In 1997, stocks rose over 33% and completed the best 3-year period in history, averaging gains of over 31% per year, besting the previous three-year high which occurred from 1926–1928. The troika of up 20% years has never occurred before in the 101-year history of the Dow Jones Industrial Average, nor have we ever had seven consecutive up years in a row. Rounding out the hat trick, stocks also posted the best 10-year stretch in history.
Congenital pessimists or historical determinists will no doubt point to the past as prologue, noting that the 1929-1932 stretch was the worst in market history. The more spiritually inclined among those with a bearish disposition will recall the biblical seven fat years followed by seven lean years. Bears even have a friend in Herman Melville, whose epic (and today forgotten) poem Clarel sounds the following warning to those who see a benign future:
Nay, nay; your future's too sublime
The Past, the Past is half of time,
The proven half.
These loomings aside, we remain reasonably optimistic about the outlook for stocks in 1998. The factors that have supported equities for most of the past 15 years are still intact: falling inflation, declining interest rates, solid economic growth, high corporate profitability, and fiscal and monetary discipline. Valuations, though, largely reflect these positive factors, and we think they are unlikely to expand from the current multiple of about 20x 1998 estimated earnings. The market looks fairly valued to us given the structure of interest rates and the outlook for corporate profits.
Put differently, the direction of stock prices will be a function of the path of profits and interest rates; There is little margin of safety at today's prices for bad news, which is why stocks are lurching around in response to the marginal items on the tape. If a company with an otherwise solid record misses a quarter its stock gets pummeled. If the news out of Asia sounds grim, the market sells off. We see no reason why this pattern should not continue for some time.
We think reasonable expectations for equity returns are in the 8-10% range, about in line with profits growth, but well below the 19% average annual returns earned over the past 15 years. Those abnormally high returns were fueled by low initial valuations due to the inflation of the 1970s and the early 1980s recession, coupled with an economic expansion that has had only 9 months of recession in 15 years. Bond investors likewise should see returns far below the 16% per year they earned from 1981 through the previous peak in bonds in September of 1993.
Bond yields have recently fallen to all-time lows on the 30-year treasury, surpassing the 1993 price peaks. The impact of Asia's currency crisis, coupled with 1.7% inflation in the US, have fueled the strong bond market. Investors have earned 25% returns in bonds since yields peaked in the Spring following the Fed's 25 basis point tightening (100 basis points = 1%). At that time the conventional wisdom was that rates would be higher now, yet another instance of the general tendency to overemphasize the impact of short-term trends and information.
The source of greatest consternation and uncertainty in markets now is Asia, and how that situation will develop over the next few months. The answer is nobody knows. The problem began when Thailand's currency came under pressure due to the country's high external debt and worsening economic situation brought on by over-investment in under-earning capacity. After the Thai currency peg came undone, investors quickly realized that most of the other economies of Southeast Asia were likewise characterized by an asset base that was overbuilt, under-earning, and debt financed at short maturities in US dollars. The so-called Asian miracle now looks like just another debt-financed investment bubble, except on a grander scale than usually encountered. MIT economist Paul Krugman was one of the few to correctly identify the fallacy behind Asia's remarkable growth and was roundly ridiculed, even by fellow economists. In general, the economics profession consistently urges more savings and investment as the path to growth; by following this formula, Asia is now in collapse. Savings and investment only lead to growth when the rates of return on savings and investment are greater than the cost of capital. This is a notion still not well understood by economists. When the local currencies collapsed, debt that was high but not punishing at one exchange rate suddenly ballooned to crushing levels. We have only begun to see the bankruptcies and economic travail that will result as these new realities feed back into the local economies.
The situation is quite similar to the Mexican crisis of late 1994-1995. Then, the Fed began tightening in February 1994, and followed that by several more interest rate hikes in quick succession. People sold pesos for dollars as rates rose in the US, finally forcing Mexico to devalue and float the currency. (Under a fixed rate regime the government has to balance the supply and demand for currency with its own reserves. A massive move to sell the local currency depletes those reserves.) That shock threw Mexico into deep recession and destabilized most of the economies in Latin America for the next year.
Looking longer term, interest rates have been falling irregularly but persistently since they peaked in late 1981. The last bottom in rates was 1993, when long bonds yielded 5.78% and short rates were 2.6%. Subsequently, both long and short rates rose for three years. Now long rates have dropped to new lows while short rates hover over 5%. We think the next important move in short rates is down, and perhaps down to levels approaching the 1993 low.
We believe that the Asian crisis is unlikely to resolve itself until the Fed eases, and that when monetary policy is eased, it will be the beginning of a long decline in short-term interest rates. This, of course, is unabashedly positive for equities, assuming corporate profits are still intact.
