The end of the first calendar quarter of 1998 is the end of the fiscal year for our Funds. SEC regulations require that investment advisors discuss market conditions and strategies that materially affected a Fund's results during its fiscal year. The format of this letter, a departure from our usual random, digressive style, is designed to facilitate covering the topics required by the regulators.
Review of Fiscal Year 1998 Market Conditions
Large capitalization stocks performed exceptionally well in the year ending March 31, 1998, returning 48.0% as measured by the S&P 500. Broader measures of stock performance also performed well. The Value Line index, which includes both large and small companies, rose 37.8% during that period. The Russell 2000 index, which covers mostly smaller companies, rose 42.0%.
Strategies Affecting Fiscal Year 1998 Results General:
The Value Trust and the Special Investment Trust follow a value investing style. Value investors attempt to evaluate the intrinsic worth of a company and purchase securities in that company at prices representing a substantial discount to calculated value. Estimates of business value are subject to substantial uncertainty arising from, but not limited to, the availability of accurate information, economic growth and change, changes in competitive conditions, technological change, changes in government policy or geo-political dynamics, and so forth. We attempt to minimize the potentially unfavorable consequences of errors in the estimation of business value by building in a margin of safety between our estimates and the price we are willing to pay for a security.
A variety of quantitative methods and qualitative assessments are used to estimate business value. These include, but are not limited to, traditional valuation measures such as price earnings ratios, price-to-book value, and price-to-cash flow ratios, both prospective and historic. Comparative valuation work is extensive and includes historic, prospective, and scenario-based methods, as well as volatility analyses. Theoretical valuation frameworks are also employed. Discounted cash flow and free cash flow analyses are extensively employed, as are private market and liquidation value analyses.
Qualitative assessment of business prospects involves studying companies' products, competitive positioning, strategy, industry economics and dynamics, regulatory frameworks, and more. We pay particularly close attention to corporate capital allocation policies and the returns resulting therefrom. We believe a management's commitment to shareholder value is often best demonstrated by how they allocate capital.
The Funds' management also devotes considerable time to the study of important academic work in financial theory and in experimental economics. We have found recent work in behavioral finance and complex adaptive systems to be particularly important in assessing and understanding markets, investor behavior, and competitive strategy.
Value Trust: Strategies Affecting Results
The Value Trust has followed a consistent investment strategy for many years. It is characterized by careful attention to value, a focused portfolio, and low turnover. The Fund had an excellent year, significantly outperforming all relevant indices of both the market and of comparable mutual funds.
The Fund's results benefited from a number of its technology holdings, an area where valuation work is often complicated and difficult. The Fund purchased large positions in a variety of technology companies such as Dell Computer, Storage Technology, and Digital Equipment over the last two years when such shares were under severe pressure due to concerns about earnings' prospects.
When those concerns did not materialize, the shares of those companies rose sharply, adding materially to the Fund's returns. We also benefited from our long-standing position in banks and financial services companies, which performed strongly in the past twelve months. Our returns were also enhanced by mostly avoiding stocks whose shares suffered heavy losses. We believe our focus on having a margin of safety in the purchase price contributed to the relative lack of poor performers in the portfolio. A more complete list of stocks affecting our results is included elsewhere in this report.
Special Investment Trust: Strategies Affecting Results
The Special Investment Trust follows the same investment strategy as the Value Trust but mostly operates in a different market segment: small- and mid-sized companies and special situations. The Fund performed well in the twelve months ended March 31, 1998, outperforming the Russell 2000 index, while performing in line with the average fund that invests in small- and mid-sized companies.
The Fund's results were benefited by many of the same factors described above in the Value Trust section: a timely commitment to depressed and controversial technology stocks and solid performance from financials.
Companies whose shares underperformed during the period usually did so for company-specific reasons such as disappointing earnings, a poor industry environment, or adverse regulatory developments. A more complete list of our strongest and weakest performers over the past twelve months is included elsewhere in this report.
