Bill Miller Letters Archive

1997 Q3 – Market Commentary

Despite the turbulence of late October, investors in the stock market have continued to earn solid returns. Even after this pullback, the S&P500 is up over 20% for the year, about double its long-term average. As we noted in our last shareholders’ report, we believe that the most likely course for the market in the next several years is what we’ve called a return to normalcy, where returns have two features that have been absent from the recent annual stock market data: a central tendency in the high single, or low double digit area, and a greater propensity for returns that may lag bonds or even cash from time to time.

We are suspicious of most measures of central tendency in time series data, and believe that betting on regression from the mean is at least as profitable a strategy as counting on regression to the mean. Robust or predictable regularities in market are usually short lived and not scalable; about the time you think you’ve found a profitable pattern it ceases to work. Markets are far too complex and adaptive to be amenable to analysis by simple formulas such as average price/earnings ratios, dividend yields, or counting the time since the last recession or the last 10% correction. This has not discouraged the press or commentators from using such formulas to generate wrong predictions. Markets are context dependent, their behavior is a function of the particular circumstances that obtain and how those circumstances are expected to or do change. The trick is not to predict an unknowable future, but to try to understand the present, and the probabilities of the various paths that may evolve from it.

The present economic circumstances in the US are about as good as it gets: high growth, low inflation, low unemployment, record profit margins and profits, high returns on capital, and a world generally at peace. Biologists often use the notion of a fitness landscape, first devised by Sewell Wright in the 1930’s, to characterize the situation in which a species (say) might find itself. The objective is to reach local or, better yet, global peaks on the landscape. If you’re on a peak, things are great, but they don’t get better. If you’re in a valley, things are bad, but since any direction will take you up, they are likely to improve almost no matter what you do.

The US economy appears to be at a peak on its fitness landscape, or maybe a plateau. The nervousness of the markets is due to investors being worried that any change from here is likely to be for the worse. After years of terrific returns, valuations in the market generally reflect the strength and health of corporate America. If the Asian currency devaluation’s had not spooked the equity market, something else would have; we agree with Alan Greenspan’s testimony on that point. The recent declines have taken a lot of froth off the market and we think it unlikely that the exuberance of the late summer will return soon.

The market is just “p” and “e”: price times earnings. If earnings are moving forward, if inflation is not rising, if interest rates are stable, and if stocks are not too overpriced, the path of least resistance for the market is higher. We think earnings are going to be up 5% to 8% next year, that the Asian flu will slow the US down a bit, that the Fed is unlikely to tighten amidst this kind of market instability, and that stocks are priced about where they should be. If prices were to fall sharply from here, we think it would represent an excellent buying opportunity.

The financial turbulence of the past few weeks makes the third quarter seem like a distant memory. Asian stock markets, already the worst performing in the world, fell apart in late October. Hong Kong dropped over 30% in a week, then rebounded almost 20% in one day. Our market saw the largest single day point drop and the largest point gain history on successive days. Although the percentage moves were not so dramatic, they were still sharp enough to generate worldwide headlines and occasion much commentary on what all of this might mean. Our current views on the market are detailed in the “Market Commentary” section above.

Of course, neither the absolute nor the relative gains experienced by the Value Trust recently are sustainable. You may think this is just false modesty, and that no matter what we say, we really expect to knock the cover off the ball all the time. If so, a brief excursus on what constitutes reasonable return expectations might be helpful.

Stocks have provided remarkably stable real (after inflation) returns averaging about 7% per year since the early 1800’s, according to work done by Jeremy Siegel, a Wharton professor. Recent work economist Peter Bernstein shows similar results, although the real rate is lower due to the different methodology employed. Bernstein found a nominal return average of 9.6%, which equated to a real return of 5.7% after inflation for the period 1871-1995. He calculates what’s called the equity risk premium to be 330 basis points (100 Basis points =1%). This is the return premium stock investors have historically earned over bond investors for the greater perceived risk of stocks relative to the contractually guaranteed returns of bonds.

With bonds yielding 6.2%, a 330 basis point premium for stocks would imply an average annual return for stocks of 9.2% per year from these levels, assuming no change in the overall valuation of the market. There is another way to extract the potential rate of return: take the 7% real return that Siegel found and add to it the inflation rate implied by the difference between the new inflation indexed bonds and regular bonds. The implied inflation rate calculated that way is 2.15%, which when added to 7% gives you an implied normal return of 9.15%, remarkably similar to that reached using Bernstein’s approach. Either way, we’re a long way from the 20% rates of return averaged by the Value Trust over its 15 year existence.

Consistent with the above, we think the stock market may average 8-10% annual returns over the next several years. This compares to an average annual return of over 20% for the past 5 years, and 18% per year for the last 15 years. This assumes that current valuations, which are among the highest ever achieved, persist. If economic conditions become less favorable, valuation would likely decline somewhat, further pressuring returns.

The Value Trust has outperformed the market over time, and we would hope to be able to continue to do so, but it is unrealistic to expect us to do it each year, or even most years. Our strategy has been and will remain consistent: we attempt to buy companies whose shares trade a substantial discounts to our assessment of intrinsic value, and to hold those shares long term.

Our technology and financial stocks were the star performers in the third quarter. These two groups have led the market since 1990, and we still think they represent the best values among the major industry sectors. When the market corrects, as it is doing now, they also tend to pull back sharply as worried investors try to protect gains. We do not get too caught up in the ebb and flow of investor sentiment, preferring instead to concentrate on understanding the economics and prospects of the businesses we own on your behalf.

Among our laggards was Columbia/HCA, the big hospital chain whose billing practices are currently under investigation by the government, MCI, whose shares fell when their merger agreement with British Telecom was amended, and Amgen, the leading biotech company, whose stock has been hurt by concerns about reimbursement rates for one of their major drugs, and by a relative lack of new product offerings for the next year of so. In each case, we used the price weakness to add to positions. We think Columbia in the mid to high $20s represents good value, even considering the headline risk associated with the flow of bad news surrounding this company. Columbia should be able to earn about $3.00 per share in a couple of years, and could then sell in the mid -$40s. The previous management has been replaced and the current team is cooperating with the government. The ride may still be bumpy from here, but it should ultimately prove rewarding. MCI has rebounded as two new bidders have emerged. We prefer the Worldcom offer at present, but are keeping an open mind as the situation unfolds. We have built up our Amgen position and think this company is the best value among the major pharmaceuticals, trading at only 15x next year’s earnings, compared to about 25x for Bristol Myers and Schering Plough, and over 30x for Pfizer.

We sold longtime holding Provident Bancshares in the quarter. It’s a good bank and has been a fine investment for us, but it reached what we believed was fair value. The Argentine government called it s Brady bonds during the quarter so we had to give up our holdings. As you may recall, we bought these during the last emerging markets panic in 1995 when everyone was throwing away their Latin American investments because of the Mexican devaluation. In a little over 2 years we nearly doubled our money on one series, and almost tripled it on the other. The Asian currency crisis is likewise inducing panic, and probably creating some outstanding values, but none are quite as obvious as were the Latin Brady Bonds. We are primarily domestic investors, and so don’t expect to end up with much of anything in the Asian markets, but would not rule out doing something if exceptional opportunities turn up.

We didn’t buy anything new in the past quarter, though we have added a name or so in the recent decline. If the market continues to fall, you can expect our buying to accelerate. We have about $300 million in cash and would love for the market to drop sufficiently for us to put it all to work.