Value Trust
Your Fund had a good fourth quarter, rising 18.91%. This outpaced both the S&P 500 and the Dow, which rose 14.88% and 11.66%, respectively. Summary statistics for those indices and for two categories of mutual funds are given below:
Our results for calendar 1999 again exceeded those of the S&P 500, the ninth consecutive year we have been ahead of that index. You may have read that the Value Trust is the only fund to have outperformed the S&P over that time period.
It is important to understand that those results are an artifact of the calendar. If our returns were measured by our fiscal year-end periods, for example, they would not show the same level of persistent outperformance. Our objective is to provide investment results in excess of those achievable by investing in an index fund over a multi-year period; it is not to beat the index every day, week, quarter, or year.
Value funds had one of their worst years in 1999, extending a period where they have underperformed funds whose investment processes focus on growth, or minimize valuation. Some funds with exceptional long-term records finished down for the year, such as Sequoia Fund, or earned low single digit returns, such as Longleaf Partners.
Investment success last year was determined almost exclusively by how heavily weighted one was in technology. As you probably know, the technology-heavy NASDAQ index rose over 85% in 1999, the largest single twelve-month increase of any broad-based index in history. Most value funds have little or no technology exposure, principally because technology stocks are among the most highly valued stocks in the market by conventional measures such as price to earnings or price to book value.
The Value Trust has had market or greater technology weightings for several years, which is why we have done better than our value-oriented brethren. We have believed, and continue to believe, that technology can be analyzed on a business value basis and that investing in companies with a sustainable competitive advantage as evidenced by their return on invested capital will provide above average shareholder returns.
We believe, though, that the dramatic price gains achieved by the major technology companies have removed most of the undervaluation present a few years ago. Accordingly, the risk of owning these securities has increased substantially. Our experience has been that most investors' psychological assessment of risk is inversely proportional to the most recent price action in their holdings. If a stock has gone up a lot, they feel more confident about it and perceive its risk to be lower than it was prior to the price rise. If a stock has dropped a lot, they believe it is riskier because of its decline. The opposite is typically the case.
Last year more funds had triple-digit returns than ever before in history. Last year the average return of general equity funds was ahead of the market for the first time in years, although the median return still lagged the market. Shareholders in the most successful funds no doubt are feeling quite cheerful, while those in funds whose returns have lagged in recent years are probably redeeming their shares in search of better results.
We have written in the past about enantiodromia, the tendency for things to swing back and forth. We think many of the securities which have performed poorly for us in the last year or so are likely to do much better this year, while many of our heretofore strongest performers are more vulnerable than they have been.
Only three weeks into the new year both America Online and Gateway, our two largest holdings, are down 15%. AOL has agreed to buy Time Warner in the largest merger in history, while Gateway has sold off due to a shortfall in this quarter's earnings as a result of their inability to secure enough chips to meet strong demand.
The history of large mergers conduces to caution. According to the accounting firm KPMG, 83% of mergers fail to create substantial shareholder value. Many of the worst performing stocks in the past few years have been the result of big acquisitions and subsequent integration problems, including Waste Management, Albertson's, Mattel, and McKesson, all names we own.
We are still assessing the implications of the AOL/Time Warner deal. The deal is strategically extremely interesting and we believe has broad implications for valuation in the Internet space and beyond. Companies involved in very large deals that take a year to close such as this one, rarely outperform the market. MCI/Worldcom is a prominent example of a company where shares have traded sideways for the past 12 months even with few evident integration problems. Shareholders need to be aware that should we conclude that the deal promises attractive long-term returns, we would be unlikely to try to trade out of a billion-dollar position just to try to cycle the money into something we hoped would do better over the next 12 months. We are investors, not traders.
We remain quite optimistic about Gateway and think they will have a good year. The stock performed well for us last year, rising 181% and helping to offset losses in other holdings. There is plenty of time for them to recover from this shortfall and for the stock to regain its lost ground.
The market's rocky start has clipped some of our financials, a group which lagged the market badly last year as interest rates rose. We think rising rates are the biggest risk to the equity market this year. Long rates have risen to about 6.7% without affecting much of the market outside the financial services sector. We believe if they approach or hit 7% the entire market will be affected. If rates peak this year and start down or even stabilize, then our financials should do quite well.
Portfolio activity was predictably modest in the quarter. We bought one stock: Albertson's, a supermarket chain. The company has had some integration issues with their purchase of American Stores, and earnings have suffered as a result. Trading now at under 12x this year's earnings, we think Albertson's is a bargain. Prior to 1999, the company had the longest unbroken string of positive returns to shareholders of any company in the S&P 500: 25 years (Coca-Cola was second). We sold several issues, mostly smaller positions in a variety of industries. The money from these sales was recycled into stocks like Albertson's and Waste Management, whose prospects we deemed greater than those of the companies sold.
As always, we appreciate your support and welcome your comments.
Bill Miller
January 18, 2000
DTIA 11560.72
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