Bill Miller Letters Archive

1995 Q1 – Market Commentary

We trailed the Lipper Growth Fund and General Equity Fund indices in the quarter and exceeded them for the past twelve months. Money managers in general have lagged the averages over the past year, due mainly to the outperformance of the very large capitalization issues that dominate the averages compared to the generally smaller names that occupy most fund portfolios, and to the way those averages are computed, a subject we have written about many times over the years.

The ebb and flow is natural, but the favoring of large companies over small was particularly pronounced in the first quarter, and was concentrated in the growth stocks. The Russell 2000, a common measure of smaller stock performance, rose less than half as much as the Dow or the S&P during the first three months of this year.

The move in the averages since the November lows was interest rate driven, and bond funds have performed as well as equity funds this year, recouping most of the losses they suffered in 1994.

We felt fortunate to have escaped 1994 in the black, considering our heavy weighting in financials and our position in Mexico. The latter continued to punish us in the first quarter, as Mexican securities again fell sharply. The situation there appears to have stabilized and the currency has risen 15% or so against the dollar in the past few weeks.

We added to our Telmex position in the quarter and also bought a large position in Argentine bonds, which have already appreciated smartly as the panic over Latin America has begun to subside. We bought a position in Sears, which is spinning off its Allstate Insurance subsidiary and has made great strides in turning around its retail group. Sears had declined due to the market’s current disenchantment with retailers, and we were able to buy it at a single digit multiple, a very reasonable price for a company of this quality.

Some observers have categorized this as the surprise bull market of 1995, since it arrived without any evident catalyst and followed a particularly difficult fourth quarter of 1994. It would be churlish and perhaps too cynical to note that the first half of 1987 constituted a strongly bullish period as well, but that year is not characterized by those six months. It is the events of October that now best describe the dominant features of 1987’s investment landscape. The felt need to characterize and assess the market, the economy, stocks, company results or strategies in ever more frequent intervals is an unfortunate by- product of our information saturated age.

The half-life of market commentary is inversely proportional to its frequency. The accuracy of one’s characterization of a landscape is likely to grow the more time one has to peruse it and to shrink as the frequency of requests for its interim description grows. Shorter time horizons, shorter attention spans, greater demand for information, and less patience seem to be an inevitable consequence of our increasing ability to collect, transmit, and access data. Reporting, analyzing, and commenting on business and markets has exploded in the past 20 years, both on Wall Street and on Main Street. In addition to a plethora of new business programs on the networks and PBS, CNBC provides real time commentary and analysis on markets all day long.

The number of analysts employed by brokerage firms, banks, insurance companies, and money managers continues to grow. Almost as many people sit for the CFA exam (the securities analysts’ version of the CPA) each year as have earned that designation over its entire history.

We have not materially added to the number of firms that supply us with research in years, yet the cascade of reports, faxes, and analytic detritus of all types now occupies one of our staff almost full time just in opening, sorting, and distributing it. This is not progress, and we are exploring ways to deal with this consequence of the perceived need for instant and voluminous commentary on virtually every news item on the Dow tape.

We write these letters every 90 days, and comment on our results and expectations. The papers print our results every day, and many of them contain ratings and rankings of mutual funds covering one week and four week periods. We have lost count of the number of publications that write about, cover, assess, and purport to analyze mutual funds, classifying them by ever finer gradations of category, style, asset group, size, and geographic orientation and slicing their results into about as many time periods as their database can muster.

It is far from clear that this information explosion has led to better decisions about investing. It is quite clear it has led to more decisions, as the turnover rate of stocks and bonds held in funds and the capital flows among funds attests. There is evidence that the pressure to react to new information may be harmful, quite apart from any transaction costs that might result from changing one’s mind about a stock, a fund, or the market.

Professor Richard Thaler, now at the University of Chicago, has studied what the academics call the equity premium puzzle: a dollar invested in stocks has returned, after inflation, about 7% per year on average for more than 68 years, while a dollar invested in bonds has returned less than 1%. The puzzle is why do any long-term investors own bonds? Not only do they own bonds, investors typically have a greater percentage of their assets invested in bonds than in stocks.

