The end of the first calendar quarter of 1997 is the end of the fiscal year for our Funds. SEC regulations require that investment advisors discuss market conditions and strategies that materially affected a fund’s results during its fiscal year. The format of this letter, a departure from our usual random digressive style, is designed to facilitate covering the topics required by the regulators.
Review of Fiscal Year 1997 Market Conditions
Large capitalization stocks performed strongly in the year ending March 31, 1997, returning 19.83% as measured by the S&P 500. Broader measures of stock performance did not fare as well. The Value Line index, which includes both large and small companies, rose 10.12% during that period. The Russell 2000 index, which covers mostly smaller companies, rose only 5.11%. It does not require an advanced degree in logic to surmise that investors whose portfolios were concentrated in large company securities fared far better than those whose investments were primarily in small and mid-sized equities.
The disparity in small stock performance was particularly acute in the first calendar quarter (our last fiscal quarter) of 1997. The Russell 2000 index was down 5.17% in that period, while the S&P 500 rose 2.68%.
The Russell 2000 peaked in January at 370, and has since fallen about 10%. Concerns about earnings, about the appropriate level of valuation, and about Federal Reserve policy, have combined to keep pressure on this sector of the market.
The S&P 500 reached an interim high on February 18 at 816. As in 1996, the S&P performed strongly in the first 6 weeks of calendar 1997, rising about 8.5%. On March 25, the Federal Reserve Board raised short-term interest rates 25 basis points (100 basis points =1%). Since that time, the market has generally had a downward bias as investors readjust portfolios in response to present or anticipated levels of interest rates, earnings, and inflation.
Strategies Affecting Fiscal Year 97 Results
The Value Trust follows a value investing style. Value investors attempt to evaluate the intrinsic worth of a company and purchase securities in that company at prices representing a substantial discount to calculated value. Estimates of business value are subject to substantial uncertainty arising from, but not limited to, the availability of accurate information, economic growth and change, changes in competitive conditions, technological change, changes in government policy or geo-political dynamics, and so forth. We attempt to minimize the potentially unfavorable consequences of errors in the estimation of business value by building in a margin of safety between our estimates and the price we are wiling to pay for a security.
A variety of quantitative methods and qualitative assessments are used to estimate business value. These include, but again are not limited to, traditional valuation measures such as price earnings ratios, price to book value and price to cash flow ratios, both prospective and historic. Comparative valuation work is extensive, and includes historic, prospective, and scenario-based methods, as well as volatility analyses. Theoretical valuation frameworks are also employed. Discounted cash flow and free cash flow analyses are extensively employed, as are private market and liquidation value analyses.
Qualitative assessment of business prospects involves studying companies’ products competitive positioning strategy, industry economics and dynamics, regulatory frameworks, and more. We pay particularly close attention to corporate capital allocation policies and the returns resulting there from. We believe a management’s commitment to shareholder value is often best demonstrated by how they allocate capital.
The Fund’s management also devotes considerable time to the study of important academic work in financial theory and in experimental economics. We have found recent work in behavioral finance and complex adaptive systems to be particularly important in assessing and understanding markets, investor behavior, and competitive strategy.
The Value Trust has followed a consistent investment strategy for many years. It is characterized by careful attention to value, a focused portfolio, and low turnover. The Fund had an excellent year, significantly outperforming all relevant indices of both the market and comparable mutual funds. In 1996, the Fund’s management believed that attractive values were appearing in technology stocks, an area where valuation work is often complicated and difficult. The Fund purchased large positions in a variety of technology companies such as Dell Computer, Seagate Technology, and Western Digital when such shares were under severe pressure due to concerns about earnings prospects. The Fund also added to other technology holdings such as IBM during similar periods in the year. When those concerns did not materialize, the shares of those companies rose sharply, adding materially to the Fund’s returns. We also benefited from our long standing position in banks and financial services companies, which performed strongly in the past twelve months. Our returns were also enhanced by mostly avoiding stocks whose shares suffered heavy losses. We believe our focus on having a margin of safety in the purchase price contributed to the relative lack of poor performers in the portfolio.
Market Outlook: Near Term
As usual, we are agnostic about the market’s near term direction. A variety of valuation tools suggest that stock prices in the aggregate approximate fair value, a view with which we concur. Prices should tend in the direction of market participants’ shifting views about rates and earnings prospects. At this writing, the correlation between stock and bond prices during the past month has been over 90%, indicating that investors are overwhelmingly focused on Federal Reserve policy and 30-year bond prices. Market direction is being dictated by the direction of the interest rates. This is a departure from what prevailed in most of the past year or so. Bond yields have risen and bond prices have fallen since the beginning of 1996, while stocks are up sharply over the same period. We think that this divergence is over and that stocks and bonds will move more synchronously over the balance of the year. If they do diverge, we believe it will be to the benefit of bonds over stocks, since the most likely cause of divergence would be poorer earnings prospects as the economy slows.
