"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
Culture and Value
We have used the above quote before, most recently in our last report to you a few months ago. Since it captures a recurring feature of how most people seem to think about markets, do not be surprised if it makes regular appearances in our letters. The expectation of what might be called linear path dependence is strong and often underlies the reactions of analysts and commentators to change. Instead of expecting change and uncertainty, which are common in capital markets, people greet these normal occurrences with surprise; The surprise would be if things continued on as they are, if markets did not exhibit unpredictable behavior, or if portfolio returns were distributed in the future much like they have been in the recent past.
Two important events occurred in the market in the past 90 days or so. First, cyclical stocks (often misleadingly referred to as value stocks) staged their strongest rally relative to the market in 50 years; second, the Federal Reserve Board raised the benchmark federal funds rate by 25 basis points, (1) and shifted their official bias to neutral from tightening. The latter move surprised the markets and led to an immediate rally that lifted the major indices to records.
The rally in cyclicals was long expected and long in coming. Steel, aluminum, paper, chemical, and copper stocks led the rebound, which extended to most major industrial sectors and to long-suffering small capitalization stocks as well.
The big growth stocks that had been market leaders since 1995, and which had propelled the capitalization-weighted S&P 500 ahead of the average active money manager, whose portfolios tend to have smaller capitalizations and more of a "value" tilt than the index, were relative losers in the quarter.
Money managers who had struggled to keep up with the S&P 500 for years suddenly were outperforming. In the second quarter around 70% of active managers outpaced the S&P 500, the highest level in recent memory. For 6 months, about 35% of active managers were ahead of the market, not a brilliant showing but still an improvement over the pattern of recent years.
As the quarter drew to a close, these trends seemed to be attenuating. The CRB index of commodity prices fell to a 20-year low, despite the strong rally in oil and copper, as grain prices continued to deflate and gold's bear market showed no sign of ending.
We believe the rally in cyclicals was a snap back from the deeply depressed levels caused by the global financial panic last year and the recessions in the emerging market economies. After Brazil devalued in the first quarter, it became clear that that was the last major negative event on the horizon for developing countries (until realistic steps to generate growth in an economy that has gone nowhere for a decade. OPEC put in place output cuts that restricted the supply of oil temporarily, leading to higher prices.
The fear of deflation that gripped markets last fall ended, and the biggest beneficiaries were those companies and industries perceived to be most negatively affected should deflation have occurred. We believe the performance of most cyclicals from current levels is likely to be more muted. We think many of them are overpriced, particularly the major oils, whose share prices appear to reflect unjustified optimism about the sustainability of oil prices in the $20 range. We think the long-term impact of OPEC's supply constraints will be to shift market share to non-OPEC producers, leading to both lower prices as they increase output, and market share losses for OPEC members. Similarly, we do not believe that the long-term trend in any of the recently rallying commodities is up, and are avoiding the shares of their producers.
We do think that the snap-back rally in cyclicals, and the poor performance of the market's previous leaders in the quarter, presages a broader market than we have experienced in the past few years. The best explanation of the character of the market is found by dissecting the relative returns on capital of its components. For the past several years, the return on capital of the biggest companies in the S&P 500 has risen, driving up the overall return on capital of the index. The median return of the index, though, has stayed about the same. This means that the relative return on capital of the largest companies has expanded compared to that of the average company, which explains (in our judgment, anyway) the outperformance of the biggest companies relative to the rest, and the underperformance of managers under-weighted in these big names.
In order for this to continue, the returns on capital of the big caps would have to continue to expand while the median returns remain stable; the world would have to continue moving as it has in the past few years. Or, if the cyclicals were to continue their relative strength, the world would have to continue moving as it has in the last 90 days. We believe both extremes are unlikely. The more likely path, in our opinion, is for a more even; but still lumpy, distribution of returns. Practically, this means that more active managers will do well relative to the market over the course of the next year, but not as many as did well last quarter.
The other important event was the shift to neutral on the part of the Fed.
This caught most observers by surprise, and has engendered a lot of comment, most of it of scant analytical value, in our opinion. The expectation was for the Fed to raise rates by 25 basis points but to maintain their tightening bias, keeping the stage set for further interest rate increases as the year wore on. Despite the shift to neutral, futures markets still expect another 25 basis point increase by year-end, strong evidence that they see the world differently.
We are willing to take the Fed at its word; they spend all their time thinking about and analyzing the economy, and they have become increasingly transparent under Chairman Greenspan. They have tried to telegraph their moves, and have indicated they do not want to surprise markets. Markets were surprised, though, by the shift to neutral, and deconstructing that move is useful.
Chairman Greenspan has indicated many times that the economic models commonly used to predict the relationship between variables such as the unemployment rate, economic growth, and inflation have failed to work effectively during this expansion. He has noted that one explanation of this failure is that our measures of productivity have understated its growth, thereby understating the sustainable growth rate of GDP and over-predicting inflation.
We think the shift to neutral on the part of the Fed is a signal to markets that the Fed has adjusted, at least conceptually, its economic models in response to the path of this expansion. This would involve adjusting the weights of the inputs in order to better capture the observed relationships that have so puzzled the orthodox but which have been so important in propelling this bull market.