The answer, according to Thaler, is myopic loss aversion. People are risk-averse. Psychological testing has established that for most of us, the pain of losing an amount of money is greater than the pleasure of winning that same amount of money. Being risk- averse, we are more likely to act to avoid the pain of loss the more aware we are of potential losses. The more short-term-oriented one is (the more “myopic”), the greater one’s willingness to react to the risk of loss. Because stocks go up and down more than bonds, they confront one with more frequent, and greater, potential losses. The shorter one’s time horizon, or the more often you look at your portfolio, the more you will see losses, the more psychological discomfort you will feel, and the riskier you will perceive stocks. The more risk-averse you are, the more you will orient your investment to bonds, or cash.

Since one’s perception of the risk of stocks is a function of how often you look at your portfolio, the more aware you are of what’s going on, the more likely you are to do the wrong thing. “Where ignorance is bliss, ‘tis folly to be wise” said the bard, who understood myopic loss aversion centuries before the professors got hold of it.

Suppose you buy a stock on Monday, and on Tuesday, while you are engrossed in the O.J. Simpson trial, it drops due to bad news. On Wednesday, though, it recovers to close higher than your purchase price. If you had been glued to CNBC on Tuesday when the news hit, and had observed the stock falling, you may have been prompted to act on the news, especially if the stock was reacting to it. If you missed the news until Wednesday, when the stock had recovered, you are much less likely to sell it then, even though the fundamentals are the same as the day before. That is myopic loss aversion at work. Put differently, you are not worried that IBM dropped overnight in Tokyo while you slept, if it closed up two points today in New York. You are worried if it drops today in New York, though it’s set to rise two points in Tokyo tonight while you sleep.

This does not do justice to Thaler’s work on the subject (done with Shlomo Benartzi), but you probably get the drift. Professor Thaler is so convinced that the avalanche of information bombarding investors about how their stocks or funds are doing is harmful, that he has proposed that universities not give faculty and employees reports on how their retirement funds are performing. For most investors, Thaler thinks, the appropriate advice is “don’t just do something, sit there.”

It should not be a surprise that his advice has been ignored. The situation is similar to that of the now forgotten Earnshaw Cook, who applied probability theory to baseball strategy in his book Percentage Baseball. After exhaustively studying the statistical history of various baseball strategies – the sacrifice bunt, when to bring in relief pitchers, etc. – he concluded that teams were not maximizing their chances of winning, they were following conventional wisdom that was not well suited to their professed objectives. He advocated numerous changes to the manager’s portfolio, such as having your best hitter hit lead off instead of the usual third or fourth, since the lead off hitter gets the most at bats and thus hitting lead off will maximize the offensive statistics of the best hitter. All of his recommendations were statistically sound, well documented, and completely ignored.

Earnshaw Cook was unaware of myopic loss aversion, but its influence extends well beyond the equity premium puzzle. Warren Buffett captured its essence when he remarked that in investing it is usually better to fail conventionally than to succeed unconventionally. Or as one fund manager put it recently when asked why he wasn’t thinking of investing in Mexico, since undoubtedly there were bargains to be had with many stocks down 70% in the past 6 months, “nobody ever got fired for not investing in Mexico.”

Our investment approach in the Value Trust has been to use the myopic loss aversion exhibited by others to our shareholders’ long-term benefit. We try to buy companies whose shares trade at large discounts to our assessment of their economic value. Bargain prices do not occur when the consensus is cheery, the news is good, and investors are optimistic. Our research efforts are usually directed at precisely the area of the market that the news media tells you has the least promising outlook (right now that includes retailers, autos, Latin America and anything else on the “New Lows” list) and we are typically selling those stocks that you are reading have the greatest opportunity for near- term gain.

This approach does not link up well with results of the major indices, and we often diverge from them in direction and magnitude. Over the past four calendar years our results have consistently exceeded those of the S&P 500. There were periods in the past when we trailed that index, sometimes by a lot. Our portfolio does not look like the S&P 500 and thus it should not act like the S&P 500.

It should provide solid returns over the long term, which it has done and we are confident will continue to do. As always, we appreciate your support and welcome your comments.