Bill Miller 4th Quarter 2002 Market Commentary
In the fourth quarter, the U.S. economy's growth "appeared to stall," according to The Wall Street Journal, oil and gold prices rose in response to the continuing buildup to possible war with Iraq, the North Korean nuclear stand-off worsened, and Venezuela was gripped by a general strike, further disrupting oil markets. Stocks, though, climbed over 8%, catching most money managers poorly positioned for a rally amidst all the gloomy news. Fewer than 20% of actively managed U.S. equity funds outperformed the market in the quarter; for the year about 45% of funds outperformed.
As the market continued to move lower over the course of the year, managers used the brief, counter-trend rallies to reduce risk by shifting their holdings to lower-volatility, "safer" names. Going into the fourth quarter of the third straight calendar year of decline, it appeared that portfolio managers had become inured to loss, and believed that the downward trend, firmly established, would continue. No reason to expect the end of the bear market with so many "uncertainties."
Certainty belongs to mathematics, not to markets, and anyone who awaits clarity, visibility, or the diminution of uncertainty pays a high price for a chimera. Managements still bemoan the lack of visibility in their markets, or in the economy, as if there ever was such a thing. When they speak about a lack of visibility, all they mean is that they don't like what they see. The money manager's analogue is "uncertainty." Since the market reflects all available information (how could it not?), what is not in the market is the unknown. The operative question does not involve trying to figure out what is going to happen, but how the investor's expectations differ from those embedded in the market. One may have the future pegged exactly, but unless it's a different future from the one the market foresees, it will be of no value to the investor. No matter what the news, good or bad, if it's in the papers, it's in the price. The only question for the investor trying to add value is: What is discounted?
The equity investor cannot avoid or evade the question: Every position in the portfolio will add value if the investor's expectation is closer to what actually happens than what the market believes will happen, and will destroy value if the market's view is more accurate.
The first duty of the investor or analyst is to figure out what is embedded in the price, what is discounted. The failure to address that question is the main source of the poor relative results of most money managers and the general lack of value provided by the opinions of analysts. Analysts (especially sell-side analysts) typically comment on a company's results and outlook, and seem to assume that good results and a good outlook merit a positive rating, and poor results, "missing the numbers," or a variety of "uncertainties" warrant a neutral or worse stance. Unless an analyst explicitly addresses the expectations embedded in the stock and then clearly explains how his or her view differs from what the market's implied expectations are, one can be sure that any relation between the rating and the subsequent performance of the stock is pure accident.
One sell-side firm a few weeks ago upgraded Kodak, one of our largest positions, and at the same time downgraded Home Depot, one of our new positions. What made this illustrative and typical is that the upgrade was after Kodak had been the best performing stock in the Dow for the prior 12 months, while the downgrade was after Home Depot had been the worst. The investor would have been well served if the ratings changes, upgrading Kodak and downgrading Home Depot, had taken place a year ago. But a year ago Home Depot had record earnings and a wonderful outlook, and Kodak was fraught with uncertainties about the outlook for film demand and pricing and the threat from digital. If such actions were isolated, they would merit no comment. They are commonplace and stem from a common error.
The characteristic behavior of analysts is to confuse current results, outlook and trend with investment merit. It is also why the proposed solution to the perceived failures of research during the Internet and tech mania will be an expensive waste of effort, at least if the objective is to improve the relation between opinions and subsequent results. Making research independent of investment banking, or funding independent research, at best will remove the incentive-caused bias that may have afflicted some analysts, but unless there is a fundamental change in research methodology it will not improve investment results for individuals or anyone else paying attention to analysts' opinions.
Indeed, any attempt to make the aggregate opinions of sell-side research of investment value is as silly as trying to mandate that buy-side portfolio managers as a whole outperform the market. Sell-side research is valuable systemically because it makes the markets more efficient, not because it expresses opinions of investment value. It hastens the rapid assimilation of new information into market prices. It performs the same function as press releases, earnings reports, CNBC, or the national news and business media: all are mechanisms for market efficiency.
I am not an apologist for a simple-minded academic view about the efficiency of capital markets. If markets reflect all available information, it does not follow that they reflect it accurately, or that prices are somehow "correct." It is just that whatever information the investor has, the market has as well. In order to earn an excess return, one has to assess that information differently from the way it is embedded in market pricing. Whether making an investment, or an investment recommendation, unless it is predicated on the difference between what you expect and what the market expects, the outcome will just be noise.
