Bill Miller Letters Archive

1992 Q1 – Market Commentary

In the first calendar quarter of this year (the Value Trust’s fourth fiscal quarter), the market marked time digesting the strong gains that occurred in December. Your fund inched ahead, rising .26% compared to a decline of 2.52% in the S&P 500. Despite the decline in the S&P 500, the Dow Jones Industrial Average rose 2.83%, a reflection of its much heavier weighting in cyclical stocks, a group the market became infatuated with during the quarter as evidence mounted that our economy was beginning to recover.

Each year market participants become enamored of some concept or other, and push favored groups up while punishing those that lack the desired qualities. Last year small stocks starred, led by the biotechs which rose over 100%, and small stock managers with heavy exposure to medical technology were heroes. Biotechnology stocks this year are the market’s worst performers, falling on average over 40% from their peaks. The risk in the group was particularly evident in Centocor, one of last year’s darlings. The FDA failed to approve their main product, stunning most observers who had already factored hundreds of millions of dollars of sales into their projections. The stock collapsed from a high of over $60 per share to a current price of $12; its market value fell from over $2 billion to just over $400 million. Even that may be too high since the company is using cash at the rate of $50 million per quarter and could be out of money in a year. The Value Trust owns no biotech stocks and so can view the damage with some equanimity. We also own few classic cyclicals, the market’s newest infatuation.

Squinting at the economic numbers, the market has concluded (correctly) that the recession has ended and that a recovery has begun. In the telling language of Wall Street, this has led portfolio managers to “play” cyclicals, whose operations are most sensitive to changes in the economy. Money has stampeded into autos, aluminums, papers and chemicals as well as basic industrial companies whose earnings have been depressed by the recession. These stocks have been bought in most cases without regard to valuation, the companies’ prospects, management quality, or even earnings sensitivity to a cyclical recovery. The perception of cyclicality has been enough. Conversely, the stocks of companies with steadily growing earnings, that is, those whose earnings will grow whether or not the economy does, have lagged in the rush to play cyclicals, again without regard to valuation.

We own all of the stocks in the non-cyclical category above, and believe they represent both excellent quality and value at current prices. We own none of the cyclicals listed and find them of trading interest only. Most cyclicals operate in undifferentiated commodity businesses with little or no control over product pricing, have fluctuating and unpredictable earnings and cash flow streams, no significant competitive advantages, poor returns on capital, and have little or no free cash flow after taxes and capital expenditures. Their reported earnings do bounce around a lot, and usually go up as the economy improves. But to earn above average returns in these kinds of stocks requires one to buy and sell at precisely the right time, such timing having little to do with careful analysis of business values and everything to do with guessing inflection points in the economy and in market sentiment. We believe the best investments are those possessing precisely the qualities lacking in most cyclicals, and expect to maintain minimal exposure to this area. We also believe that the rapid price run-up in the shares of cyclical stocks implies an economic recovery more robust than we are likely to experience.

The economy is recovering as the reported GDP data make clear. Indeed, the recession ended last spring and we have been in a labored recovery ever since. Popular press reports as well as the general perception are quite different. Although the press is beginning to note harbingers of recovery, deep gloom persisted in the fall and winter even as the data indicated a recovery had begun. Perception and reality are often quite different and the persistent belief in recession even as the recovery was underway demonstrates again that emotion, not evidence, underlies the popular Weltanschauung.

The popular perception is that stocks are richly valued and thereby quite risky. Our view is that stocks are always risky, that is, subject to sudden, unpredictable price swings due to either real or imagined events positive or negative. We believe that the best characterization of the current equity market is that it is bracketed: short rates are too low for a meaningful decline to be sustained, and long rates are too high for an advance to proceed without running into substantial resistance. We generally have a benign view of the U.S. equity market for the balance of the year. Returns are likely to be uninspiring compared to the past 10 years, but corrections should be mild, 5-10% at most. A meaningful advance in general requires a lower long bond yield.

The current inflation rate is 3.1%, according to the latest economic numbers. This is also the average inflation rate since 1925. Treasury bill yields of 3.7% are hovering near their average levels since 1925. Yet long treasury bonds yield 8%, compared to their average yield of 5% since 1925. One could argue that long bond yields failed to anticipate rising inflation, thus their historic yield is too low as a guide to future yields in a 3-4% inflation environment. We believe that is right, but also believe that if inflation does average 3- 4%, long bond yields will fall to the 6-7% area. Current yields reflect both the fear induced by the high inflation of the 1970s and cyclical pressures from the nascent recovery. Long term, bond yields tend to approximate the nominal growth rate of the economy (inflation + real growth). The economy looks to have a nominal growth potential of 5-6%. Borrowing at 8% to finance something growing at 5% is not a winning proposition. As long as rates stay this high, the economy’s growth can be expected to be labored, ultimately putting downward pressure on long-term interest rates.

This type of scenario is positive for stock prices, and especially positive for companies that can grow and finance their growth internally. Our portfolio is full of such companies, all purchased at prices that we believe undervalue their current operations as well as their long-term prospects.

We appreciate your continued support and welcome your suggestions and comments.