Bill Miller Letters Archive

1993 Q3 – Market Commentary

Your fund picked up some ground on the two major averages during the quarter, trails them year to date, and exceeds them for the past twelve months. The Value Line, which consists of around 1700 mostly smaller and mid-size companies has been the strongest performer during 1993. We do not believe this is just a statistical fluke, but rather the beginning of a longer-term trend.

The eighties, and especially the last four years of the decade, were highly unusual in stock market history because large, well-known companies with consistent earnings growth significantly outperformed smaller companies. Put somewhat differently, risk and return were inversely correlated: risk-averse investors choosing safety earned higher rates of return than those willing to assume greater risk in search of greater return.

The S&P and the Dow are capitalization weighted indices whose returns are heavily influenced by the performance of large companies. The Value Line Index consists of the stocks in the S&P and the Dow, plus an additional 1,500 smaller and medium-sized companies. The outperformance of the S&P and the Dow is even more remarkable considering that 10 years ago the largest company in the Dow and the S&P was IBM, which has gone down for the past decade, and now hovers just above its lows of the past 10 years.

The anomalous returns accruing to safety really began in the early 1970s. After two decades of strong returns for equity investors and mostly losses for bondholders, equities were then fully priced and bonds were about to enter the final and most painful stages of their long bear market. But investors in treasury bills and the new money market funds were on the verge of investors’ nirvana: no risk, high returns. The source of this happy period for the risk adverse was the rising inflation of the 1970s, which battered price/earnings ratios and bond prices throughout the decade.

The bear market in bonds ended in 1981, and a twelve-year bull market began, running side by side with the T-bill bull market. Stocks were pulled along by the bond rally; as rates fell the justifiable p/e ratio rose. Since stock prices are just two things – earnings and the price investors are willing to pay for those earnings – rising bond prices fueled rising stock prices. Leading the way were the safe stocks, those that most resembled bonds in their quality and in the predictability of their cash flows.

Even though money market rates fell sharply in the 1980s, inflation fell faster, providing money market investors with high real rates of return. We mark the end of the T-bill bull market in the early summer of 1992, when rates fell below 4%. We believe that for the balance of the decade riskless assets such as T-bills will provide no real rate of return on a pre-tax basis, and will provide negative returns on an after-tax basis.

The bull market in bonds has run well into 1993, with its most explosive phase ending (we think) just about now, with rates at 5.79%. After being bond bulls for many years, we now believe that long-term rates are about where prospective inflation, economic growth, and financial theory would indicate, and that the excess returns are nearly wrung out of long bonds.

The rich vein of excess returns mined by investors in safe assets – T-bills, bank CDs, money market funds and bonds – appears to be largely exhausted. We think that over the balance of this decade investors choosing safety will once again earn lower returns than those willing to assume more perceived risk. (There is a difference between perceived risk and real risk, as the investors who stuck with IBM because of its quality and safety can ruefully attest.)

Stocks are perceived as the riskiest asset class because they are volatile and unpredictable. We believe stocks will handily beat bonds and cash over the next several years. The stocks of small and mid-sized companies are perceived to be riskier than those of large, well-known companies, international markets riskier than domestic, emerging markets riskiest of all. We believe emerging markets will outperform all other markets, international will outperform domestic (mostly because of the high growth emerging markets) and small and mid-sized companies’ securities will outperform large. We believe they will do so for sound, fundamental reasons, namely, that’s where the values now are.

The press repeats like a mantra that the stock market is overvalued and the danger signs are all around, from high p/e ratios to low yields to public purchases of mutual funds. We believe the absolute levels of p/e ratios and dividend yields are meaningless in assessing the market outlook unless they are related to inflation and interest rates. Inflation reduced the value of earnings and dividends, and interest rates are the benchmark for the investment alternatives to stocks. It is not high p/e ratios or low dividend yields that lead to market vulnerability; it is the relation of the two to the level and direction of interest rates.

Contrary to the perceived wisdom, the public does not rush lemming-like into stocks just because they are rising. During the long rise in stock prices in the 1980s, the public consistently liquidated equities, moving assets into fixed income, where the risk/return trade-off was more favorable. The public began liquidating stocks in the late 1960s, when equities were peaking. They have begun to move assets from fixed income to equities, because the risk/return trade-off now favors stocks over bonds.

How long will this process continue? We believe it will continue until stocks are no longer attractive relative to the fixed income alternatives, that is, until either interest rates or stocks rise significantly. Most valuation models calculate that it would take a 20% rise in stock prices or an increase of well over 100 basis points in short and long-term interest rates to significantly diminish the attractiveness of stocks relative to bonds and cash. That seems to us about right and, accordingly, we remain fully invested. Although we expect stocks to outperform bonds and cash over the next several years, the absolute returns earned in equities are likely to be significantly lower than the 18% annual returns of the 1980s.

The low inflation, slow growth environment that has led to the dramatic decline in interest rates has the consequence that earnings growth will be lower than most analysts expect. The aggregate of analysts’ earnings estimates for the S&P 500 comes to about 7% forecast annual growth over the next 5 years. We believe the number will be between 4 and 5%. This implies average annual returns in stocks of about 7% per year (2.7% dividend yield plus 4-5% growth), still considerably better than one is likely to achieve in bonds. By concentrating our research efforts in out-of-favor stocks with low valuations, both domestic and international, we hope to achieve returns 100 to 200 basis points above those of the market.

We are finding, consistent with the comments above, more values in mid-sized companies, and in companies and countries with higher perceived risk. Purchases in the third quarter include securities firms Bear Sterns and Salomon Inc., both trading at single digit p/e ratios; Reebok, which is also at under 10x earnings, earns 20% on equity, has little debt, and is aggressively repurchasing its shares; and Storage Technology, which traded at over $70 per share last year when people thought they might ship their Iceberg mass storage system. Now we think they will, after many delays, ship the system and that it will be successful. The market is skeptical and the stock languishes at $25.

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