The market got off to a fast start in calendar 2003 before faltering as conflict with Iraq loomed closer. After a good October and November, December had its worst result since the early 1930s. Those who squint hard at such things have pronounced the January early warning indicator positive. The bears remain bearish and the bulls bullish.
I think the odds favor a solid year after three bad ones. That is based not just on the rarity of four consecutive down years as a matter of market history, but on the difference between valuation - what's in the price - and what I think is likely to happen as the year unfolds. Unpredictability increases with time. As Ben Graham noted, the market is not unaware of the prospects of most companies looking out six months or so. Analysts would generally increase their value if they thought less about the outlook for the next six months to a year, and more about what, in a year, the outlook will likely be for the six months or year after that. The returns we will earn over the next year will be due largely to the difference between what today's prices imply about our companies' prospects over the next twelve months, and what the 2004 prospects look like a year from now.
For the first time in many years, all the indicators of a better economy and a better market are aligned. Fiscal policy is stimulative and is likely to get more so with additional tax cuts on the way. Interest rates are low and monetary policy is accommodative, and it will stay that way until the economy and profits are doing a lot better. The dollar is falling, making our goods cheaper abroad, and the stock market has been rising the past four months, improving the wealth and the mood of the country. Banks are rolling over debt, bond spreads are narrowing, especially high yield spreads, merger and acquisition activity is picking up, and even the IPO market is starting to stir.
Investing is about probabilities, not certainties, and the probabilities seem to be lining up in favor of an economy that gathers strength as the year progresses, with business capital spending taking over from a satiated, debt-laden, and aging consumer. The market appears skeptical 2003 will bring a sustained recovery with solidly rising profits, at least judging by how portfolios are positioned.
The character of this rally differs from those we saw during the past three years. In those rallies, as noted above, investors took the opportunity to shed risk. Since October, they have used pull-backs to add risk. That is why high yield spreads have narrowed and it is why the rally has been led by tech and telecom, the two sectors where risk is most prevalent. Most investors are still too risk-averse, and are short risk relative to the market. Only one of the ten largest actively managed mutual funds beat the market in the fourth quarter, whereas nine of the ten outperformed for the first nine months of the year.
This rally has had three drivers, in my opinion: first, valuation got too low in early October; second, the Fed cut rates 50 basis points (100 basis points = 1%) and provided an incentive to borrow short and lend long, indicating it was willing to subsidize additional risk taking; third, Fed Governor Ben Bernanke's remarkable speech of November 21 effectively removed the threat of deflation from the market's list of worries. Since concern about deflation was an important factor in pushing the market lower in the late summer and early fall, the effective elimination of that risk allowed it to move higher. His speech should be read by all investors, or at least all who are concerned about deflation. To continue higher, the markets will need to believe that fiscal and monetary policy will be effective in moving the economy forward. I think they will.
The geopolitical situation remains the chief threat to positive returns, but no one is vouchsafed special access to the outcomes in that realm. If conflict arrives in Iraq, the market expects a quick resolution and lower oil prices next year. I think Korea is exploiting the U.S. focus on Iraq to press its advantage. A satisfactory result in the Middle East could lead to a better tone on the peninsula. Complications in Iraq would likely be amplified in Korea and perhaps elsewhere, and constitute the main impediment to a good year, in my opinion. Venezuela is already a mess, so staying that way would not be a new negative.
Our portfolio reflects the difference between what we believe and what the market believes about our companies. In general, the market is fearful and we are hopeful. The market is worried about the effect of digital on Kodak's film business; about the liability Tenet may have and about what it might be able to earn; about the effects of the scandals at Tyco and whether Ed Breen and his team can deliver; about Nextel's debt load, its technology transition, and its growth rate; about UnitedHealth Group's margins and pricing flexibility; about Home Depot's employee morale and whether Bob Nardelli can restore growth; about J.P. Morgan's credit quality and Citigroup's ability to rebound from the Wall Street scandals; about whether Qwest and AES can ever dig out from under their debt, and so on.
The year has gotten off to a positive start, and, so far, we are doing well. I do not expect a return to the exuberance of the '80s and '90s, but I am optimistic that there has been a regime change in the stock market. The excesses of the late 1990s have been wrung out, the losses have been taken, investors are chastened and expectations are modest. The market has demonstrated it can make progress even with all the uncertainties. As the current uncertainties abate, and if the economy improves, investors will be willing to pay higher prices for a more positive outlook and trend, and for the illusion of greater clarity and visibility than is apparent today.
- Bill Miller, CFA
January 20, 2003
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