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Apr 11, 2017

Thoughts from Sir John

Bill Miller

The US equity market continued its post-election rally, rising 6.07% percent in the first quarter. I remain of the opinion that we are in a secular bull market for equities that began in March 2009 and that probably has years to run before its inevitable demise. Recalling Sir John Templeton’s view that bull markets are born in pessimism, grow on skepticism, mature on optimism, and die on euphoria, I think we are around the point where skepticism meets optimism. A few more quarters like the first will probably move us nicely into the beginning of the optimism phase.

Every day brings new prices, new economic data, new comments on markets, new geopolitical events such as the recent cruise missile attack on a Syrian airfield, all amplified by the financial news channels, the 24-hour news cycle, and the emotional Sturm und Drang of social media. As Yale’s great game theorist Martin Shubik said, “It’s not what the numbers are, it’s what they mean” that matters. There exists no shortage of folks willing to provide their version of that answer to the media.

All of this daily back and forth reminds me of something Sir John told me several decades ago. He said that there are two types of investors in the world. The first he called “outlook and trend” investors and they make up the overwhelming majority. They are constantly reading and reacting to what is going on, changing their positions as the outlook and trend changes. The other type he called “price and value” investors, of which he, along with Warren Buffett and Ben Graham, were the outstanding exemplars of the 20th century. Warren and his partner Charlie Munger are of course still going strong in this century. Sir John estimated that price and value investors could comprise as little as 10% of the population of people active in the market, which sounds about right to me.

Price and value investors spend little time trying to predict the next economic release. “I don’t spend 15 minutes a year on macro,” Peter Lynch of Magellan fund fame once remarked. They (we) compare the current price the market puts on the long-term value of the business with their own appraisal of that value. Their (our) efforts are directed at trying to buy companies that trade at large discounts to intrinsic business value, defined as the textbooks do, as the present value of the future free cash flows of the business. Time horizons for such investors run in years, not weeks or quarters, and the best of them do not construct their portfolios to minimize tracking error or drawdowns, but to maximize rates of return appropriately adjusted for risk. Risk is not defined as volatility, but as the probability of permanent loss of capital.

In this market, as is typical in bull markets, stock prices have risen faster than earnings and valuations have expanded, just as in bear markets stocks fall faster than earnings and valuations contract. Today’s valuations of around 18x earnings are cause for concern among many, as they are higher than the long term average of 14 to 15 times earnings. I think that concern is misplaced for two separate reasons. First, as bull markets progress valuations usually expand as confidence grows about the sustainability of the economic expansion. Higher prices beget higher prices as long as the economy is moving forward. Stock prices are driven by earnings and not by the first derivative of earnings growth. Second, one has to compare stock valuations to the investment alternatives, typically bonds and cash. Savings have to go somewhere, and stocks are cheap compared to what’s available in cash and across the fixed income landscape. This may change if the economy continues to grow and the Fed continues to move interest rates higher, but we are a long way from cash and bonds providing any meaningful competition for stocks.

The signal-to-noise ratio in the stock market is very low in my opinion, and is exacerbated by outlook and trend investors, as well as high frequency traders, constantly reacting to both an ever evolving and changing news flow, and to price changes themselves (stocks breaking out or breaking down on chart patterns for example). I believe most investors way over-think the market, over react to ephemera, and generally do not add value by trading. Cash has a negative rate return after inflation and even more negative after taxes. “Risk-free” treasuries trade at over 40 times their non-growing coupon, while stocks provide a higher yield than treasuries with a 5-year maturity and trade at 18x earnings, while providing an average growth rate of around 4 to 5%. Moreover, the Fed has entered a tightening cycle since inflation is picking up (albeit from very low levels) and the economy is operating with an unemployment rate of 4.5%, a rate that usually leads to higher inflation and interest rates. I continue to think the 35-year secular bull market in bonds is over and we are in the early stages of a bear market, which I expect to be benign, at least for a while.

Our default position is to ignore the market’s daily drama and noise and focus on long term value creation at the macro and micro level. Alas, that appears to be impossible for the average individual and institutional investor. It does, though, create opportunity for the patient, long-term, contrarian investor. We think there are plenty of opportunities in this market, some of which my colleagues and I address in our quarterly commentaries.

Bill Miller CFA
S&P 500 2355.54
April 7, 2017

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of publication, the date of the call. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

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