Bill Miller Letters Archive

1994 Q2 – Market Commentary

“Exit, pursued by a bear”.

Shakespeare, The Winter’s Tale, III, iii

After six months, most investors have only losses to show for 1994. The average general equity fund has lost almost 6% of its value so far this year, while growth funds have declined by a similar amount. Those conservative folks who shun equities as too risky and prefer bonds have seen the value of their investment in funds holding U.S. Treasuries drop 6.1%.

The Value Trust proved no exception to the general malaise, falling 1.52% in the second quarter, and 3.45% year to date. For the past twelve months we are up 4.86%, still well ahead of the S&P 500 (+1.40%), the general equity fund average (+1.52%) and the growth fund average (+.97%).

We are occasionally asked why investors should not put the bulk of their money in index funds, those vehicles created to invest in the S&P 500, whose results will generally track that index. After all, most money managers do not beat the S&P 500 over long periods of time, and the very best managers have only done it two-thirds of the time. This question comes up somewhat more frequently when the market is down and the investor is losing money: “I’m paying someone to lose money for me?”

Proponents of indexing believe the case for it gets stronger every year. The market is fairly efficient and the competition keeps getting tougher, as the outperforming managers get more money, and the underperformers get less. Those with the ability to beat the market thus become a greater percentage of the market, simultaneously making it harder for them to beat the market and for others not so gifted to beat them. Chronic underperformers lose assets, becoming a smaller part of the market, and are eventually replaced, at least some of the time, by someone who can outperform. Long-term outperformance thus becomes more difficult as bad money managers are weeded out, and good investors compete with each other and, increasingly, become the market. You can’t beat yourself.

Perhaps it’s better – so the argument goes – to at least insure market performance by being in an index fund and not paying higher fees for active management and risk getting below-market results.

Even Warren Buffett, the country’s richest man, whose disdain for academic theories of investing is well documented, appeared to indirectly endorse indexing when he remarked that “in aggregate, people get nothing for their money from professional money managers.”

The trouble with Buffett’s remark is that it is about mathematics, not money management. Because they make up such a large percentage of total investment in the market, institutional investors in the aggregate will not outperform the market. In the aggregate, major league baseball players don’t outhit the average player. It does not follow, though, that it is fruitless to try to outperform, or that some methodology may not lead to aggregate outperformance. Buffett himself identified such a methodology in his talk called, “The Superinvestors of Graham and Doddsville.”

In the past six months, the average index fund underperformed the index, falling 3.60% compared to a decline of 3.38% in the S&P 500, both with dividends reinvested. In the past twelve months, index funds also underperformed the index, rising .95% versus the S&P’s gain of 1.40%.

This is not an aberration. The main reason not to invest in an index fund is that you do not get the return of the index, you get a lower return. Funds have expenses, even index funds, and they also have trading costs. The S&P 500 has neither, but you can’t buy it. Those expenses are why even if your fund’s stocks perfectly track the index, your fund will underperform that index.

By investing in an index fund you can be quite confident you will underperform the index, and you will do it consistently, the underperformance compounding inexorably; creating a larger and larger gap between your returns and those of the index. If you manage once in a while to match or even exceed the index return, it will be due to a statistical fluke. Index funds are appropriate for those whose goal is consistent underperformance, quarter after quarter, year after year, decade after dreary decade.

We, of course, strive for outperformance. Despite having outperformed the S&P 500 in each of the past three years, and cumulatively over the life of the fund, we will experience periods of underperformance. You should expect that. You should also expect, though, that we will add value over time through active management.

The first half of this year has been more difficult than we expected, as the market reacted much more negatively to the Fed’s raising of short-term interest rates than we initially thought likely. Had we read Kevin Kelly’s new book, Out of Control: The Rise of Neo- Biological Civilization, we would have realized that complex adaptive systems like the market need a long time to adjust to certain kinds of new information and they will do so in ways impossible to specify in advance. The ripple effects of the Fed’s decision to raise rates in order to quell future inflation are still coursing through the market and the economy.