If we are right that future rates of return will be much lower than those of the past 15 years, that inflation will stay low, and that the Asian crisis will be resolved only through Fed easing, a few implications for investment strategy follow: 1) Yield will be a much more important component of returns than it has been in the past decade or so. 2) Missing earnings estimates will become more frequent and will be punished more severely. Good companies whose prices have collapsed due to disappointments will be quite rewarding to investors who are able to value them properly. 3) Companies which can demonstrate consistent growth will see their valuations rise, no matter what their industry. Fifteen years ago people thought Coke was fully priced at a single-digit multiple, given its stodgy nature and plodding growth: Now it is regarded as a quintessential growth stock at about 40x earnings. 4) Merger and acquisition activity will accelerate from today's frenetic pace since money will be cheap and growth hard to come by. Companies will buy growth if they can't generate it internally. 5) Pressure on corporate management to take steps to increase shareholder value will also be intense. We hope to take advantage of these factors over the coming year.
All in all, we think 1998 will be tougher than previous years, but with some luck, it may still prove quite rewarding.
The market has gotten increasingly efficient as the years have gone by, and money managers have had a tougher and tougher time beating it. Their difficulties are compounded by the capitalization-weighted nature of the index: bigger companies have a bigger impact on the index's results than do smaller companies. If you had owned an equal dollar amount of every company in the S&P 500, you would still have underperformed the index the past several years.
We are increasingly asked what we do differently from other managers that might account for the results achieved over the past few years. It is easy to identify our points of departure; whether they account for our outperformance is another issue. Someone who flipped heads seven times in a row would probably believe he was in possession of a superior coin-flipping process.
Our approach consists of three main features: 1) We are investors, not speculators. We do not try to guess the direction of the market, which industries are likely to perform well, or which stocks are likely to come into favor or outperform. While most market participants are focused on outlook and trend, we are focused on value. As investors, our time horizon is much longer than other mutual fund managers. The average fund turns over 90% of its portfolio each year. Our turnover is about 10-20%, implying an average holding period of 5-10 years, versus a little over 1 year for the average mutual fund. 2) We do intensive research on our holdings and try to buy companies whose prices represent large discounts to our assessment of the intrinsic value of the business. We use an economic value approach to our analytic process, which involves going well beyond simple accounting-based measures of value such as price/earnings ratios or price-to-book value ratios. In addition to all the quantitative tools in the professional investor's toolkit, we focus on corporate capital allocation, competitive positioning, and strategy and spend a lot of time with company managements trying to understand industry and company dynamics. 3) We run a tightly focused portfolio, usually limiting ourselves to 35 or 40 stocks, compared to the more than 100 stocks that populate the average fund's portfolio. We pay no attention to industry or sector weightings in the popular indices, seeing no reason to own any industry or company whose long-term prospects are unattractive, just because someone has put them in the S&P 500.
We expect to continue to invest this way whether or not our results outperform or underperform some benchmark. Since no one outperforms forever, you may be sure we will underperform for some periods, and those periods may be strung together for an uncomfortably long time, as they were in the late 1980s. We are confident the long-term results will remain satisfactory on both a relative and an absolute basis.
As noted above, we gave back some relative gains in the fourth quarter. Investors spooked by Asian turmoil sold banks and technology stocks, the former on fears of loan losses and spread compression due to the flattening yield curve; the latter due to fears of future earnings weakness due to diminished Asian demand. Banks and technology stocks have been among the strongest groups in the market, and investors apparently decided to pocket profits while they still had them. We added to our positions in both groups during the quarter, believing that the problems in Asia are long-term positives for both sectors, despite the very real near-term concerns. US banks are relatively unexposed to Asian problems compared to banks in Japan and Europe. The real devastation will be among local banks, many of which will fail. Banks such as Citicorp will pick up significant market share and should be able to take advantage of new lending opportunities at wider spreads. Technology companies will benefit as excess capacity is wrung out of the sector.
We bought several new names in the quarter, most of them well-known. Ford is a storehouse of value, trading at 8x earnings with lots of excess cash and assets that can be monetized. Digital Equipment in the high 30s is trading at half of what we think it's worth. It has sold off capital intensive or money-losing businesses and, in our opinion, is poised to begin to grow for the first time in years. It reminds us of IBM when we bought it several years ago. Metro-Goldwyn-Mayer came public, and we must have been the only buyer, considering how poorly it traded. We think it is worth $24 or so on assets, with a value that should grow at 10% a year or more. Hilton lost the takeover battle for ITT, and we decided to buy both. The latter provided a nice arbitrage into Starwood Lodging, while Hilton we found attractive in its own right. We think Hilton, currently trading in the high 20s, is worth over $40 per share.
As always, we appreciate your support and welcome your comments.
Bill Miller, CFA
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