Some interesting evidence of this has come by way of Lyle Gramley, a former Fed governor, and one of the more sensible and discerning of Fed watchers. Dr. Gramley notes that recent data from Macroeconomic Advisors of St. Louis, the forecasting firm of current Fed Governor Meyer, supports the view that productivity growth, the main engine of economic prosperity, may be on a sustainably higher path. Without getting into the details, this data suggests a more bullish outlook for the economy—faster non-inflationary growth potential—than had been previously believed warranted. The evidence is consistent with the view of former Fed Vice Chairman Alice Rivlin, who believes that current tight labor markets may be fostering not greater inflation, but greater productivity, as companies search for ways to employ capital more productively since they cannot easily find skilled labor at satisfactory prices.
We will not settle the debate about either the meaning or the appropriateness of the Fed's changed stance. Events will make that clear. There are two other aspects of the rate increase that we believe are important, and that have not been sufficiently elucidated. First, the Fed is not now, nor has it been signaling markets about the future direction of rates by the act of raising, or lowering, them. Second, to the extent that the Fed has either raised or lowered rates, that action has been bullish.
Beginning in the early 1980's, the Fed began increasingly to incorporate market-based indicators into their economic models. Market-based indicators are forward-looking and adaptive; standard economic models are built using historical data and are static. As predictive mechanisms, standard models are mostly useless, though their explanatory value is often high.
More recently, the Fed has been following, not leading markets. Last year's three interest rate cuts followed sharp drops in both long- and short-term rates. This most recent increase followed very strong increases in rates since last fall, and merely brought the Fed Funds rate into line with market rates. We think that future rate increases will follow a similar path. If long bond rates do not rise from here, we think it unlikely the Fed will act. The futures market thinks differently at this point.
The Fed has also noted explicitly that actions taken on rates have been designed to extend the expansion. In other words, if they did not act, they believed the expansion would be more likely to end sooner than if they did act. Without judging how successful they will be, one notes that over the past 17 years we have only experienced one recession, and that one followed a war, skyrocketing oil prices, rising inflation, and the S&L crisis.
Equities continue to look approximately fairly valued to us. They reflect current circumstances, which remain about as perfect as an investor could hope for: budget surpluses, low inflation, high profitability, strong profit growth this quarter and next, and a general absence of global turmoil. Pessimists have wrongly predicted the end of this environment for years and have suffered significant opportunity costs as a result.
We see no evidence the expansion cannot continue, albeit at a slower pace than we have experienced in the past 6 months. There is little margin of safety in current valuations for any negative change from the present trajectory of the world. Pace Wittgenstein, it would be surprising if the current trajectory didn't change, but then the world is always surprising.
Our returns recall George Soros' comment that it's not how often you are right or wrong that counts, it's how much money you make when you're right, less how much money you lose when you're wrong.
As discussed more fully in the market comment section, the second quarter saw the strongest rally in cyclical stocks—steel, aluminum, chemicals, papers, oils, etc.—relative to the market in 50 years. Since we have almost no exposure to these companies, our returns suffered accordingly. Our banks and other financials also performed poorly as interest rates rose and concerns about inflation began to appear. Finally, our two biggest holdings, America Online and Dell, fell 24.3% and 9.5%, respectively, after rebounding sharply from the lows reached early last October.
Portfolio activity was, as usual, fairly light in the past several months. We sold Compaq and Conseco, reducing by 500/4 the number of companies beginning with "C" in the Fund. We still own Chase and Citigroup.
Compaq suffered its traditional first-quarter earnings shortfall, the third in the past four years. Historically, that has been a good time to buy the stock, since the company usually is able to recover and string together a few good periods, igniting investor enthusiasm before disappointing again. This time we elected to exit the position since we think the company may be facing deeper and longer-lasting structural problems. Subsequent to missing the quarter, the company lost most of its top management in a board-induced shake-up and is still looking for a CEO.
Conseco was sold because we could not get comfortable with underlying business fundamentals amidst confusing accounting treatments. Management also appears quite generous in their assessment of the compensation and incentives due them for their stewardship.
We bought three stocks in the quarter: Aetna, which is a relatively small position; McKesson HBOC, and Waste Management. Aetna appears to be effectively consolidating its purchase of US Healthcare, finally, and also is beginning to benefit from better pricing in the HMO sector. Valuation is low and improvability is high.
McKesson collapsed after an accounting scandal surfaced in its newly purchased HBOC subsidiary. The company has fired the senior executives responsible, and McKesson's own CEO and CFO had to resign as well. In the low 30's, where the stock now trades (down from 90 or so at the peak), we think it represents solid, but not spectacular, value.
We started buying Waste Management in the low 50's on the strength of a low multiple and accelerating free cash flow in an industry that has rapidly consolidated. We had some concerns about estimates being too optimistic, so we proceeded cautiously. Our concerns were well-founded as Waste indicated they would miss the quarter, and they lowered guidance for the balance of the year and for next year. The stock collapsed as outraged analysts and growth stock investors pulled the plug on the company, sending the stock to the low 30's. We have been buying aggressively, believing the business is worth substantially more than the present price.
It would be a surprise if McKesson and Waste added much to our return in the second half. Companies that dramatically disappoint take a while to regain investor confidence. We expect that if our analysis of their business is correct, both stocks should perform well over the next few years.
Overall, we believe your portfolio is well-positioned to provide satisfactory returns in the years ahead. As always, we thank you for your support and welcome your comments.
Bill Miller, CFA
Portfolio Manager
Share