Inflation expectations, fueled mainly by rising commodity prices, have risen in tandem with long-term interest rates. Oil and copper have been particularly strong, and the price of aluminum has also begun to stir.

We believe these commodity price increases do not presage a return to higher rates of core inflation but are normal cyclical moves typically associated with the higher rates of economic growth experienced in the last several quarters. Commodity prices rise during periods of economic growth as demand expands faster than the ability of producers to expand supply. As supply later inevitably expands, prices stabilize, then fall back during periods of recession.

Contrary to the general perception, the long-term historic trend in commodity prices has been down, not up. Real commodity prices (prices adjusted for inflation) usually decline over the long term as technology lowers the cost of production. The average driver pays less today in real terms for a gallon of gasoline at the pump than he or she did in the 1950s, even after the inflation of the 1970s.

Inflation expectations can themselves lead to higher prices if they lead to significant shifts in resource allocation. Companies can build inventories in anticipation of rising raw material prices; they can also bid up labor rates if they think workers will be in short supply. Unlike commodity prices, labor costs are relatively inelastic on the downside: wage rates seldom decline; the market is cleared through layoffs or hiring freezes.

Resources can also flow from financial assets to tangible assets, creating potentially significant price fluctuations. A 1% shift in the asset allocation of individual investors amounts to over $150 billion moving from one asset class to another. Price fluctuations are not the same as inflation, which is a generalized increase in prices. If commodity prices rise by the amount stock prices fall, that may be good news for hard assets types and bad news for equity investors, but it is not inflation.

Weakness in the dollar has also been a contributor to the market’s malaise. With our currency falling to a post-war low against the yen and continuing to drift lower against other major currencies, overseas investors are withdrawing funds from dollar denominated assets, contributing to falling bond and stock prices.

All of these factors have weighed on the market and undermined investor confidence. Investment advisors have turned bearish and get more so as prices decline. The percentage of bullish investment advisors is at a five-year low, while the percentage of bearish advisors is close to a five-year high. Over 70% of all stocks are below the average price they have traded at in the past six months.

Amidst all this somber news, corporate insiders are buying their stock at the fastest pace since the market bottom in 1990 – also the last time investment advisors were so bearish. Those who make their living talking about investing are negative, while those who know the value of their company’s shares are buying. Both are common phenomena at market bottoms and are absent at market tops.

The market may, of course, have further to fall before it reaches a bottom. But with 70% of stocks already down, with the dollar on the front pages and with people lining up at the Citibank branch in Tokyo to get out of the dollar at its all-time low, with pessimism about stocks at a five-year high, and with analysts speculating about when the next Fed rate hike will come, the scene is set for the bear to exit. We believe the stage is being readied for a better second half, accompanied by a stronger dollar, a slowing economy, and falling long-term interest rates.

During the quarter, we added two stocks to the portfolio and disposed of two. We bought the new RJR Nabisco PERCS, which came to market with a yield of over 9% and an implied total return to its cap price of over 20% per year compounded. We expect the company to announce before the end of this year that it will separate its food and tobacco interests in order to enhance shareholder value. We also bought Sun Microsystems, a leading factor in workstation computers. Sun is trading near a three-year low, has over $8.00 per share – 40% of its total market value – in cash on the balance sheet, has been buying in its shares, and is selling at 8x the next four quarters’ estimated earnings.

We sold Loews and Phelps Dodge in the quarter, both long-time holdings. Phelps ran up on rising copper prices and reached what we believed was fair value. Loews still trades at well under its fair value, but the controlling Tisch family seems to have little interest in public shareholders and, unlike Warren Buffett, no interest in having their company trade around business value. We believe shareholders’ funds could be better employed elsewhere.

We also added significantly to many of our existing holdings during the quarter, most notably Caesars World, which came down sharply with the gaming group. Caesars now trades at under 10x the next twelve months’ estimated earnings, all of which are free cash. We believe the company is worth at least 60% more than its current stock price.

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