Bill Miller 1st Quarter Commentary 2001 (FYE 2000) Value Trust: Review of Fiscal Year 2001 Market Conditions and Strategies Affecting Results
"When we think about the future of the world, we always have in mind its being 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
The above quote from Culture and Value, which we’ve used at the head of this letter for several years, has never been more appropriate. Twelve months ago the NASDAQ was only a few weeks removed from a peak in its spectacular multi-year run. Investors were uniformly optimistic about the Internet, the New Economy, and technology in general. In the fourth quarter of 1999, U.S. GDP growth exceeded 8%. Earnings growth for the S&P 500 was 20% in 1999 and was expected to be 15% in 2000. Economists and strategists were likewise sanguine about 2000; if they had a concern it was that growth would be too fast and the labor shortage would grow worse. The Federal Reserve was raising interest rates, oil prices were rising, and real rates were close to record levels. These warning signs were ignored or dismissed as unimportant. Technology leaders such as Microsoft, Sun, Cisco, EMC, and Oracle didn’t borrow money so rising short-term rates were irrelevant, or even positive since they meant greater income on these companies’ cash balances.
In the first quarter of 2000, most mutual fund managers outperformed the market, even though only two sectors were ahead of the S&P 500: technology and utilities. As we noted then, the funds that were buying EMC and Cisco were probably not also big buyers of Duke Power and Potomac Electric. The will to believe in technology was overpowering.
Those who didn’t believe were ridiculed or discredited. Prominent value investors were being fired or were resigning in frustration at the market’s obsession with technology and neglect of anything else. We noted at the time "the prospects for ... prominent technology companies are now well recognized and well discounted by the market" and that "investors ... bid up the shares of large numbers of technology companies to unrealistic levels." The demise of Julian Robertson’s value-oriented Tiger Fund led the New York Times to proclaim "The End of the Game," meaning the end of value investing. We wrote then the Times was wrong and that "the game we believe ended was the new economy technology game."
Consistent with our beliefs at the time, we significantly reduced our holdings of technology stocks in the first and second calendar quarters of 2000, moving the money into the depressed financial sector, and into such unpopular names as Waste Management, Toys ‘R’ Us, and McKesson, the large drug distributor. This proved to be well timed as these issues rose in the second half of 2000 when technology began to decline. This was a major change for us since we had been positive on the relative return potential of technology since early 1996 when these stocks were last quite depressed.
One of the remarkable things about the results above is that for every period from three months to fifteen years, the NASDAQ has now underperformed the Dow. After more than a decade of the greatest technological change in history, after years of technology-driven productivity growth, after a period that has seen companies such as Microsoft, Cisco, and EMC become major members of the S&P 500, after all this, the Old Economy Dow has outperformed the tech-driven New Economy NASDAQ. We think this shift to non-tech reached extreme levels in late March and early April, and believe that good values have again begun to appear in the technology sector.
You might also note that large-cap value funds have outperformed large-cap growth funds in every period. This is not a coincidence. Value funds typically are underweighted in technology and growth funds are usually overweighted in tech. Value funds are often overweighted in financials and growth funds are usually underweighted in financials. Since financials and technology are the two largest sectors in the market, the behavior of these sectors relative to each other and the market often provide greater insight into relative performance than whether someone is following a "value" or a "growth" strategy.
As we have written many times, we do not believe that carving the world into "value" or "growth" is a sensible or useful way to think about the investment process. Growth is an input into the calculation of value. Companies that grow are usually more valuable than companies that don’t. If a company earns below its cost of capital, though, then the faster it grows, the less it’s worth. Companies that earn returns on capital above their cost of capital create value; those that earn below it destroy value. Those that earn returns equal to the cost of capital grow value at the rate they add capital.
What we try to do is find companies whose economic models support returns on capital above the cost of capital, so that they create value at a rate greater than the mere addition to capital that occurs through the retention of earnings in the business. Such companies usually are recognized by the market and valued appropriately, but sometimes they are available at discounts to intrinsic value. These discounts can arise for many reasons. The most common are macroeconomic change, problems with the company or its industry, or the immaturity of the business. In each case, the long-term economics of the business are obscured by factors or events that prove to be temporary. These temporary factors produce the mispricings that eventually lead to excess returns.
One of the most powerful sources of mispricing is the tendency to over-weight or over-emphasize current conditions. A year ago investors were unduly optimistic because the economy was strong and corporate profits were growing at double-digit rates while inflation was low. They capitalized growth that was unsustainable long-term, resulting in securities prices that were too high, especially in technology.
Now the market has a bad case of enantiodromia, the tendency of things to swing the other way. Until the Fed cut rates unexpectedly on April 18, investors were being unduly pessimistic, capitalizing current conditions into stock prices in a way that created significant opportunity for the long-term investor. It is not a secret that earnings are bad and will probably be down 9% or 10% this year, the worst showing since 1991. It is not a secret that technology investment spending is under severe pressure and that the sector suffers from short-term inventory and intermediate-term capacity problems. These difficulties are well publicized and well discounted in the market.
The key question in markets is always what is discounted. Excess returns are earned when expectations—what is discounted—are different from what occurs. What is not discounted today in our opinion is an economic recovery, the resumption of growth in corporate profits. That is why the market responded so dramatically to the Fed’s rate cut: it increased the probabilities of the economy recovering sooner than the market expected.
From its low on April 4, the NASDAQ has risen over 30% in just a few weeks. According to data from Birinyi Associates, this is the fastest rise in any U.S. index since the rebound from the low in the Great Depression in late July and early August of 1932.
It took three years for the market to decline over 80% from 1929 to 1932. The NASDAQ dropped nearly 70% in one year from its March 2000 peak, so it is not surprising that this burst off the bottom would be similar to that which followed the depression-driven 1932 low. Just as it took until the late 1940s for stocks to regain the levels they reached in 1929, many investors believe it may be years before the NASDAQ is again 5,000.
I recall that after the market crash of 1987, many analysts predicted that the Dow would not see 2,700—the old high, until the turn of the century. The old high was exceeded in August 1989. The issue, though, is not when some index will exceed the old high, but what rate of return will be earned by investing in securities today.
There is a universal sense that things happen faster today, that the pace of change is faster, in the economy, in the world, in life in general(1). Many of the technology companies whose results are now so dreadful are saying that they have never seen business change so rapidly from good to bad. Fed Chairman Greenspan remarked that businesses are reacting simultaneously to information because they can all get information so much faster than before. This suggests that anticipating change will carry greater rewards and perhaps pay off faster than before, and that reacting to change, even quickly reacting, will not confer any competitive advantages.
(1) This issue is explored in depth in James Gleick’s book Faster: The Acceleration of Just About Everything.
We were fortunate in being able to anticipate the change away from technology last year. In the past month or so we began to anticipate a more balanced market environment, one that would not systematically punish technology and reward non-tech, by beginning to increase our technology holdings, buying such names as Tellabs and Level 3. We do not expect a return to the tech-driven market of the late 1990s, although we do expect that the technology sector will perform significantly better than it has in the past year.
We are optimistic about the broader market. Valuations are attractive, monetary policy is accommodative, inflation is low, the budget is in surplus, tax cuts are imminent, and corporate profits appear to be bottoming. It is highly unusual for the market to be down two years in a row. We believe that returns from present levels are likely to be above average over the next twelve months. The direction of the world twelve months from now will be different from what it is today.
Bill Miller, CFA
April 23, 2001
DJIA 10532.2
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