Bill Miller Letters Archive

1997 Q2 – Market Commentary

The S&P 500 has almost doubled in the past two years, an extraordinary performance. Such strong results are usually achieved early in an economy recovery, when valuations are modest and earnings are growing strongly. That such returns are being seen after many years of strong economic growth and rising stock prices is testimony to how unusual this period is in financial history.

The second quarter’s surge, coming after a weak first quarter that was impacted by the Federal Reserve Board’s raising short-term interest rates, was fueled by a potential combination of better than expected earnings growth and astonishingly low inflation.

Earnings grew about 13% in the first quarter, year over year, and appear to be on track to grow perhaps 10% this quarter. The Producer Price Index has fallen 6 months in a row, something unprecedented in the 50 year history of that index. The Consumer Price Index is rising at only 2.4% while the consumer price deflator, a better measure of price behavior, is up at a 1.5% rate. Gold and oil prices are down 20% from a year ago, and the commodities complex is registering no signs of incipient inflation. Wage pressures, the most important factor in future inflation, are muted, showing only a modest upward tilt despite the lowest unemployment rate in the generation.

With corporate profitability high, earnings growing, interest rates gently declining, and inflation quiescent, stock prices have powered ahead, reflecting these unique economic circumstances. Real earnings growth and profitability- the reported numbers minus inflation-are the highest in history. All of this is terrific, and all of it is reflected in current stock prices.

The market’s pattern throughout history has been that of short, powerful bursts upward, followed by consolidation and range-bound trading until the next wave of fundamentals becomes clearer. We see no reason to expect otherwise from here, and so would expect the second half of the year to be less exuberant and more volatile than the past 90 days or so.

In the second quarter, the economy’s growth rate moderated from the 4.9% first quarter rate, as consumer spending slowed markedly. If consumer spending accelerates, the Fed may raise rates again, a development the market is currently not anticipating. If it occurs, a correction similar to the almost 10% decline seen earlier this year would not be surprising.

After the sharp run-up this year, stock prices are vulnerable to any bad news. Current valuations leave little room for disappointment. In our last report to shareholders, we expressed the view that equity investors should lower their expectations and be prepared for returns more in line with historic norms of 10% or so, than with the 19% per year experienced over the past 15 years. With the recent move in stock prices, the past 15 years’ returns have now exceeded those of any 15year period in any stock market in the world.

Although we are firmly in the camp that more modest returns are to be expected, we do not believe, contrary to the views of many market strategists, that this period of exceptional returns is likely to be followed by an extended period of sub-par returns. Those who believe that the seven fat years we’ve had must be followed by seven (or at least several) lean years don’t rely on scriptural warrant, but they do rely on faith, faith in the notion of regression to the mean.

They believe that many factors that underlie stock price growth-economic growth, earnings growth, inflation, real interest rates-are constant, or nearly so. If these factors veer sharply above or below the historic norms, they expect them to move back in the opposite direction to re-establish the long-term mean.
There is no doubt that regression to the mean has been a powerful force in economic history, but as circumstances change and evolve, so too may the mean. The implicit growth rate of the S&P 500 is a good example.

Most strategists estimate the long-term growth rate of the S&P 500 to be little over 7%. Where do they get this number? From history. The 40 year growth rate has been 6.6%, while the 70 year growth rate is slower at 5.5%. The longer period encompassed the Great Depression, which lowered the growth rate. The 10 year growth rate, though, is 10%, the 5 year growth rate has been 13%, and the 3 year growth rate about 20%.

The acceleration in the growth rate has been due to the relative lack of cyclicality in the economy over the past 15 years and, importantly, to the change in the composition of the S&P 500. This latter factor is little noticed but extremely significant.

Thirty-five years ago the S&P 500 was heavily weighted in utilities, energy, and basic industry. Finance had no weighting, and technology was only 5%. Today finance and technology make up 30% of the index, with health care, and branded consumer companies such as Coca Cola, Philip Morris, and Procter and Gamble having significant weights. The composition of the index has changed as the economy has changed. It is heavily influenced by more stable, faster growing companies. The component companies of the index also change. Just in the past two years, over 10% of the index components have turned over, with the general direction continuing toward more rapid growth than historically has been the case.

Strategists have consistently underestimated earnings growth this decade because they have assumed the growth rate of today’s S&P will be the same as yesterday’s, despite the index being significantly different. It is as though they expected the Yankees to win the pennant this year because Mantle, Maris, Berra and Ford had great numbers back in the early 1960’s.

It looks as if the earnings growth rate of today’s index is about 10%, considerably higher than that assumed in most analysts’ models. Valuation is highly sensitive to real growth rates. In an environment of 6.5% long bonds, it makes a big difference if the growth rate of earnings is 7%, or 10%. We believe it is closer to the latter, and that the future rate of return on stocks is likely to be considerably higher than the current spate of bearish strategists suggests.

That rate of return, though, may encompass significant fluctuations. Investors should be prepared for periods, sometimes extended periods, of returns that may be well below 10%.

Value Trust

The second calendar quarter provided exceptional returns for many investors in the stock market. All of the major averages surged, a trend that continued early into the third quarter. Our results were as follows:

As is evident, our returns compare quite favorably with those of the major indices and funds with similar objectives. Most fund managers continue to underperform the indices, with this year’s under performance being particularly acute. The S&P 500 is basting about 95% of actively managed funds so far in 1997, as the largest capitalization stocks maintain the remarkable run that they have experienced in the past few years.

Our results have benefited significantly from our large positions in financial services and technology. Those groups have been market leaders since this bull market began in late 1990. We have long a major position in financial services. Our commitment to technology is more recent and generally accounts for the difference between our performance and that of other value managers, many of whom avoid technology stocks.

Many of our largest holdings have had astonishing moves in the past year. Dell is up over 500%, IBM 130%, Western Digital 250%, Warner Lambert 160%, Philips Electronics 160%, MBNA 130%. That’s the good news; the bad news is that the business values of these companies have not expanded at that rate. Over long periods of time, you can only earn returns in line with the expansion of business value, adjusted for whether your purchase price was above or below that value. We try to buy companies at large discounts to underlying value. If our analysis is right, we hope to capture the expansion of business value and the purchase discount.

Technology stocks have offered that opportunity over the past few years, but it is waning as the stocks surge ahead. Our research efforts are still active in that area, but there now appear to be better values in other sectors. We have increased our weightings recently in the gaming industry, where the stocks have underperformed for quite some time and expectations are low. We are quite optimistic about the return prospects in the lowly valued auto stocks and in the much maligned tobacco industry. We believe there may be opportunities in airlines and in utilities, two industries where it is still possible to find stocks selling at single digit price earnings ratios (and rightly so, many think, since very little money has been made in these areas over the years). We haven’t bought anything here, but are looking.

Portfolio activity was light in the quarter. We sold Standard Federal Bank, a long-standing position that was acquired by a foreign financial institution. We bought American Express during the sharp sell-off early in the quarter. We were not able to buy a significant position before it moved out of our price range. Two technology stocks were added: Compaq and Storage Technology. We were able to get solid positions in both before they rallied. Compaq trades at a below-market valuation on next years’ earnings, while growing at almost 3x the market’s rate of growth and earning 4x the market’s return on capital. We bought Storage Technology at 10x forward twelve month earnings. It has no debt, a strong cash position, a 12-15% growth rate, and has been repurchasing its shares. We also bought Conseco, a highly acquisitive consolidator in the insurance industry with an excellent long-term record and a modest valuation.

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