E) and fee income of $4.50 – $4.75 (18% CAGR). Management plans to roughly double assets under management by 2026 to $1 billion from $481 billion currently, with a 2.25x increase in fee-related revenue to $4.6 billion
- Sculptor Capital Management (SCU) was the biggest detractor in the quarter, falling 22.5% despite posting strong third-quarter results. The company reported distributable income of $0.58 in the third quarter, ahead of consensus of $0.52, thanks to incentive income of $27m and lower compensation expense. Accrued incentive income increased 13% to $252.6 million on a strong quarterly performance, while net flows totaled $417 million. The company declared a quarterly dividend of $0.28/share (5.2% annualized yield).
- Sberbank (SBER LI) (OTCPK: SBRCY) fell 14.7% in the period despite a third-quarter overshoot and an increase in FY21 guidance. Sberbank reported net profit of 348 billion rubles in the third quarter, +28% year-on-year annual and ahead of the consensus of 3% for a return on equity (ROE) of 26.8%. Net interest income of 470 billion rubles beat the net interest margin consensus of 5.36% (+14 basis points quarter-on-quarter (Q/Q)) while Net fee and commission income of 164 billion rubles remained strong thanks to growth in bank card operations. Management raised its forecast for FY21 ROE to over 23% (from 22%). Additionally, the company held an investor event on its mortgage business, highlighting its expectation of a CAGR of over 15% from 2021 to 2023 in the loan book while maintaining a market share of over 50%. Shares, however, fell in sympathy with Russian indexes after the United States warned its European Union allies that Moscow may be considering a possible invasion of Ukraine.
- One Main Holdings (OMF) down 8.4% over the period. The company reported Q3 EPS of $2.37, +9% year-over-year and ahead of consensus of $2.30, driven by interest income of $1.1 billion and a yield of portfolio of 23.77%. Originations of $3.9 billion were up +34% year-on-year, bringing end-of-period receivables to $18.9 billion, while net write-offs of 3.5% improved 167 bps . Management maintained its strategic priorities for FY21, including managed receivables growth of 8% to 10%, stable performance (>24%) and net write-offs of 4.2%. Additionally, the company repurchased $100 million of shares in Apollo Global Management’s $10.01 million secondary offering while increasing its current repurchase authorization to $300 million (from $200 million). millions of dollars).
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.