Bill Miller Letters Archive

1998 Q4 – Market Commentary

The Value Trust had one of its best years in 1998, rising 48.04%. Our returns were especially strong (+35.86% vs. the S&P 500’s 21.30%) in the fourth quarter rebound from the panic selling of late summer and early fall. As indicated in our last quarterly report, we believed the decline in share prices resulting from Russia’s debt default and fears about the effects of global financial instability on domestic profits had created an attractive investment opportunity. General Equity Funds were up 14.56% with growth funds rising almost 23% according to Lipper Analytical Services, Inc.

Our results substantially outpaced those of the major market indices, which exhibited unusually wide variation in the past 12 months. The Russell 2000 Index of mostly smaller companies fell 2.55% while the large capitalization S&P 500 rose 28.58%. The price weighted and more cyclically oriented Dow Jones Average rose 18.15%. General equity funds were up 14.56%, with growth funds rising almost 23% according to Lipper Analytical, Services, Inc.

Some Thoughts on Indexing and Performance

Most money managers again failed to keep pace with the benchmark S&P 500, which outperformed over 80% of active managers in 1998 and over 95% of active managers over the past five years. Last year was a particularly hard year to beat the market, since only 28% of the stocks in the S&P 500 outperformed the index, and those were concentrated mostly in the largest names. As evidenced by the very poor returns of the Russell, to the extent active managers focused their efforts on smaller companies, by charge or by choice, they had very little chance to deliver index-beating returns.

The S&P 500 is the benchmark for most active managers; it is the competition. It is also the cost of capital for active management. Just as companies that invest above their cost of capital- which is the weighted average cost of their debt and equity-add value for owners and those that do not destroy shareholder value, so too with money managers. To the extent money managers outperform the index, they are adding value for their shareholders; to the extent that they under perform, they are destroying value relative to returns that could be obtained by investing in an index fund. The rapid growth of indexing over the past decade or so is a direct result of the inability of most active managers to add value relative to what is misleadingly referred to as passive investing.
Money managers are often quick to criticize companies that do not perform well, and to offer management advice on how to do better. Companies that are consistently beaten by the competition are rightly admonished and urged to adopt strategies with a greater probability of success. Those companies that are consistently superior are closely studied and their methods are often copied in order to improve results.

Surprisingly, scant attention appears to be directed at the methods and strategies of the S&P500 despite its long-term record of superiority relative to most active money managers. Data compiled by Tweedy Browne & Co. indicates that since the beginning of 1982, the S&P 500 has outperformed over 90% of all surviving mutual funds. The proportion would of course be even higher if funds that subsequently failed or were merged were included. A recent book, Indexing for Maximum Investment Results, contains the results of numerous studies of active managers vs. index performance. The results are consistent across a wide variety of time frames: index funds routinely beat the overwhelming majority of active managers. Index funds do particularly well relative to active managers in large capitalization stocks such as those found in the S&P 500. Even with very broad market indices such as the Wilshire 5000, the superiority of indexing holds. From 1973 through 1995, there were only 8 years that active managers beat that index, and 6 of them occurred prior to 1983.

Two questions suggest themselves: why does indexing work, and can active managers improve their results by careful study of the competition?

The answer to the first question is easy: indexing works because the market is efficient. Academics refer to the notion of market efficiency as a hypothesis, but they are just being overly fastidious. We can dispense with trying to distinguish, as they do, between various forms of efficiency, and with an unnecessary discussion of the various studies of possible market anomalies and inefficiencies. For the purposes of real world investing, lets call a market “pragmatically efficient” if it beats most active managers most of the time. It is clear that the market for capitalization US stocks is pragmatically efficient.

An efficient market is one where stock prices reflect all available information. Notice that this description does not say prices are correct, just that in the aggregate they incorporate what is believed about the present value of the future. The information available to the market is reflected in prices throughout the collective behavior of the agents operating in it. These agents encompass an ecology of objectives, time horizons, risk tolerances and utility functions. This leaves plenty of room for recurrent, exploitable anomalies such as those that may arise due to systemic errors in probability assessment. But any such opportunities are unlikely to be available to the average investor. Average hitters can’t win many batting titles.

The most important implication of a market that is efficient is that there is no algorithmic or systematic way to outperform it. More simply, there is no formula, which can specify a portfolio that is likely over time, to outperform the market. Any such formula of mechanism would be copied and its advantage arbitraged away as it quickly spread among investors. There may be formulations or principles used by those who have outperformed, but such statements will not specify a portfolio. We use just such formulations: We buy companies that trade at large discounts to intrinsic value. Unfortunately, that simple description doesn’t specify any particular portfolio. (When asked the secret to hitting, Stan Musial-I think-said, “wait for a good pitch and then smash it.”)

This means that all of the popular methods of stock selection: value, growth, momentum, sector rotation, thematic investing, etc. are either too vague to be useful, or if specific, as many purely quantitative methods are, likely to have a short half-life.

Is active management just a loser’s game and passive indexing the only viable investment strategy? Not at all. Just as poorly performing companies can often improve their results by studying winning competitors, active managers can improve theirs by deconstructing the sources of competitive advantage of the index, in our case the S&P 500.

The first and most important feature of the S&P 500 is that it does not employ a passive selection strategy. Managers of index funds employ such a strategy, since they engage in no active stock selection. But the S&P 500 is an actively selected index. Its stocks are chosen from the nearly 9000 publicly traded securities on the New York, American, and NASDAQ markets by a committee using specific investment criteria.

The returns of the S&P 500 are the best evidence of the long-term advantage of active portfolio construction. It has consistently beaten broader, passively constructed indices such as the Wilshire 5000, the Russell 2000, and the NYSE Composite. That it has also beaten other active money managers is not an argument against active management, it is an argument against the methods employed by most active managers.

