Value Trust: Review of Fiscal Year 2000 Market Conditions and Strategies Affecting Results
"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 have written extensively about the obsessive focus on and attempts to dissect short-term performance data and won't repeat our remarks here. As numerous academic studies have shown, past performance is not much help in predicting future results. The data above show what we have done, not what we will be able to do.
The best way to understand the twelve months ended March 31 is to put that period in a broader context. As a result of the global financial crisis that began with the collapse of fixed exchange rates in most Asian developing countries and culminated in the collapse of hedge fund Long-Term Capital Management in September 1998, the Federal Reserve Board cut short-term interest rates three times that fall. As we entered calendar 1999, most observers fretted that the Fed had not done enough and that the world faced slow growth at best, a long workout in emerging countries, and a real risk of a global deflationary collapse. Oil was at $12 a barrel; other commodities were similarly depressed.
No one predicted what actually happened: exceptionally strong U.S. growth, solid international growth that was accelerating into 2000, oil prices more than doubling, and emerging stock markets the world's best performers. As is often the case in financial markets, when the opinions are all on one side, the opportunities are usually on the other.
We can also describe the same period in terms of the ebb and flow of risk preferences. Prior to the financial crisis, years of high returns made investors risk-seeking. Large losses in stocks from the summer of 1998 into the autumn led to a flight to quality. Interest rates fell as money fled to risk-free treasuries. As 1999 progressed, investors gradually began reallocating assets back into riskier assets as they observed that those assets were gaining in value and treasuries were falling. Last year (1999) was among the worst bear markets in history for fixed income securities as interest rates rose steadily throughout the year and investors increasingly sought riskier assets.
Stock prices meandered through most of 1999; the S&P 500 gained only about 4% through September. Then, in the fourth quarter, technology stocks exploded, propelling the S&P to a gain of over 20% and the NASDAQ, over three-fourths of whose capitalization is technology, to a yearly gain of over 85%.
Consensus expectations entering 2000 were for more of the same (what else?). Most people tend to expect a continuation of observed trends. Since growth had been strong, it was (and is) expected to remain so. Since technology had consistently been the source of high returns, it was expected to remain so. Since investing in the so-called "old economy" had been a sure path to underperformance, it was expected to remain so.
As the first quarter got underway, technology stocks had a sharp correction, but quickly recovered and began their expected strong advance. "Old economy" names fell, as expected. The long drought in "value stocks," the concomitant underperformance of funds that invested in them, and the apparent inability of investors, the press, and fund boards to understand that all investment styles and managers have periods of underperformance, led to the firings or resignations of many outstanding investors, all of the value persuasion.
On March 10, the clamor for "new economy" technology reached its peak, with the NASDAQ up 24% year-to-date, while the Dow was down 14%. For the 12 months ending that day, the Dow was up 3.16% with dividends reinvested, versus 110% for the NASDAQ. The frenzy has been such that more than 100% of the net flows into equity funds this year have gone into technology-sensitive growth funds; value-oriented funds have experienced redemptions.
One month later, the picture is much different. The NASDAQ is down 14% for the year, and is down 31% from the peak reached on March 10. The Dow is down 7% for the year, but is up 10%, including dividends, since March 1.0.
During the first quarter, your Fund was flat, the result of a tug of war between our financial and our technology holdings. Several of our major technology holdings fell during the quarter after posting strong fourth quarter 1999 performance. These include AOL and Gateway. Other large tech holdings did well, such as Nextel and Nokia. Our financials have performed well since early March, but not well enough to have them outperform as a group this quarter.
Our one-year results are also skewed by the very strong first calendar quarter of last year, when we were up 18.69%. Our calendar 1999 results, which were well ahead of the indices, were obtained by strong results in the first and fourth quarters, and comparatively weaker numbers in the second and third. Rolling forward one quarter to get fiscal year results gives a different comparative picture since a strong, above-market quarter is being replaced by a below-market one.
