Bill Miller Letters Archive

1995 Q3 – Market Commentary

Your fund continued its strong results in the calendar quarter ending September 30, rising 10.74%. We again beat all the relevant stock market indices, as well as the average returns of general equity funds and the average returns of growth stock funds for the past three months. Our returns also exceed all of these benchmarks for the year to date, the past twelve months, and the past five years.

Our year-to-date returns of 34.56% are, of course, unsustainable over any substantial period of time. Stocks move in jerky, unpredictable bursts. We are now enjoying one of those pleasant periods when financial assets are marked up in price due to the confluence of reasonable valuations, falling interest rates, and rising profits. Last year, sharply rising interest rates led to big losses in bonds and modest losses in stocks despite rising earnings.

We squeaked by with a small gain in 1994 and are fully participating in this year’s rally due to our large holdings in financials – banks, insurance companies, and the so-called government sponsored enterprises (GSE’s), Fannie Mae and Freddie Mac. IBM has also been a big winner, as was Lotus, bought by IBM earlier this year. Just as important, we have avoided a lot of the market’s landmines. The only conspicuous area of disappointment has been Mexico, which has continued to languish.

Financials and technology have been the market’s leaders this year. Both groups are especially sensitive to interest rates and earnings trends, financials because changes in interest rates can directly affect earnings, changing the companies’ cost of money and what they can charge for it. Technology stocks have soared because this year’s powerful earnings growth has surprised most market participants. The market has marked these stocks up twice: once due to earnings, and then again by placing a high multiple on those earnings as interest rates have fallen. Technology stocks, unlike financials, are usually thought of as growth stocks, and growth is accorded a high multiple in periods of low inflation.

The fourth quarter is starting out with the usual year-end cross currents. Last year people dumped stocks in the last three months of the year, as they often are wont to do. That set up a wonderful buying opportunity. The early line on this quarter involves investors selling financials after third quarter earnings to lock in the gains those stocks have achieved and dumping anything with disappointing results or a murky outlook. We are also seeing a pause in the bond rally as the budget debate in Washington heats up. Those political battles may cause some market volatility, but the direction of budget policy is clear. There is bi-partisan consensus for a balanced budget, and we believe the odds now favor the achievement of that goal. The path to budget balance will not be smooth, but as the deficit continues to decline financial assets should benefit accordingly.

Technology stocks are bouncing all over the place as investors try to figure out if product supply will rise to meet demand next year, leading to pricing pressures and earnings disappointments. We think the answer is yes and have only moderate exposure to technology. We remain quite enthusiastic about financials, though, and intend to ride out the near-term turbulence in that group. Major banks such as Citicorp, Chase, and BankAmerica, are still too cheap at single-digit multiples and high-teens returns on equity. The just announced hostile takeover offer for First Interstate by Wells Fargo may lead to more hostile deals, and should lead to higher valuations on all bank stocks. The pace of consolidation, already brisk, may even accelerate over the next twelve months.

We think the economy next year will look a lot like this year, only more subdued. Corporate profits should again be up, but only by 5% or so. The big move in long-term interest rates from over 8% last November to the current 6.4% is behind us. In 1996, we think long rates will be banded somewhere between 5.75% and perhaps 6.5%. We believe the major positive next year will be lower short-term rates. Over the past 60 years inflation has averaged 3.1%. It is now 2.5% and the Federal Reserve Board seems to believe it will remain under 3% next year. The average T-bill rate that has historically persisted in a 3% inflation environment is 3.7%. Because the Fed has adopted an especially vigilant attitude toward any increase in inflation, we think short-term yields are unlikely to drop as low as 3.7%, but twelve months from now T-bills under 5% look likely.

If we are right about the economic environment, stocks next year should again do well, but probably not as well as this year. They should beat bonds and cash and remain the best performing asset class. We believe dividend growth will accelerate over the next few years, averaging about 7%, much higher than the long-term average of just over 5%. This strong dividend growth should help to underpin the market. High returns on assets and the lack of new high return projects, coupled with the current low dividend payout ratios, will spur companies to look for something to do with their excess cash. Share buybacks, acquisitions, and dividend growth should be common features of the investment landscape over the next year or so.

There were no new positions initiated or eliminated in the fund last quarter. Most funds seem to engage in hyperfrenetic asset shuffling in an attempt to guess which stock or groups will do best in the near term. We prefer to make long-term investments, which minimizes taxable gains and enables us to more carefully evaluate and monitor the companies in the portfolio.

As we have noted many times in the past, the near-term direction of the market is unknowable, and the long-term direction is clear: higher. After a move such as we have had this year, prudence would indicate reduced near-term expectations. A decline may come at any time. We believe it would be a mistake, though, to deviate from, or alter, a long-term investment program because of near-term concerns, even if those concerns prove justified.

The new biography of Warren Buffett by Roger Lowenstein shows how even market sages can let near-term concerns affect long-term decisions. When Warren Buffett was in his twenties he solicited the advice of Benjamin Graham, the father of securities analysis and a legendary investor, about his intention to pursue a career in investing. This was in the early 1950s. The market had moved up sharply in the previous few years, and Graham advised Buffett to wait until the market declined substantially before embarking on his life’s work. Buffett has remarked that this was about the worst advice he ever got, since the 1950s and 60s were a marvelous period that saw only brief declines in stock prices. Happily, Buffett ignored the advice and is now worth about $14 billion.

The 1950s and 1960s were a period similar to what we are in today: one of low inflation, peace, rising productivity, and slow but steady economic growth. Long-term investing, despite the inevitable setbacks, proved rewarding then and is doing so now. We expect that to continue.

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