Bill Miller Letters Archive

1993 Q2 – Market Commentary

The Value Trust slipped .78% in the second quarter, while the S&P 500 eked out a small gain due entirely to dividend payments made in the past three months. The more cyclically oriented Dow was up 3.09%. In contrast to the first quarter, where we handily beat most other money managers, our results this period trailed the average growth fund, which rose about .73%.

Most investment managers are uncomfortable when the construction of the portfolios strays much from the S&P 500. Stock selection is often a byproduct of whether to underweight or overweight this or that industry relative to its makeup in the index. Those decisions, in turn, are heavily influenced by the near-term outlook. Everyone wants to be long those groups that are “acting well” (going up fast) and underweight those that are lagging.

As the second quarter wound down, even the most dull-witted investors could see that cyclicals and energy stocks were the place to be, while financials and consumer stocks were the groups to avoid. Portfolios were adjusted accordingly, just in time for the economic data to raise new concerns about the strength of the recovery, triggering a fall in long-term interest rates and in oil prices, a spurt in financials, and concomitant weakness in most cyclicals and energies.

Nervous portfolio managers must ponder whether to try to shift back to more defensive issues, whether earnings this quarter will be below expectations, whether the economic numbers will disappoint or excite, whether Iraq will be allowed to sell some oil, whether the tax bill will be more like the Senate or the House version, whether to be in gold or whether this is just a pyrite rally. While they’re at it, they can ponder whether the deficit will sink the economy or whether new taxes will usher in new prosperity, whether NAFTA will pass this year or die in the courts, whether rates will rise or fall, or maybe fall then rise, or perhaps the yield curve will flatten, or twist. They also must wonder whether a further fall in interest rates will be good for stocks, as usual, or maybe bad, because it will signal new economic weakness and the inability of very low rates to engender prosperity. This could go on for pages, but you get the drift.

We do not construct our portfolio with an eye to the S&P’s industry groupings, and do not try to guess the next economic number or the next story on the tape. We do not try to anticipate the vicissitudes of investor psychology or the timing of the next correction or rally. Our approach is fundamentally based, value driven, and long-term oriented. Its objective is to build a portfolio of stocks purchased at large discounts to the economic value of the underlying businesses. Price and value are often poorly correlated over the short term, so whether a stock or industry is acting well or poorly is of interest only insofar as we may be able to improve returns for fund owners by selling when prices move well above value, and buying when the market is unduly pessimistic. Our results can and do differ from those of the market and shareholders should be prepared for results that may lag or exceed those of the indices in no predictable fashion quarter to quarter.

We recently received a copy of a study on mutual fund performance done at Stanford University that focused on the after-tax returns of funds. Investors are rightly interested in understanding the results they are likely to achieve and are bombarded with advice about load vs. no-load, the relationship between expenses and returns, and of course the endless rankings, ratings, and opinions expressed by newspapers, newsletter writers, and magazines. This should be expected in a business where the results are tallied and published every day.

The Stanford researchers noted that to the individual investor the important issue is what returns are actually achieved after expenses, after taxes; yet performance results, ratings, and rankings, are always based on pre-tax numbers. Their study adjusted fund performance for income and capital gains distributions and then compared the results. We were quite interested since we take taxes into account in the portfolio management process, preferring to minimize taxable events so that shareholders have the maximum amount of capital working for them. Funds that trade aggressively and have high portfolio turnover usually generate more tax liabilities for shareholders than those with a long-term orientation and low turnover.

The study found that for the ten year period 1983-1992, the Value Trust outperformed two-thirds of all funds using the conventional pre-tax numbers. On an after-tax basis, for the same ten year period, your fund outperformed four-fifths (over 80%) of all funds. This was one of the largest performance differences in the study and we were pleased to see tangible evidence of the incremental benefits of patient, long-term investing.

In the quarter, as you might expect, there was a lack of frantic portfolio activity. Our only sale was a short-term Treasury note to fund some additional purchases. We bought three technology stocks: Digital Equipment (DEC), Philips NV, and Apple Computer. DEC has been going down for six years as its business deteriorated; it is now poised to report its first profit in some time. After several billion dollars of write-offs, it still has a strong balance sheet and trades around book value. Most importantly, expenses are being brought into line with revenues and the company has a sound strategic plan. Philips is a giant Dutch technology firm that has leading positions in consumer electronics globally. New management is reinvigorating the company, selling off underperforming assets, and focusing on the company’s core strengths. Philips controls Polygram, the record company, whose publicly traded stock alone has a value almost equal to that of the parent. Apple is trading at a three year low, has no long-term debt, almost a billion dollars in cash, and first rate technology. We expect a few quarters of poor results as new CEO Michael Spindler cuts costs and the company navigates a difficult product transition.

We added to our financials with a large new position in Bank of Boston and a small one in TIG Holdings, the latter a spin-off of Transamerica Insurance. Bank of Boston had corrected from $29 to $22 in the quarter. We believe they can earn well over $3.00 next year and perhaps $4.00 the year after, making the stock very cheap in the low 20s.

The economic and market environment remains one of slow growth and low inflation on a global scale. We do not believe the gold rally is a harbinger of rising inflation. Gold rallied to $440 in 1986 while inflation fell to 2%, and it traded above $500 and ounce in 1987 and 1988. There may be good reasons to own gold but an imminent inflation surge is not one of them. Industrial commodities prices remain in a downtrend, and oil is near a 3-year low. Unit labor costs are steady, loan demand is weak, and the broad money supply is growing slowly. Consumers are highly indebted and income growth is sluggish. Raw materials, consumer goods, and labor are in ample supply. The economic fundamentals support low interest rates and high market valuations in the US, declining interest rates abroad. Companies whose earnings are disappointing should continue to be heavily marked down and often will present investment opportunities.

As always, we appreciate your support and welcome your comments.