Bill Miller Letters Archive

1994 Q1 – Market Commentary

For the three-month period your fund outperformed all the major indices as well as the Lipper Growth Fund Index. Over the past year, we trailed only the Dow, whose 30-stock component is both price weighted – higher priced stocks count for more than lower priced ones – and the most economically sensitive of the typical benchmarks. As we have noted many times in past letters, the S&P 500, despite its shortcomings, is regarded as the best overall measure of the trend in stock prices. The Lipper Growth Fund Index is probably the best general benchmark of how well we are doing, since it consists of actively managed funds with similar long-term objectives, albeit dissimilar styles of achieving those objectives.

Judging by the market’s action in the past two months, investors began the first quarter unaware of two things they were fully cognizant of by quarter’s end: stocks do not react well to rapidly rising interest rates and Mexico is not the fifty-first state. After 39 months without a 10% pullback, many investors had apparently become complacent, understanding intellectually that markets fluctuate, but having little memory of the emotional impact of actually experiencing portfolio losses.

The year began with few impediments to rising equity prices. Long bonds were 6.34%, the Federal Reserve Board was accommodative, and double digit earnings growth was in the offing. During January stocks were up sharply, led by the Dow. Investor enthusiasm was tempered only by the belief that the Fed would begin to restrict credit when it became concerned about incipient inflation. With little evidence in the reported numbers that inflation was soon to become a problem, investors were unprepared for the increase in short rates when it came on February 4. The steep run-up in January only exacerbated the impact of the Fed’s action. The magnitude and speed of the sell-off in both fixed income and equity markets is testimony to the surprise the markets experienced at the timing of the Fed’s move.

In congressional testimony Chairman Greenspan opined that the actions of a vigilant Fed in raising short rates could lead the markets to lower long rates, thereby signaling improved prospects for continued low inflation. Perversely, the bond market seemed to be saying the inflation outlook had worsened because the Fed tightened.

That Mr. Greenspan expected long rates to fall is the surprise. In the 80 years since the Fed was established, inflation has eroded the value of the dollar by 95%. When the Fed began to tighten, it indicated its belief that the risk of inflation is now sufficient to justify action. The prudent response by a holder of long bonds to this new information would be to reduce one’s exposure to the increased risk of holding those bonds relative to the higher returns now available at shorter maturities.

Stocks are usefully thought of as long-term bonds with indeterminate coupons, the coupon rate being the sustainable return on equity of the underlying company. With their valuations being driven by interest rates, stocks went along with bonds for the ride, falling almost 10% from the highs in late January.

What is driving the Fed’s fear of inflation is the rapid growth of the economy, 7% in the fourth quarter of 1993, perhaps 4% now. It is generally thought that if the economy is growing too fast, monetary authorities should slow it down by raising interest rates. This is what economist Ed Yardeni calls the Tonya Harding approach to monetary policy. If you are worried the economy is going to do too well, you club it in the knees to damage its performance.

Like the three little bears’ porridge, the economy’s growth rate is rarely just right. More often it is too hot or too cold, leading to incessant meddling by politicians and central bankers to cool it down or heat it up. Since the growth rate in the fourth quarter of 1993 was much too hot, monetary policy is now in the process of cooling the economy down.

The markets have long experience with this, and rightly fear the usual cycle of tightening until recession and a bear market become inevitable. Predictably, the central bank says the purpose of its policy is to sustain and enhance the expansion. We would be more sanguine about Fed policy if it focused on price stability, not economic manipulation.

We believe this period in the stock market is similar to the 1983-1984 experience. After 10% growth was reported in the first quarter of 1983 the Fed began to tighten. Short and long rates rose and stocks began to sell off. The S&P fell about 15% before rates peaked. When that growth scare was over, stocks resumed their advance, rising another three years without a significant correction.

Evidence is already accumulating that rising rates are beginning to bite. The recent break in commodities prices such as gold and lumber, the weakness in cyclical stocks, and the better behavior of banks and drug stocks indicate this growth scare may be abating. If the economy slows in the second half, we expect long rates to drift lower and the equity market to firm.

While our U.S. equities have been pressured by the Fed’s action, our Mexican stocks have been devastated. The Mexican economy is struggling to emerge from recession, while ours is experiencing rapid growth. With the peso linked to the U.S. dollar, rising interest rates here mean either rising rates in Mexico or a falling currency, or both.

Mexican short rates have risen from 8.8% in February to 18% a few weeks ago. The peso has declined 6% against the dollar and Mexican stocks are down over 30% from the peak only 60 days ago. Including currency, the Mexican stock market decline rivals ours from the August 1987 peak to the October Crash lows.

Telefonos de Mexico, the Mexican phone company, one of our largest holdings, fell from $75 to about $50 before recovering. Grupo Financiero Serfin, the third largest Mexican bank group, peaked at $37, then declined to $17. At that price, it was trading at under 5x next year’s earnings, and yielded over 7%. With only 10% of Mexicans having checking accounts, the country is woefully underbanked and Serfin should experience many years of strong growth. We have added to our position in the recent weakness.

Compounding Mexico’s economic problems are political difficulties. Struggling with social unrest and trying to recover from the tragic death of presidential candidate Luis Colosio, Mexico is experiencing the pains that so often accompany the emergence of countries toward industrialization and democracy. It is important to our investment case that the free-market reforms begun under President Salinas continue under the new candidate, Dr. Ernesto Zedillo. It is also important that the Mexican central bank defend the value of the peso. A sound currency is the foundation of a stable economy and the monetary authorities have sufficient reserves to ensure the peso’s value. We expect Dr. Zedillo to win the election this summer and we believe the monetary authorities will continue to preserve the peso’s value within the current bands. We remain enthusiastic about the long-term opportunities in Mexico.

There were only two portfolio changes during the quarter: we bought IBM and sold Bristol-Myers Squibb. Bristol is a fine company with a good yield, but its earnings growth prospects are modest, perhaps 5% per year. We elected to increase our holdings in Amgen, which sold off sharply in the quarter on earnings fears, only to rebound after quarter’s end on surprisingly good results. Even after the rebound, Amgen sells at only 12x earnings with a 15% estimated growth rate, significant excess cash generation, and an active share buyback program.

We had just about completed our position in IBM when the company reported excellent first quarter results and the stock surged. Although the market is focusing on IBM’s earnings, we are much more intrigued by its growing free cash flow. We estimate that IBM could generate over $6.00 per share of free cash flow after-tax and after capital expenditures next year. That free cash flow should grow over the next several years and we believe IBM’s intrinsic value is over $100 per share.

We are, as usual, agnostic about the near-term direction of the market. Investors have suffered a lack of confidence triggered by rising interest rates and by political turmoil here and abroad. Such ebbs and flows in investor psychology are characteristic of markets and, in our opinion, do not presage a more severe or protracted decline than the sort of correction experienced from the fall of 1983 to the summer of 1984. Investors were ill-served then and no doubt will be again by excessive focus on near-term events, ignoring the opportunity to buy long-term value at more attractive prices than prevailed a few months ago.


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