Bill Miller 2nd Quarter Commentary (2001)
The market continues to reward valuation sensitive strategies, with most value funds making money and beating the market. Growth funds generally have posted quite poor returns; the average growth fund is down around 16% in the first 6 months of this year. The problem for growth funds remains technology; the tech heavy NASDAQ is down almost twice as much as the S&P; 500. As we have noted before, "growth" and "value" have been less helpful in understanding returns than have "tech" and "non-tech" for most of the past 5 years. From early 1996 through the first quarter of 2000, if you were over-weight tech you probably out-performed the market. Since then, being over-weight tech has virtually guaranteed under-performance, no matter how the rating services or consultants classify your style.
Technology stocks benefited from a multi-year surge in capital spending that not only fueled the productivity boom of the late 90’s but also served to obscure the inherently cyclical nature of that sector. Unlike other traditional cyclicals such as paper, steel, aluminum, and chemicals, technology exhibits solid secular growth. Even more importantly, technology is the driving force in productivity growth and economic progress.
Over the past five years, investors became accustomed to high growth and mesmerized by the promise of breakthrough technologies whose potential seemed limitless. Unsustainable trends became capitalized into unsupportable valuations. The painful process of unwinding the prior excesses has in the past not ended until valuations reflected a level of pessimism not evident in today’s market, even as we are well into our second year of decline.
The relatively high level of valuation at 22x earnings and several times book value with yields still under 2% has led many investors to believe this bear episode has much longer to run. We disagree. Stocks tend to bottom when the economy or corporate earnings bottom. Since the market is a discounting mechanism, stocks often begin to rise well before the general economic news turns positive. We continue to believe that the lows reached in late March and early April of this year will be the lows for this bear market and that the direction of the market is higher. That’s the good news.
The bad news is that the pessimists are not entirely wrong. The strong returns of value investing relative to growth, or more accurately, of the old, non-tech part of the stock market relative to the new economy stalwarts such as Cisco, EMC, Sun, and Oracle, has removed much of the valuation discrepancy that existed between those groups for most of 1998 and 1999.
"Value stocks" are no longer cheap. The median price earnings multiple of stocks with earnings is about 17x, compared with about 13x a year ago, despite the "market’s" poor performance over that time frame. Despite their precipitous decline, most tech stocks are not cheap either, and not just because their earnings are depressed. We have always thought price to sales is at least as useful a valuation measure as price to earnings, because sales are less volatile than earnings, and because sales are economically prior to earnings (i.e. earnings are what’s left over after you subtract costs from sales - before there can be earnings, there must first be sales). At today’s prices, for example, Cisco is trading at over 6x sales estimated for next year, and that assumes those sales grow significantly from the level reached last quarter. If the sales number is roughly right, Cisco is trading at almost 40x earnings. All across the tech space, the story is similar: investors are pricing in growth that reflects growth rates companies have achieved in the past, but not what they are likely to achieve in the future.
With valuations among sectors relatively homogenous-i.e. with valuation anomalies scarce-and with economic growth sluggish at best, the market is exhibiting what might be called hyper-efficiency. In a mostly efficient market, all publicly available information is reflected in stock prices. There may exist, though, exploitable anomalies as investors over-react to information, pushing prices well away from fair value. The over-valuation of Internet stocks provided abundant opportunities for short sellers in the past 15 months, while the persistent under-valuation of old economy names set the stage for the excess returns being earned by value investors today.
In a hyper-efficient market, all information is reflected in a way that provides few opportunities to alter portfolios in a way that will improve returns. Investors are alert to the possibilities of over-reaction and move so quickly to exploit it that price divergences from fair value do not persist.
One of the few areas that seems to us to be an exception is telecommunications. A rash of bankruptcies, regulatory uncertainty, technological confusion, overcapacity, declining sales and collapsing earnings have combined to create a deep pessimism that may provide opportunity for long term investors. We are under no illusions that this area will rebound quickly; but we do think that spending will begin to recover by 2003. A rebound that far away has created an opportunity now for patient investors, as those less willing to wait have pushed these companies prices to levels we think will enable investors to earn excess returns over a 3 to 5 year period that will compensate them for what may be subpar returns for the next 6 months to a year.
We are optimistic that the economy will improve over the balance of the year and that economic growth will be better next year than this, as will corporate profits. Monetary and fiscal policies are both more oriented toward growth than has been the case in years. Bank balance sheets are strong and can support loan growth when demand resumes. Consumer spending is surprisingly robust considering the circumstances. We do not expect it to get better, but it shouldn’t get worse either, even if savings rates begin to rise, as we expect.
The international situation remains problematic. Non-US growth is weakening as our trading partners begin to feel the effects of US economic weakness. Japan is mired in the same morass that has plagued it for years. Argentina is in crisis and looks to be headed for default or devaluation or some combination of the two. Contrary to the worries of the pessimists, we think that would be good news, since it would free the country from the rigidities of its currency peg, which was a temporary solution to its inflation problem but whose weaknesses are now evident.
It will not be international economic strength that will re-energize our economy. As our economy improves, so too will the international economic environment. For our economy to improve, monetary policy must be effective in stimulating demand. The transmission mechanisms of monetary policy are the stock market, the dollar, and the yield curve. Since the Fed began easing, all have moved the wrong way: stocks are down, the dollar is up, and bond yields are higher. We expect that by the end of this year, all will be supportive of stronger growth.
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