Most stock fund investors have had good results this year, with the best returns being earned by funds that specialize in science and technology. High technology stocks, along with financials, have led the market; the former because of spectacular earnings and the latter because of falling interest rates.
Our results are noteworthy because we have managed (so far) to outperform the indices. Although the indices are challenging benchmarks, and manage to beat most actively managed funds over long periods, this year they have proven particularly tough, beating 90% of all managers. A closer look at the composition of this half's results helps in understanding why most investors, even in funds that focus on S&P 500 names, lagged the index.
Within the S&P 500, 12% of all the stocks are down in 1995, and 60% of the companies in the index underperformed the index. Only four stocks in the index outperformed every month this year. Even the average stock in the index couldn't keep up with the index; if you had put an equal amount in each S&P 500 company at the beginning of the year, you would have underperformed the index!
Our results were driven by financials, where we have long had a significant commitment. Our holdings in this group did not help us last year when rates were rising, but they have moved sharply higher this year as both short and long rates have fallen. The S&P financial sector has risen 23.7% this year. The operating results of banks, for example, have not been significantly affected by the interest rate fluctuations of the past 18 months. Investors, though, persist in buying and selling these companies using simple-minded formulas that would fit on a bumper sticker (e.g., Rates up? Sell banks). As long as this continues, it will create opportunities for us.
We have not had much exposure to the super-hot technology sector, where emotion and psychology interact with the results of the companies to produce a lot of excitement. The semiconductor index on the Philadelphia exchange was up about 100% in the first half. In the S&P 500, three of the top five performers this year were tech stocks – Micron Technology +149%, Applied Materials +105%, and Intel +98%. Microsoft, the cult company for which no valuation seems too high, was "only" up 47%. Our largest technology holding was and is IBM, which is up 30% this year. We were also helped by Lotus, up 56% due to its being acquired by IBM.
The technology frenzy that has erupted this year is, like many enthusiasms, soundly based. Technology is transforming society as the computer moves from a business tool to a home appliance, and as the effects and implications of BEING DIGITAL, as Nicholas Negroponte's new book has it, come to be instantiated. On July 17 and 18, though, the market's fever for technology finally broke, and the NASDAQ composite, which is heavily weighted with technology – Intel and Microsoft are 28% of the index – fell over 5% in just two trading sessions. We don't know if this is the beginning of a bear market in tech stocks, but we do believe it is the beginning of more realism in the evaluation of those stocks.
At its peak of $109 a few weeks ago, Microsoft had a market value of almost $70 billion, over 12x its revenues for this fiscal year and 35x next year's expected earnings. The market believed it was worth more than IBM, valued now at about $60 billion, whose after tax earnings this year will exceed Microsoft's total sales. IBM's sales this year will be over $70 billion, versus about $6 billion for Microsoft, and it is generating excess cash of around $400 million per month. IBM this year will generate more excess cash from its business than Microsoft had business last year: $4.8 billion of excess cash this year for IBM versus Microsoft's revenue last year of $4.6 billion. Even Microsoft's chief financial officer said he was "mystified" at the company's valuation, and called it "unbelievable." These comments were shocking to hi-tech investors as hearing the truth about the tooth fairy would be to a 6 year old. Many investors are mystified by the stock market's 20% rise in only six months, and find it hard to believe a bear market (or worse) is not imminent. The last time the market rose this fast was in the first six months of 1987. Many market commentators advise caution, and the popular press appears full of articles on how to protect your assets, how to hedge your portfolio with options, and so forth.
Our view echoes something Warren Buffett once said: the market may look expensive, but it's not as expensive as it looks. Some of the traditional market measures are in ranges that previously led to below average returns, most prominently dividend yields. The S&P 500 yields about 2.5%, near the low end of its historic range. But with inflation also at about 2.5%, the real yield is zero, which is not demanding by historic standards. With payout ratios well below traditional levels, balance sheets solid, and cash generation strong, dividend growth should average at least 7% for several years. If inflation stays at today's level, which we expect, that would put the real return on stocks at 7% per year, right in line with the long-term average.
Price/earnings ratios on the Dow are only about 13x earnings, again about the long-term average. Even though stocks are up 20% in only six months, their average annual return from January 1, 1990 through June 30, 1995 has been 12%, good but certainly not frothy.
The stock market almost always goes up; it rises about two thirds of the time, measured yearly or even monthly. People seem surprised when the market is at a new high, and worry that it may fall. But the surprise should be when it is not at a high. GDP is at an all-time high, as are corporate profits, and both usually rise. The stock market tracks those economic variables, adjusted: for changes in inflation and interest rates.
Bear markets do not just appear mysteriously when the real economy is doing well. Persistently poor periods in the market – more than the usual 5-7% correction – arrive when things are going badly. Last year stocks were flat because interest rates rose dramatically due to Fed tightening and fears of inflation. The last bad market, in 1990, was a year of recession, war in the Middle East, and skyrocketing energy prices. The Crash culminated a 40-day bear market caused by relentless Fed tightening that drove price/earnings ratios 50% higher than today and long-term interest rates 300 basis points higher than now. The 1981-82 bear market was due to recession, Fed tightening, a third world debt crisis, and mid-teens interest rates. The worst bear market since the depression, 1973-74, occurred when we were in recession, had an oil embargo, double-digit interest rates for the first time and a constitutional crisis culminating in the President's resignation.
Bear markets begin when four conditions come together: earnings peaking, inflation rising, interest rates rising, and stocks being overvalued. What Federal Reserve Chairman Greenspan calls the most probable of several credible scenarios has profits rising and inflation falling next year. The Fed has recently moved to lower rates, and most measures of stock valuations are at long-term averages. None of the typical preconditions of poor markets are in evidence.
The market, though, does not rise the way the balance in your money fund does: steadily, inexorably, linearly. Those returns are algorithmic. A formula is applied to a fixed quantity to generate a new quantity. Markets are what the professors call complex adaptive systems. They process information and react to it. Those reactions are part of the new information that generates a continuous recursive feedback loop between market participants and the external environment. Markets exhibit what is known as sensitive dependence on initial conditions. In plainer English, you can't tell what's going to happen with certainty, it's just too complex. A researcher in this area, when asked to explain more simply how complex adaptive systems work so a client could understand it, replied, "I can't explain it simply. It is the nature of complex things to be complex."
Does the break in tech stocks presage a broader market decline? Does the recent bond market decline, which was even sharper than the fall in the NASDAQ index, mean the rise in financials is over? If the market were algorithmic you could tell, if you could figure out the algorithm, which is what all those technicians, strategists, and quants are trying to do.
The market may not be predictable, but it is bettable. As someone once said, "the race may not always be to the swift, nor the contest to the strong, but that's the way to bet." In the past, when the market had a first half where the returns have been as robust as this one, the second half usually has been down. That outcome thus would not be unusual if it were to recur. It would also not be terribly unnerving, though undoubtedly the press and pundits would do their best to make it so.
It should not be surprising that we are agnostic about the near-term direction of the market, believing it not only unpredictable but probably random. We do believe that the long-term outlook for financial assets is unusually favorable, and that low inflation, and moderate, persistent growth will continue to reward the patient shareholder.
Portfolio changes were modest in the quarter. Lotus was acquired by IBM. We swapped our Burlington Northern into GENERAL MOTORS, picking up more earnings and free cash flow per dollar of stock price. We also bought DUPONT, which has been steadily reducing the capital intensity of its businesses, raising its returns on assets, and increasingly operating the company for the shareholder. As always, we appreciate your support and welcome your comments.
Bill Miller,
CFA July 26, 1995
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