Total Return Trust: Strategies Affecting Results
The Total Return Trust follows an investment strategy similar to that of the Value Trust and the Special Investment Trust, while focusing on securities with above-market yields. The Fund had a very good year, outperforming its peer group, although underperforming the S&P 500. The Fund's results over the last twelve months benefited from our long-standing position in banks and financial services companies, as well as a variety of stocks in other industries, including Ford Motor Company, up 107%, Unicom, an electric utility, up 80%, and Masco, a manufacturer of kitchen and bathroom products, up 66%.
In addition to focusing on securities with above-market yields, our objective is to have the Fund's results be less volatile than those of the overall market.
Dissecting the Fund's results during the fiscal year reveals the lower volatility profile we strive to achieve. During the third fiscal quarter (the fourth calendar quarter of 1997), the market came under pressure due to concerns surrounding the Asian currency crisis. During this period, the Fund significantly outperformed its peer group, appreciating 4.1% vs. 0.8% for Lipper Growth & Income Funds, and also outperformed the major market indices (please see the December 31, 1997 quarterly report for additional performance information).
However, on the flip side, during periods of strong equity performance, such as the first calendar quarter of 1998, lower volatility funds will tend to underperform. We do not manage the Fund to outperform every quarter or every year. Shareholders who expect this will most likely be disappointed. Our goal is to outperform our peer group and the major market indices over long periods of time by purchasing securities that we believe are selling at a discount to their intrinsic value.
Our returns over the last twelve months were enhanced by avoiding stocks whose shares suffered losses. Remarkably, none of the stocks we owned on April 1, 1997 posted a negative total return (change in share price plus dividend) over the twelve-month period! We believe our focus on having a margin of safety in the purchase price contributed to the lack of poor performers in the portfolio.
Market Outlook: Near Term
As usual, we are agnostic about the market's near-term direction. A variety of valuation tools suggest that stock prices in the aggregate approximate fair value, a view with which we concur. Prices should tend in the direction of market participants' shifting views about interest rates and earnings prospects.
Share prices have begun the year with another strong advance, fueled by continued low inflation, stable monetary policy, a growing budget surplus, and high corporate profitability. Mergers and acquisitions activity remains extremely robust and is expected to remain so.
We believe short-term market forecasts have no predictive value and generally avoid them. The current market advance has further extended valuations, having occurred without a commensurate increase in profits or decrease in interest rates. This has eroded the margin of safety we would prefer to exist when new investment commitments are made. As a result, we believe share prices are becoming increasingly susceptible not only to changes in fundamentals but to changes in mass psychology.
We believe that calendar 1998 will be characterized by moderate economic growth and subdued inflation. Corporate profits growth could be in the 6-8% area. We think the probabilities favor a moderate stock market advance, albeit with perhaps more volatility than has been common over the past few years.
Market Outlook: Long Term – The Era of Extraordinary Returns is Over; "Return to Normalcy"
"When we think about the future of the world, we always have in mind its being at the place where it would be if it continued to move as we see it moving now. We do not realize that it moves not in a straight line… and that its direction changes constantly."
—Wittgenstein
We thought it might be instructive to reprint in this space what we said last year about our views on the long-term market outlook. We indicated that we thought the extraordinary returns of the previous 15 years were over and that investors should expect returns in the 9-10% annual range over the longer term. In the ensuing twelve months, share prices continued to soar with the S&P 500 rising nearly 50%. This brings to mind Warren Buffett's comment that the function of stock market forecasts is to make fortune tellers look good.
We find little to change, though, in our long-term outlook, hence our repetition of it. (We have left the piece as written, with last year's interest rates and valuation data.) Share prices rose so strongly last fiscal year because interest rates fell from 7% to under 6%. Price earnings ratios expanded as a result, and coupled with solid profits growth, propelled stocks higher. A similar advance would require another sharp drop in rates amid continued strong earnings growth, a combination that does not appear probable, though in financial markets almost anything is possible.
"A Return to Normalcy"
In the 1920 Presidential election, Senator Warren G. Harding, a former Ohio newspaper editor, promised a return to normalcy. The country had experienced both the activism of Teddy Roosevelt and the idealism of Woodrow Wilson. He thought neither extreme suited the post-war mood. According to one source, "Voters responded to his genial nature, impressive stature, and bland message; he won in a landslide."
