Value Trust
Investment success in both 1999 and 2000 was determined almost exclusively by how heavily weighted one was in technology. In 1999, the tech-heavy NASDAQ rose 85%, the largest single increase of any broad-based market index in U.S. history. In 2000, that index fell 39%, its worst showing ever. Managers who were overweight in the TMT area (tech, media, and telecom) had a great 1999 and a terrible 2000.
Most value funds have minimal technology exposure. Sometimes the reason is valuation: in the past few years, technology valuations have soared and the sector remains highly valued by most conventional measures and compared with other parts of the market. More often, though, the reason is lack of familiarity or an unwillingness to try to analyze what appears to be a complex group whose fundamentals often seem unpredictable. Many of today's most highly valued tech companies, such as Sun, EMC, and Oracle, sold at single digit multiples in the early 1990s. Even with multiples that low, value managers steadfastly avoided tech shares.
The persistent under-investment in technology by value managers is why they performed poorly relative to the market in the late 1990s and why they had one of their best years in 2000. Those who focused on beaten down areas such as financials did particularly well. The S&P financials gained 24% in 2000, ending two years of underperformance relative to the market.
Since 1996, your Fund has had a significantly greater weighting in technology than most other value managers. We have believed, and continue to believe, that technology can be analyzed on a business value basis, that intrinsic value can be estimated, and that using a value approach in the tech sector is a competitive advantage in an area dominated by investors who focus exclusively, or mainly, on growth; and often ignored by those who focus on value.
At the beginning of 2000, we recognized that most of the under valuation we had identified in the tech stocks we owned had been fully reflected in their share prices. At the same time, the market was severely marking down the shares of banks and other financials. We began selling our tech names and moving the proceeds into financials and other selected names where we saw a large discrepancy between our estimate of intrinsic business value and where the shares were trading in the market.
Technology and financial stocks have moved in opposite directions over the past 1 1/2 years since the Fed started tightening in the summer of 1999. We believe that divergence will end this year, as the Fed moves aggressively to lower short-term interest rates and stimulate growth. The 50 basis point cut in short term rates on January 3rd was the first time the Fed has moved between meetings since the global financial panic in the fall of 1998. From that rate cut until the tightening began, both groups outperformed. We think they will again.
The one-year Treasury bill rate is 4.80%, which is a good approximation of where we believe three-month T-bill rates will be in twelve months. If rates fall that much, financials should do quite well as spreads widen, credit quality concerns dissipate, and loan growth begins to move higher. Technology shares, especially those whose current valuations reflect great skepticism about growth, such as PC makers, should also do well as the market begins to discount the resumption of growth in the second half of this year and on into 2002.
As a general rule, when the Federal Reserve is trying to encourage growth by lowering rates, it’s time to play offense in the market. When they are trying to slow growth by raising rates, emphasizing defense is the right strategy. Last year, defensive, lower-risk names were the winners: REITs, utilities, drugs and other health care, tobacco, food and beverages, oils. Financials did well as the market began to anticipate Fed easing, especially as the economy began to weaken noticeably in the fourth quarter.
This year we believe that most of last year’s winners should be avoided, with the exception of financials. Within that group, lower P/E names such as Washington Mutual and MGIC should do well. We think low P/E in general will do well again this year, although it is harder to find those names since many of them performed strongly last year. As noted, we like tech, but think there is substantial risk in companies with high valuations if the economy remains weak.
The fears about the economy’s weakness may be greater than the reality. Many companies report that an abrupt fall in demand occurred in the fourth quarter, which is being confirmed by data such as the lowest purchasing managers index in 10 years, and the lowest Philly Fed shipments index ever. Manufacturing production fell at an 18% rate in December, and consumer confidence is also down. This has led a number of economists to worry that we may already be in recession. We of course have no idea whether the economy is in recession or not (neither do they). We will have to await the data. If we are, then short-term interest rates are likely to be considerably lower than the market is expecting in twelve months, and that will be good for equities.
The economy is different from what it was in most of the post-war period. That is why we have had only eight months of recession in the past 18 years. The low inventory-to-sales ratios now existing are the result of much better information about sales and inventory, and allow for a much quicker reaction to shifts in demand, leading to greater near-term volatility in the economy but rarely allowing imbalances to reach a magnitude that can’t be rapidly corrected. We believe it is possible that the weakness currently being experienced is due to many parts of the economy adjusting simultaneously to slowing demand by cutting production, orders, and inventory. Such weakness would end quickly, and be replaced by solid growth, just as occurred from late 1998 to 1999.
Our portfolio doesn’t depend on our being right about the twists and turns of the economy. It depends on our understanding the prospects for our companies and what is discounted in their share prices. The market now is worried about growth, and is placing a high valuation on companies where it is confident about growth. We believe that greater opportunities are present in companies with less visible growth and lower valuations.
Bill Miller, CFA
January 23, 2001
DJIA 10649.8
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