We believe that calendar 1997 will be characterized by moderate economic growth and subdued inflation. Corporate profits growth could be in the 8-10% area. Subject to the interest rate concerns noted above, we think the probabilities favor a moderate stock market advance, albeit with perhaps more volatility than has been common over the past few years.
Market Outlook: Long Term-The Era of Extraordinary Returns is Over, “Return to Normalcy.”
In the 1920 Presidential election, Senator Warren G. Harding, a former Ohio newspaper editor, promised a return to normalcy. The country had experienced both the activism of Teddy Roosevelt and the idealism of Woodrow Wilson. He thought neither extreme suited the post –war mood. According to one source, “Voters responded to his genial nature, impressive stature, and bland message; he won in a landslide”.
We think that after the inflation driven extremes in hard asset returns in the 1970’s, and the abnormally high returns in bonds from 1981-1993 and in stocks from 1982-1996, a return to normalcy is in store for investors across a variety of asset classes. For much of the past 20 years, returns far higher than historic norms could be achieved by following investment strategies simple enough to fit on a bumper sticker: e.g. in the 70’s buy oil, buy gold; in the 80’s buy bonds; in the 90’s buy stocks. Oil, gold, and bonds are mostly undifferentiated assets, one is much like another. With stocks, the question of which one (or ones) to buy was likewise easy. For most of the past 15 years, no work was required: if you bought an index fund you earned far higher returns that historic norms, and you beat almost all the stock investors who bothered to actually do the work and understand what they own. The past 15 years have seen the highest returns of any 15 year period in stock market history.
From the bond market bottom on October 26, 1981 until the top on October 15, 1993, investors in government bonds earned average annual returns of 16.2% per year! This compares to returns of 5.1% per year from 1926 through 1996. Excluding the extraordinary return of the past 15 years, the long-term return of bonds averaged just 3.2% per year from 1926 through 1981. Today’s bond yields of over 7% are thus quiet high by historical standards. (But not as high as they look; read on.)
During the same period (Oct. 1981-Oct. 1993) the S&P 500 rose 16.54% per year, just about the same as bonds. But 1926-1996 returns in stocks were more than double those of bonds, averaging 10.7% per year.
Since the bond market peak in late 1993, stocks have far outperformed bonds, rising in 1994, 1995 and 1996, while bonds declined in both 1994 and 1996. Bonds are down again this year, while the S&P 500 is up modestly.
One problem in assessing long-term rate of return data is what physicists call sensitive dependence on initial conditions. It matters to the measurement where the measurement begins. Returns measured from lows to highs give one perspective, those measured on a calendar basis another. Economist Peter Bernstein has attempted to adjust for this phenomenon in a new study of stock and bond returns. He found that stock returns have averaged 9.6% per year (including dividends) across wide historical periods. Inflation has averaged 3.9%, meaning the real return on stocks has been 5.7% per year. This is moderately lower than the 10.7% return noted above.
With bonds, the sensitivity to the starting point was more acute. Actual returns were about 6% higher than the 1926-1996 average of 5.1%.
From this data, we can make some reasonable judgments about future rates of return in stocks. With dividend yields only 2%, stock prices will have to rise 7.6% per year to equal the ling-term average. If valuation remains the same at about 17x earnings, earnings growth will have to average 7.6% per year. Over the past 40 years earnings have grown at just under 6%. In the past ten years, earnings growth has averaged almost 9%. Most analysts’ forecasts peg the next 5 years earnings growth rate at about 7%.
Reasonable expectations for stock returns would thus seem to be in the 9-10% range (2% yields with 7 or 8% earnings growth) or about the long-term historic norm. This is far below the returns of the past 15 years.
We think that the period of extraordinary return in bonds ended in October 1993, when yield fell well under 6%. Today’s 7% coupons are good, but they are a long way from the 16% annual rates earned when yields peaked and prices bottomed in 1981.
We believe that the period of extraordinary stock returns that began in 1982 ended in 1996. Valuations are too high and future growth rates too low for stocks to average more that 9 or 10% per year. Although earnings growth is still solid, pricing power is non-existent, unemployment is low, and wage pressures are building. Corporate profit margins are high by historical standards, suggesting that competitive pressures may result in weakening margins and reduced profits when the economy slows from its present 4% pace. We think that, absent some deus ex machina, 9-10% long-term returns are the best that can reasonably be expected. Sensible investors will be prepared for periods, perhaps extended, where returns are well below those levels, or even negative.
A return to normalcy in stocks, like Harding’s message in 1920, may seem rather bland compared to the excitement of the past few years. We believe though, that such returns will still exceed those of bonds and cash and that equity investors will continue to be rewarded for the commitment to that asset class.