We believe that some clues to future market developments can be gleaned from the first quarter performance statistics. As the table shows, the average general equity fund gained over 7% in the quarter, while the Dow was down almost 5% and the S&P was up over 2%. The NASDAQ was up 12.4% in the quarter. You probably see the picture. After years of underperformance, the average fund manager decided to get overweighted in technology and underweighted not-technology. The stampede to tech was no doubt exacerbated by the high profile firings or resignations of several prominent value investors. Just how overweighted most funds are in tech can be glimpsed when one realizes that only two of the eleven S&P sectors beat the index in the quarter: technology and utilities. Utilities make up only 2% of the market, whereas technology was 33% of the S&P 500 at quarter end. The funds that were buying Cisco, EMC, and Sun were not likely loaded with Duke Power or Potomac Electric.
Perhaps more telling is the following: the technology weightings in the roughly 5,000 general equity funds averaged 42% for large company growth funds, 48% for mid-cap, and 45% for small-cap. In the value category, the comparable numbers hover in the 14% range. The data from the March 31 database of fund tracking service Morningstar, long used by most funds as the key measure of equity mutual fund performance, are the most interesting we have seen in years. It is obvious that most of the largest funds tracking indexes that require certain stock weightings actually represent end-of-year holdings. It is reasonable to surmise that such weightings actually rose during the quarter.
We believe the correction in the NASDAQ, and especially in the more speculative hot spots, was long overdue. Valuations had reached levels that made it highly unlikely that one could earn a competitive return no matter how brilliant the future turned out to be for those businesses.
We also believe that what is going on is more than just a correction in the technology arena. Much of the excess returns earned by Value Trust shareholders in the past several years has been due to our being early in investing in great businesses such as AOL, Dell, and Nokia. The prospects for these and most other prominent technology companies are now well recognized and well discounted by the market. The returns earned by shareholders in these and other great companies such as Microsoft and Cisco have led investors to bid up the shares of large numbers of technology companies to unrealistic levels in the hope of uncovering the next big thing.
The losses now being experienced will, we think, reintroduce the notion of risk to people, and will, after the excess emotion has been wrung from the market, set the stage for returns more in line with the growth of long-term business value. As we have previously said, we believe the long-term returns of equities going forward will approximate what it has in the past: about 10%.
As for technology, it will no doubt present considerable opportunity. But we think that investors, who figured out in the middle of last year that the way to win the game was to overweight tech, will have to learn a new game.
In a wonderful example of irony, the New York Times reported on the dissolution of Julian Robertson's Tiger Management on March 31, the end of the quarter. Once commanding over $20 billion under management, Tiger had to be dissolved after disastrous bets in favor of old economy "value" stocks and against technology. The Times headline read "The End of the Game," referring to the demise of the most prominent value hedge fund, a casualty of the new, technology-based investment game. The game the Times thought had ended was the old economy value game. The game we believe ended was the new economy technology game.
We have no idea what the new game will be. By "game," we mean the simple-minded rule that will explain, after the fact, what you should have done to beat the market during the period in question.
We are, though, opportunistic about the ability of patient, disciplined investing to produce satisfactory long-term returns. Most stocks have been declining for two years, declines that have been masked by the sharp rise in large capitalization "growth" and technology shares. The median price earnings ratio of all companies with earnings peaked in April 1998 at 19.7; it is now about 13.1. In 1987, after the Crash, the median P/E was 10.6. In late 1987 the long bond yielded 9% and inflation was 4.5%.
Today bond yields are under 6% and inflation is half what it was 13 years ago. Adjusted for inflation and interest rates, and for today's much higher levels of productivity, today's budget surpluses, and the prospects for continued peace and prosperity since the fall of communism, we think the average stock in the market is as attractive as it was post-Crash in 1987.
We believe that investments made at today's levels of the market or lower, and made on the basis of a rational assessment of long-term business value, will provide attractive rates of return to the long-term investor.
Bill Miller, CFA
April 14, 2000
DJIA 10305.80
Share