Bill Miller Letters Archive

1993 Q4 – Market Commentary

The Value Trust outperformed the S&P 500 in 1993, rising 11.26%, compared to a gain of 10.06% for the index, with dividends reinvested. After trailing the market for much of the year, we pulled ahead in the last week, thanks to a particularly strong December. In December, your fund rose 4.91%, while the S&P was up 1.25%.

We also outperformed the average of all growth funds, which rose 10.61% for the year. The average return of all equity funds was 12.54%. Among the better performing categories were small company funds, up 16.93%, and capital appreciation funds, up 15.16%.

Although we beat the S&P 500 for the year, we lagged the Dow, which gained almost 17%, and the Value Line, which rose almost 14%. As we have noted in past shareholder reports, the results of the 30-stock Dow Jones Industrial average are heavily influenced by economically sensitive issues and by high priced stocks, since the index is calculated on a price-weighted basis (a 1% increase in a $100 stock has the same effect on the index as a 10% increase in a $10 stock). The 1700 stock Value Line Index is also more cyclically oriented than the S&P 500 as well as having a much greater weighting in small capitalization stocks.

The Dow was paced by very strong performances by cyclical stocks such as Caterpillar, up 66%, and General Motors, up 70%. For reasons discussed in previous reports, we are not predisposed to loading up on cyclicals in the hopes of getting right the timing of both the entry and the exit in that sector sufficient to compensate us for the risk of being wrong about those points. We continue to research a variety of cyclicals in the hopes of finding some where the risk/reward is favorable. The best prospects appear to be in technology; where our exposure is increasing. Autos, despite a strong showing in 1993, have valuations lower than most other cyclicals, and could be attractive on pullbacks.

We have written extensively about the uneven dispersion of returns in the equity market and about how stock prices bounce around unpredictably in the short term, but tend to track underlying company value over the long term. Changing investor psychology; deviations from expectations, unanticipated news items, the general noise level of the market and its commentators, all have a greater impact on intermittent price fluctuations than does a dispassionate assessment of value. That creates the opportunity for us, but may create anxiety for you, especially is the fund’s results lag the market (the S&P) over various periods, we well they might.

Most investors, retail and institutional, are trend followers. They want to buy when prices are rising, sell when they are falling, and they hope to be right often enough to earn satisfactory returns. In the past year this led to price spikes in gold, in energy, and in many industrial cyclicals.

Riding the trend is also the motivation behind the appetite for forecasts, the “what do you think of the market, the economy, interest rates, small stocks, foreign stocks, emerging markets, health care stocks, technology, gold,” etc. type questions that fill the business shows, investment forums, and magazines. The air is particularly full of forecasts around the beginning of the year as people tally the previous year’s results, laud the winners, castigate the losers, tout the hot new managers, and pan those who did not measure up in the performance derby.

The assumption is that one can derive the direction of stock prices from more general forecasts of industry or macroeconomic trends. If this never worked, people would give up on it; but it works about as often as a nickel lands on heads, spurring the forecaster to greater efforts to improve the hit ratio.

We spend our time trying to understand the environment, not forecast it. By observing the path of the economy and by studying industries and companies, we hope to be able to put together a portfolio of stocks trading at large discounts to what those companies are worth. If we are right, over time the market price will tend to converge on business value, and fund shareholders will earn satisfactory returns.

The Value Trust is currently fully invested, with cash making up 2% of fund assets. This is not because we are forecasting a strong equity market, but because stocks appear to be attractively priced compared to the investment alternatives, bonds and cash. We can find sufficient companies trading at large enough discounts to our assessment of fundamental value to populate the portfolio, and have no dearth of opportunities awaiting further research.

There appears to be a great deal of bearish sentiment around, especially among professional investors. The bears are concerned by the high price-to-book value and price-earnings ratios, the low dividend yields, and the abnormal length of this bull episode – 39 months. They are worried because in the past these things were followed by falling stock prices.

Inflation also appears to be a growing threat since the economy is strong, unemployment is falling, capacity utilization is rising, commodities’ prices are stirring off multi-year lows, and gold is nearing $400 per ounce. The Federal Reserve is believed to be on the verge of raising short-term interest rates, beginning the tightening process that eventually leads to recession and bear markets.

We would not be surprised to see the Federal Reserve tighten by 25 or 50 basis points this year, especially if the economy’s strength continues at current levels. This could precipitate the 10% correction so long espied by market seers, especially if those whose mantra is, “Fed tightens, sell stocks,” do so. If such were to occur, we would view it as a buying opportunity, other things equal.

It would be unusual, though not unprecedented, for the market to end a year of strong earnings growth and moderately rising interest rates lower than where it began. In the past forty years there have been ten years when the market ended lower. Most of the declines (seven) were due to the market’s correctly anticipating a recession. Two others

followed sharp increases in interest rates and rising inflation. In only one, 1962, was there a decline when rates rose less than 100 basis points (a basis point is 1/100 of a percentage point). That was the year of the Cuban missile crisis, when the threat of global annihilation gave the market pause.

We continue to believe that absent some negative catalyst, the path of least resistance for stocks is up about 5 to 8%, plus dividends. This should be sufficient for stocks to beat bonds, whose returns will probably approximate the coupon, and cash.

The Value Trust portfolio contains heavy concentrations in financials, which we believe are dramatically undervalued and which have begun the new year on a strong note. We continue to hold a variety of technology stocks: Digital Equipment, Apple Computer, Storage Technology, all trading at less than half their prior highs, with fundamentals that we believe will show improvement both this year and next.

We added three new securities in the quarter, Grupo Financiero Serfin, the third largest bank group in Mexico, a National Intergroup redeemable preferred issue that we swapped our National Intergroup common for under the terms of an exchange offer, and Nike, the shoe company, whose stock was marked down 50% last year due to an earnings disappointment. We are quite optimistic about Nike’s long-term prospects, as is the company, which repurchased over 1 million shares last quarter.

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