Bill Miller Letters Archive

1992 Q2 – Market Commentary

Stanley Bridge
Prince Edward Island, Canada

Distance may improve perspective for some kinds of art, but the scene that encompasses the US economy, politics, and stock market does not look startlingly different from rural Canada than from Baltimore. The viewing though, is more pleasant when the temperature is 70 instead of 98, the humidity is low and a cool breeze sweeps across New London Bay.

The equity market has been uninspiring so far this year. The Value Trust ended the second quarter just about flat for the year. We are ahead of the broad market, as represented by the S&P 500, which is down .67% through the six months. Our results trail the Dow, which is heavily represented with cyclical stocks, but we are comfortably ahead of other growth funds, which on average have declined over 4%. We expect the second half will be better and believe that the next twelve months will see returns in the low double-digit range.

You should be aware, though, that beliefs about prospective stock market returns over a six or twelve month horizon have an epistemological status just this side of schemes to help you pick winning lottery numbers. Current prices embed all that is known and believed about the outlook for profits and interest rates, and un-embedded new information is generally randomly distributed or so the academics tell us. Changes in expectations resulting from the flow of news thus tend to drive short-term stock price movements.

Long term, the situation is somewhat better. The growth of stock prices tracks the growth rate of corporate profits, adjusted for changes in valuation. Valuation – the multiple investors are willing to pay for profits – is driven by interest rates, which are a function of present and expected inflation. One’s ability to assess long-term trends in profits and inflation exceeds the ability to predict changes in expectations brought on by random fluctuations around the trend. This is illustrated by the story of the CEO who addressed a group of analysts thus: “This year our earnings will be $2.50 per share. Next year they will be $3.00 per share and the year after that $3.60 per share. Any questions?” An analyst raised her hand, “What will you earn this quarter?” “It’s too early to tell,” said the CEO.

The existing level of stock prices consists of earnings and the multiple put on those earnings. In order to estimate long-term returns, one needs to estimate the long-term growth rate of earnings plus any estimated change in the multiple and add the result to the current dividend yield. This assumes the percentage of earnings paid out as dividends is roughly stable.

The following table shows the growth rate of earnings and dividends for the S&P 500 over the past 10, 20 and 30 years. As you can see, the numbers have been remarkably stable. The low 10-year earnings growth rate is due to the beginning and end points being recession earnings.

With a current yield of 3%, if the growth rate of earnings averages 6% and the current multiple of 14.5x the next year’s estimated earnings does not change, the market ought to provide a total return of 9%. This is slightly below its 66-year average annual return of 10.4%.

Price/earnings multiples are a function of interest rates. Interest rates, in turn, are a function of inflation expectations plus a premium for deferred consumption, usually estimated at about 3%. If the economy grows faster than expected, rates will tend to rise, pushing p/e ratios down. This will be offset somewhat in the return formula above, by faster dividend growth.

In general, things that are very large or mature tend to grow at slower rates than things that are small or young, whether they be economies, elephants, or redwood trees. The US has the largest economy in the world, and the most productive, measured by output per man hour. We have a mature economy, a population whose demographics would suggest a developing preference for saving over consumption, and heavy debt at the individual, corporate and government level. The 1990s promise to be a slow growth, low inflation, low interest rate period, absent exogenous commodity shocks or egregious policy errors.

The growth rate coming out of this past recession has lagged badly the average 6% real growth rate experienced early in recoveries in the post-war period. Much of the present discontent with the pace of the economic recovery is due to unrealistic expectations about what kind of sustainable growth rate is possible given a slowly growing labor force in a mature, debt-burdened economy. That the difficulty is not cyclical but secular should be evident. The current recovery is the slowest in the post-war period while interest rates are the lowest in 20 years and the amount of fiscal stimulation represented by the deficit is the highest in history. Believing that more federal spending on infrastructure, research and development, or whatever, or another cut in the discount rate will reinvigorate the economy can only result in more frustration, in our opinion.

We believe the 1990s will witness slower growth than occurred in the past 30 years, which encompassed periods of high growth and high inflation. We think earnings and dividends can grow about 5% during the 1990s, but multiples may rise modestly as long- term interest rates drift lower. This gives the same 9% growth rate for equities. If this is right, equities should outperform all other asset classes during this decade. (But 30-year treasuries will be stiff competition.)

In this fund, we hope to do somewhat better. Our portfolio currently trades at 11.8x this year’s earnings, with a one-year estimated growth rate of earnings approaching 20%, and a five-year estimated growth rate in excess of 10%. We believe the portfolio represents excellent value both absolutely and relative to the market, and that we are positioned to perform quite well over the next few years.

Our quarterly activity is summarized on the next page, along with those stocks that did best and worst in the past 90 days. As always, we appreciate your support and welcome your comments.