Your fund had an excellent first quarter, rising 7.15%. Our results for the 3 and 12 month periods ending March 31, 1996, as well as those of the major equity fund comparative indices, were as follows:
All of the above figures include reinvested dividends. As you can see, the Value Trust outperformed the average growth fund and the S&P 500 for the quarter, but trailed the economically sensitive Dow. We outperformed all the above indices by a fairly wide margin over the last twelve months.
It has not always been so, and you should not expect it always to be so, on a quarterly or an annual basis. Although the Value Trust is one of the few funds to have outperformed the S&P 500 since our inception in early 1982, and one of only about two dozen to have outpaced that index in each of the past 5 calendar years, we have had periods of underperformance.
In the late 1980s the fund underperformed in two separate two-year periods. Those were years of greater economic volatility than we have experienced recently, as the more cyclical parts of the economy swung from periods of strength to weakness and investor behavior alternated between euphoria (1986 to mid 1987) and panic (late 1987 and 1990). Contributing to this enantiodromia were the collapse of oil prices in 1986, the dollar's weakness and the Fed's raising of interest rates in 1987, the fall of communism in 1989, the S&L and banking crisis in 1989 and 1990, and the invasion of Kuwait in 1990; which sent oil prices soaring to the levels of the late 1970s.
Our style of value investing was not and is not oriented to rapid rotation in response to the vicissitudes of investor psychology or to temporary political or economic events. We are patient, long-term investors who try to invest in solid businesses at bargain prices. This will often lead us to being out of fashion with the market, investing where the press or public have near-term worries. As Warren Buffett has noted, a cheery consensus is not the friend of the value investor.
You might think that such a consensus exists in financial assets now, with stocks rising smartly in the first quarter, following a strong 1995. The proximate cause – for a complete description of the taxonomy of causes, consult your Aristotle – of the market's ascent is often reported to be the public's rush into mutual funds, and their childlike belief in high, consistent returns by investing in stocks. The press is full of stories about the current "mania" for mutual funds, about how it is reminiscent of the great manias of the past such as the South Sea bubble, or the tulip-bulb mania in Holland in the 17th century, and how it will all end badly, as such episodes do.
We think such stories are not just nonsense, but to use the great British utilitarian Jeremy Bentham's phrase, nonsense on stilts. Valuations remain moderate, despite press reports to the contrary. Your portfolio trades at about 10x next year's earnings. The equity mutual fund flows are a macroeconomic effect of changing demographics and the felt need to begin accumulating assets for retirement on the part of the 76 million baby boomers whose oldest members began to turn 50 in 1996.
For years we have been bombarded with stories of how Americans consume too much and save too little. Our profligate ways have been contrasted with those of the frugal Asians and Europeans, who have much higher national savings rates. We have been told we must save and invest more if we are to create new jobs and provide a reasonable prosperity for the future.
When we begin to do that, when consumption spending slows and savings increase, we are then told how bad retail sales are, how people aren't spending enough because they have lost faith in the future. With 30 million households putting their savings into long-term investments such as stocks via equity mutual funds, this is regarded by the popular press, and by many on Wall Street, not as prudent behavior, or as evidence of confidence in the future, but as a mania. It is no wonder the public has such a low opinion of negative and cynical commentators whose attitude is that of the observer who, upon seeing someone with flowers, asked where the funeral was.
During the bull market of the 1980s, less than $100 billion flowed into stock funds in the entire decade. The powerful returns generated in stocks and bonds did not induce an increase in the savings rate, which actually declined over that period. The explanation for the savings decline then was that the high returns earned in stocks and bonds substituted for savings, allowing people to spend more. That the bulk of the population was in their high spending years (ages 25-44) was little noted. This group peaked demographically in the late 1980s.
With the oldest baby boomers turning 50, and the youngest at 32, the bulk of the generation is now hitting the front edge of the high savings years, which began around age 45 and extend to age 65 or so. It should be no surprise that flows of funds into financial assets should be strong. So far this decade, those flows are averaging more each year than was invested during the entire decade of the 1980s. The '80s argument that high returns in stocks stimulate spending and depress savings has been updated to now argue that high stock returns stimulate savings and depress spending. The philosophically inclined would say this argument has a rather "post hoc" feel to it.
Low economic volatility, low inflation, and low interest rates all contribute to the willingness to invest in long-dated assets. It is a legitimate question whether the high real returns earned in stocks and bonds over the past 15 years have affected the perception of risk that attends investing. The public has rightly learned to buy the dips in stocks, which alarms the alarmists. They worry about what will happen when a real bear market occurs, like 1973-1974. Why they are worried about people acquiring assets when prices are depressed, is a mystery yet to be solved.