We think that after the inflation-driven extremes in hard asset returns in the 1970s, and the abnormally high returns in bonds from 1981-1993 and in stocks from 1982-1996, a return to normalcy is in store for investors across a variety of asset classes. For much of the past 20 years, returns far higher than historic norms could be achieved by following investment strategies simple enough to fit on a bumper sticker: e.g., in the 70's buy oil, buy gold; in the 80's, buy bonds; in the 90's, buy stocks. Oil, gold, and bonds are mostly undifferentiated assets; one is pretty much like another. With stocks, the question of which one (or ones) to buy was likewise easy. For most of the past 15 years, no work was required: if you bought an index fund, you earned far higher returns than historic norms, and you beat almost all the stock investors who bothered to actually do the work and understand what they own. The past 15 years have seen the highest returns of any 15-year period in stock market history.
From the bond market bottom on October 26, 1981 until the top on October 15, 1993, investors in government bonds earned average annual returns of 16.2% per year! This compares to returns of 5.1% per year from 1926 through 1996. Excluding the extraordinary return of the past 15 years, the long-term return of bonds averaged just 3.2% per year from 1926 through 1981. Today's bond yields of over 7% are thus quite high by historical standards. (But not as high as they look; read on.)
During the same period (Oct. 1981-Oct. 1993), the S&P 500 rose 16.54% per year, just about the same as bonds. But 1926-1996 returns in stocks were more than double those of bonds, averaging 10.7% per year.
Since the bond market peak in late 1993, stocks have far outperformed bonds, rising in 1994, 1995, and 1996, while bonds declined in both 1994 and 1996. Bonds are down again this year, while the S&P 500 is up modestly.
One problem in assessing long-term rate of return data is what physicists call sensitive dependence on initial conditions. It matters to the measurement where the measurement begins. Returns measured from lows to highs give one perspective, those measured on a calendar basis another.
Economist Peter Bernstein has attempted to adjust for this phenomenon in a new study of stock and bond returns. He found that stock returns have averaged 9.6% per year (including dividends) across wide historical periods. Inflation has averaged 3.9%, meaning the real return on stocks has been 5.7% per year. This is moderately lower than the 10.7% return noted above.
With bonds, the sensitivity to the starting point was more acute. Actual returns were about 6%, higher than the 1926-1996 average of 5.1%.
From this data, we can make some reasonable judgments about future rates of return in stocks. With dividend yields of about 2%, stock prices will have to rise 7.6% per year to equal the long-term average. If valuations remain the same at about 17x earnings, earnings growth will have to average 7.6% per year. Over the past 40 years, earnings have grown at just under 6%. In the past ten years, earnings growth has averaged almost 9%. Most analysts' forecasts peg the next 5 years' earnings growth rate at about 7%.
Reasonable expectations for stock returns would thus seem to be in the 9-10% range (2% yields with 7 or 8% earnings growth) or about the long-term historic norm. This is far below the returns of the past 15 years.
We think that the period of extraordinary returns in bonds ended in October 1993 when yields fell well under 6%. Today's 7% coupons are good, but they are a long way from the 16% annual rates earned when yields peaked and prices bottomed in 1981.
We believe that the period of extraordinary stock returns that began in 1982 ended in 1997. Valuations are too high and future growth rates too low for stocks to average more than 9-10% per year. Although earnings growth is still solid, pricing power is non-existent, unemployment is low, and wage pressures are building. Corporate profit margins are high by historical standards, suggesting that competitive pressures may result in weakening margins and reduced profits when the economy slows from its present 4% pace. We think that, absent some deus ex machina, 9-10% long-term returns are the best that can reasonably be expected. Sensible investors will be prepared for periods, perhaps extended, where returns are well below those levels, or even negative.
A return to normalcy in stocks, like Harding's message in 1920, may seem rather bland compared to the excitement of the past few years. We believe, though, that such returns will still exceed those of bonds and cash, and that equity investors will continue to be rewarded for their commitment to that asset class.
Bill Miller, CFA
Nancy Dennin, CFA
Share