Bill Miller Letters Archive

1996 Q4 – Market Commentary

Our results were driven by our large, longstanding position in financial stocks, exceptional returns from our technology holdings, and the lack of any disasters in the portfolio. If you can avoid big losers, your investment returns are usually going to be satisfactory. To have a year like we had in 1996, you also need a lot of luck. The market went from panic to exuberance in technology during the year, and we benefited from both emotional extremes.

Dell Computer, which we bought in February at about $14 is now trading above $60. Seagate Technology has doubled in the past 6 months. IBM, which we added to both last January and again in the summer sell-off, is up almost 100% in the past year. Our financials were led by MBNA, Chase, Citicorp, BankAmerica, Bank of Boston, and Zions, which rose on average over 60%.

Over the past two years, the Value Trust is up over 94% in what has been an exceptional and unlikely to repeated, period for stocks. We started the fund in early 1982 just before this long bull market began. Along the way there have been the inevitable panics, corrections, and a recession-induced bear market in 1990. Our strategy has been consistent: to look for quality companies with excellent management selling at bargain prices.

After almost 15 years during which the S&P 500 has averaged 17.39% per year (our return is over 100 basis points better, with 100 basis points = 1%), the obvious bargains are rare and the benefits of low inflation, steady growth, and high corporate profitability have been well reflected in today’s level of stock prices.
The S&P 500 sells at about 17x 1997 estimated earnings, a level we regard as fair in an extended expansion that has seen earnings grow almost 20% per year on average. Although bargains are hard to come by, we believe our portfolio offers good value and should provide acceptable returns going forward.

Despite their strong performance last year, banks, for example, still offer solid investment opportunities, in our opinion. They have earnings growth rates faster than the market, dividend yields higher than the market, dividend growth rates greater than the market, they are generating excess capital and are using that capital to enhance shareholder value by repurchasing their shares. Their balance sheets are the healthiest they have ever been, returns on equity are well above the market’s average ROE, and asset quality is excellent. Yet they still trade at 40% discounts to the market. We believe banks in general are about 25% undervalued.

We are often asked what we think of the market, the question recently seeming to take on greater urgency with the strong returns of the past few years. Many people appear to have firm opinions about what is in store for 1997, a position we find surprising since no one is vouchsafed privileged access to what the future holds. There appears to be general agreement that stock prices are elevated, with even Fed Chairman Alan Greenspan wondering whether “irrational exuberance” may be affecting asset prices.

The price level of any freely functioning market or of any stock is the price at which buyers and sellers are evenly balanced. At any level of stock prices, you will find bulls and bears, though the decibel count may differ according to the emotional state of the protagonists.

The short-term direction of stock prices is unknowable, a “random walk” as the professors like to say, but the long-term direction is clear: higher. People always seem surprised when the stock market is at an all time high and they often fear a correction or worse. But GDP is at an all time high, corporate profits are at an all time high, inflation has never been lower in the 6th year of an expansion, monetary policy is stable, the deficit continues to decline and is the smallest relative to our economy of any industrial nation. The surprise would be if the market was not at an all time high.

We will not rehash the arguments of the bears, except to note that this year the most commonly cited reasons for pessimism are based on numerology: year ending in 7 have historically been bad years, and years that are prime numbers have been really bad (such as 1907, 1929, 1937, 1987). Moreover, after the two great years in a row, the market usually suffers, having fallen two-thirds of the time after cumulative gains of 60% or more.

Those who are often bearish seem to us to suffer from simultanagnosia, a disorder in which one can pick out parts and features of some situation, but where one is unable to organize them into a coherent or meaningful whole. The long range picture does not provide much support to the pessimists.

Since 1870, real (i.e., after inflation) returns in the stock market have averaged 6.6% per year. Over the past 70 years, real returns have been over 7% per year, and since 1982 they have been over 12% per year. We are six years into an expansion that shows no signs of ending, but in which profits growth is decelerating.
Corporate profits growth was 15% in 1995, over 10% last year, and should be between 5-10% this year. Over long periods of time, stock prices track profits growth adjusted for changes in the price earnings multiple. The P/E multiple is driven by interest rates, which in turn are a function of inflation.

The disinflationary trend of the past 15 years is well recognized. Core CPI inflation was 2.6% last year and should be about the same this year. It is unlikely we are due for much more multiple expansion unless interest rates fall from current levels.

This means the central tendency of stock prices in 1997 should be moderately (5-10%) higher, with perhaps above average volatility as the bulls and bears square off over the next economic number or the next news item on the tape. If the Fed bumps interest rates higher to constrain inflation, we are likely to see a moderately strong sell-off, or if long rates rise much above present levels the market is also likely to come under some pressure.

The overall picture seems to be that it makes sense to have diminished expectations relative both to the absolute and comparative returns recently achieved. We remain confident, though, that we will continue to generate acceptable returns and we are committed to working diligently on your behalf.

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