If the financial press seems unusually cynical and too often negative, it is not alone. The bond market has its own malady, a persistent case of cosphobia: fear of prosperity. Bond holders fear that if the economy does too well, demand will outstrip supply, and inflation will be the inevitable outcome. Each time there is evidence that the economy is getting stronger, as we had in the first quarter, investors sell bonds, pushing interest rates higher.
During the first quarter, 30-year Treasury bonds had their biggest price decline in history accompanied by Federal Reserve action to raise rates. Stocks and bonds decoupled: equity prices held steady or advanced while bond holders lost money. We believe this decoupling has about run its course. If bond yields continue to decline, we think stocks will follow. We also think the fears ran overhearing economy are way overdone and that bond yields approaching 7% offer excellent value. As the year unfolds, we expect the inflation worries plaguing bonds will dissipate as it becomes clear the economy remains in a moderate growth phase and that inflation is unlikely to exceed 3% or so.
Feeding the fears of inflation has been first, the strong rise in gold prices at the beginning of the year and, more recently, rising prices in oil and grains. The broadening out of the price rise effect to general commodity price indices has raised the specter of persistent underlying inflation pressures – about to erupt. We think such worries are groundless.
Gold has already retreated back to the $390 level, from a peak of over $420 reached in January; Not only is the price in a short-term downtrend, it recently broke below its two-year average price. Those who were most insistent that rising gold prices signal rising inflation are now silent about the benefit of falling gold prices.
Oil prices have also rallied sharply this year, recently surpassing $25.00 per barrel on the nearby futures contract, the highest price in years. Wheat and other feed grains have likewise risen, the result of low inventories and drier than normal weather.
We have long held the view that oil bulls are a peculiar breed of inflationist whose beliefs are generally impervious to facts. Many of the arguments they offer as reasons prices are going to go up are reasons why either prices have already gone up or reasons why prices are about to go down. Two of these humbugs are particularly hearty: prices in real terms are the lowest in 40 years and inventories among oil companies and refiners are the lowest in 10 years. The argument is that prices are so low because inventories are tight and that low inventories mean supply is tight and, since demand grows steadily; prices will be forced higher sooner rather than later.
The short version of why these are wrong is as follows (there is a much longer version): commodities prices tend to trade close to the marginal cost of production, which for most commodities falls in real terms due mainly to technological improvements in the ability to extract, produce, or grow the products. The long-term trend in commodities prices has been down since the industrial revolution began, save for short episodes, the most unusual of which was the 1970s, a period commodity bulls constantly try to recreate. That prices are at 40-year lows in real terms is not an aberration soon to be corrected; it is the norm.
Inventories are low because a colder than normal winter led to a temporary price spike in oil. Companies drew down inventories because they could sell oil on the spot market at higher prices than were available in the forward market, a condition known as backwardation. They have been reluctant to replenish inventories today at high prices when they can lock in supplies in the futures market at lower prices. The last time oil companies actively drew down inventories was in 1985, just before prices collapsed. We don't think prices are going to collapse, but we do think they are headed 20% lower over the course of the year, measured by the near-term futures contract.
If we are right that the recent inflation and growth scare will abate as the year progresses, interest rates should gradually decline, allowing stocks to continue to advance. Corporate profits growth so far appears solid, at least in our portfolio companies, and we are optimistic that stocks will again be the best performing asset class this year.
Portfolio purchases were modest in the quarter. We took advantage of the panic surrounding a feared slowdown in personal computer demand to buy DELL COMPUTER, whose strong balance sheet allows very high returns on capital relative to its competition. We bought the stock at less than 10x this year's expected earnings. CIRCUS CIRCUS is a superbly managed gaming company with exceptional long-term prospects. WALT DISNEY shares made a brief stop in the portfolio. They came to us via the merger with CAPITAL CITIES/ABC. DISNEY is justly regarded as a wonderful company, yet it has no lines of business that are as profitable as the basic business at CIRCUS.
We sold APPLE COMPUTER at higher than present prices when it became clear their market share driven strategy was not working. Both BANCOMER and SEARS were also sold in the quarter. They were quite small positions and we continue to want to keep your portfolio tightly focused.
As always, we appreciate your support and welcome your comments.
Bill Miller,
CFA May 8,
1996 DJIA 5420.95
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