The S&P500 is a long-term oriented, low turnover index employing a buy and hold strategy, which is by nature tax efficient. It lets its winners run, and selectively eliminates its losers. It never reduces a successful investment no matter how far up the stock has run, and it does not arbitrarily impose size or position limits on holdings, either by company or industry. Size is fixed at 500 names, and new manes usually come into the index because of the merger or acquisition of existing companies. Periodically, new names are added and others eliminated in an attempt to replace companies that are marginal with those whose position in the economy or an industry are deemed more important.

The overall index is positioned to represent the broad sweep of the US economy. The stock selection committee at S&P consists of 9 analysts, and new names are meant to be seasoned companies with a history of profitability, financially sound, leaders in their industry or market, with a probability of being a business over the next 10 to 20 years. Index turnover averaged 25 to 30 names in the 1980s but has picked up to 40 or so in the past few years.

The contrast with the typical active manager is stark. The average mutual fund is short-term oriented, has high turnover, is tax inefficient, and employs a trading oriented investment style. Most funds systematically cut back winners or rotate out of stocks that have done well into those expected to do better. Position limits and industry weightings are usually rigidly maintained in the name of either investing disciplines or risk control. The number of holdings is usually weighs over 100, but may vary significantly, but among funds and within the same fund over time. The overall portfolio is constructed in accordance with some style the manager erroneously believes is likely to outperform the long-term, low turnover approach of the S&P 500.

Part of the success of the Value Trust is no doubt due to our not employing methods that place us at a disadvantage to the S&P. We employ a long-term, low turnover, buy and hold investment approach that as a by-product is tax efficient. We employ no rigid industry, sector, or position limits, save only those mandated by the broad mutual fund rules. We let our winners run and eliminate those positions deemed to have poor long-term economic prospects. If we have companies merged for cash, we will redeploy that capital into new names.

Operating similarly to the S&P in the way noted above does not help us outperform the index, although it probably has helped our results compared to other managers whose methods have been different and sub optimal relative to the index. Our results have improved in the past several years as our turnover rate has fallen and as we have let our winners continue to run without cutting positions back in the guise of risk control or portfolio balance. There is a limit to all good things, though, and our positions in Dell and AOL are much larger relative to our portfolio than the largest position in the S&P is relative to that index. Those positions are at or near their peaks and we would expect then to decline gradually over time.

Since the selection criteria for inclusion in the S&P 500 are not terribly arcane, it is not superior stock selection that has led to its methods beating most other active management style. There are services out there that are pretty good at identifying likely candidates for the index. America Online was widely expected to be added, as happened at December 31, and Warren Buffett’s Berkshire Hathaway is another favorite for eventual inclusion.

What is the source of the S&P’s superiority over active management style? I think it comes back to market efficiency. The market is pretty well aware of the information that may affect the prospects of its constituent companies for the next year of so. New information arrives unpredictable. Beyond the next year, the complexities, uncertainties, and vagaries are such that no one is vouchsafed any special insight into the future. Most of the activity that makes active portfolio management active is wasted; it adds no value since it is engendered by the mistaken belief that the manager possess information the market is unaware of, or that the market has misplaced. It doe impose costs: trading costs, market impact costs, and taxes. It is also often triggered by ineffective psychological responses such as over weighting recent data, anchoring on irrelevant criteria, and a whole host of other less that optimal decision procedures currently being investigated by cognitive psychologists.

Money managers often wrongly decry the growth of indexing and complain that it is a mindless strategy. While they may be right that pure factor based indexing strategies, e.g., buy all companies with characteristics xyz, are unlikely to add value over time (the evidence is not clear on this,) they are surely wrong to bemoan either the desire of investors for S&P 500 index funds or their own inability to compete with the results of such funds. Investors are rationally selecting an active money management style that is sensible, tax efficient, has long history, and works.

Portfolio Activity and Outlook

As usual, our portfolio activity in the quarter has been modest. We sold our Daimler Chrysler subsequent to the closing of the merger, and we sold our Columbia/HCA Healthcare. We believed that Daimler Chrysler was fully priced at 15x earnings especially since GM was trading at 8x. Columbia was swapped into WPP Group, plc the largest communications company in the world, and the owner of ad agencies Ogilvy and Mather and J.Walter Thompson. WPP at the time was trading at 14 x earnings, earning 20% on capital, and growing nicely. It trades at a huge discount to comparables such as Interpublic and Omnicom for reasons we believe are unwarranted. Since the swap, WPP shares have risen, while Columbia’s have declined. We also bought First Data, the largest merchant processing company; and MGIC Investment, the largest independent private mortgage insurance company. First Data has under performed for years as returns on capital deteriorated. We believe that is about to change. MGIC has suffered from slow growth in the mortgage insurance market and recent competitive pressures from Fannie Mae. At 8x earnings, with excellent management, high returns, and active share repurchase, it is just too cheap. We also bought a little Fred Meyer when the arbitrage into Kroger became compelling.

We believe the next year in the market will be unpredictable, just like all other years. The economy appears solid, though the profit cycle is extended and profitability pressures are increasingly evident across a wide variety of industries. Inflation is well controlled, real rates are high but not punishing, and the Fed appears on hold for now. The budget surplus could hit $100 billion this year. Brazil’s floating of the currency appears to have been well tolerated by the markets, although at the margin it will be negative for growth in their hemisphere. Market values in the US stock market have out-stripped business value growth for some time, a trend we do not expect to continue. The combination of modest profit growth, low inflation, a disciplined but not hostile Fed, and continuing high demand for long dated financial should lead to satisfactory results in 1999.