The Imminent Comeback of Bill Miller

Norman writes:

Thanks for yesterday’s great observations from Bill Miller. I’m wondering if you can provide a few words in defense of his poor showing in recent years. I’ve read that he was a great manager for a while, but that he’s lost his touch and doesn’t understand today’s market.

It’s a little odd being asked to defend one of the greatest portfolio managers in recent times, but if ever there was a fat pitch to make for an easy article, this is it.

When you write that Miller was a “great manager for a while,” you understate the case. He beat the S&P; 500 every year for 15 years straight. That streak ended two years ago, and that two-year period since is what critics focus on. To put Miller’s streak in perspective, understand that it was nearly twice as long as that of former Fidelity Magellan Fund Manager Peter Lynch, which lasted for eight years.

Beyond the duration of Miller’s winning streak, the margin of his outperformance was impressive. His annual return was 16.4% per year versus 11.5% for the S&P.; Given that, describing him as having been a “great manager for a while” doesn’t do him justice. He’s one of the all-time greats.

As for his poor showing in the last two years, he addressed it himself. The following is the first two pages of Miller’s Feb. 10 letter to shareholders in review of 4Q07:

This commentary will be short and to the point: We had a bad 2007, which followed a bad 2006.

Over this two-year span, we underperformed the S&P; 500 by around 2000 basis points, our worst showing since the two-year period 1989 and 1990, where we underperformed by 2500 basis points.

In the 25 years since we started the Value Equity mandate in 1982, we have had six calendar years of underperformance. Despite that 19-6 record against the market, all the losses are painful. They are also unavoidable and unpredictable. It would be great if we could figure out how to never underperform. No one has been able to do that, but that does not make it any less painful.

I will talk a bit about what caused the results of the last couple of years, and a bit about how I see the current investment environment. I will conclude by discussing the situation with Countrywide Financial, which has been at the epicenter of the present housing turmoil, and offer some thoughts on Microsoft’s bid for Yahoo, one of our substantial holdings.

About the only advantage of being old in this business is that you have seen a lot of markets, and sometimes market patterns recur that you believe you have seen before. It is not an accident that our last period of poor performance was 1989 and 1990. The past two years are a lot like 1989 and 1990, and I think there is a reasonable probability the next few years will look like what followed those years.

The late 1980s saw a merger boom similar to what we have experienced the past few years and a housing boom as well. In 1989, though, the merger boom came to a halt with the failure of the buyout of United Airlines to be completed. The buyout boom had been fueled by financial innovation. Then it was so-called junk bonds, which had been purchased by many savings and loans in an attempt to earn higher returns. Now it is subprime loans repackaged into structured financial products. The Fed had been tightening credit to guard against rising inflation, which began to impact housing. By 1990, housing was in freefall, the savings and loans were going bankrupt (as the mortgage companies did in 2007), financial stocks were collapsing, oil prices were soaring in 1990 due to a war in the Middle East, the economy tipped over into recession, and the government had to create the Resolution Trust Corporation to stop the hemorrhaging in the real estate finance markets. Eerily similar to today, the situation began to stabilize when Citibank got financing from investors from the Middle East.

Although the overall market was down only 3% in 1990, we got trounced, falling almost 17%, the result of our large holdings in financials and other stocks dubbed “early cycle,” and which tend to perform poorly as the economy is slowing or when it sinks into recession.

If it were possible to forecast with any degree of accuracy, one might be able to descry a slowing economy from an examination of economic data, and perhaps adjust portfolios accordingly. But unfortunately, as I have often remarked, if it’s in the newspapers, it’s in the price. The process works the other way: stocks are a leading indicator, so first they go down and then the data comes in.

In 2007, financial stocks began to decline in early February, before the market corrected in March. They then rallied into May, began a slow decline that culminated in an intermediate bottom in August when the Fed lowered the discount rate, rallied into early October, and then began the precipitous fall that appears to have made a bottom around the third week of January. The decline in financials reflected the freezing up of credit markets that began in August and which still persists, and was followed by a steep drop in consumer stocks in November that also may have seen their worst days now that the Fed has begun to aggressively cut rates.

All of this was accompanied by the decline in the housing stocks, which fell almost continuously throughout 2007, ending with a loss of almost 60% on average.

The financial panic got going in earnest as we entered 2008, with global markets all dropping in the double digits or close to it as of this writing. The so-called decoupling thesis, which maintained that non-US and emerging markets and economies would be unaffected by a US slowdown, while not dead (yet), is severely wounded.

The monetary and fiscal authorities have now begun to move with alacrity, with the Fed cutting the funds rate to 3.0% (with likely more to come), and the administration
and Congress coming up with a fiscal stimulus package estimated at around $150 billion dollars.

Will it be successful? Yes. More precisely, if these measures aren’t enough to free up credit and stimulate spending sufficient to set the economy on a growth path, then additional measures will be taken until that is accomplished. The important point is that the monetary and fiscal policy makers are focused and engaged, and will do what is necessary to stabilize the markets and restore confidence. This does not mean that the recovery will be swift, or seamless, or without additional trauma. But there will be a recovery, and I think the market abounds with good value. Those values may get even better if the markets get more gloomy, but they are good enough now for us to be fully invested.

I think the market is in for a period of what the Greeks refer to as enantiodromia, the tendency of things to swing to the other side. This is not a forecast, but rather a reflection on valuation.

All of the poorest performing parts of the market, housing, financials, and the consumer sector — with the exception of consumer staples — are at valuation levels last seen in late 1990 and early 1991, an exceptionally propitious time to have bought them. The rest of the market is not expensive, but valuations cannot compare to those in these depressed sectors.

Bonds, on the other hand, specifically government bonds, which have performed so wonderfully as the traditional safe haven during times of turmoil, are very expensive. (In bond land, the only values are in the so called spread product, and there are some quite good values there.) The 10-year Treasury trades at almost 30x earnings, compared to about 14 times for the S&P; 500. The two-year Treasury yields under 2%, and is thus valued at over 50x earnings!

The valuation disparity between Treasuries and stocks is as great today in favor of stocks as it
was in favor of Treasuries 20 years ago. Just prior to the Crash of 1987, stocks yielded about 2% (same as today), but traded at over 20x earnings. The 10-year Treasury yielded over 10%, vs. 3.6% today. The two-year Treasury now has a
lower yield than the S&P; 500, and that is before share repurchases, meaning you can get a greater yield in an index fund than you can in the two-year, and a free long-term call option on growth. Even more compelling are financials, where you can get dividend yields about double that of Treasuries, which only adds to their allure, with them trading at price-to-book value ratios last seen at the last big bottom in financials.

I think enantiodromia has already begun. What took us into this malaise will be what takes us out. Housing stocks peaked in the summer of 2005 and were the first group to
start down. Now housing stocks are one of the few areas in the market that are up for the year. They were among the best performing groups in 1991, and could repeat that
this year. Financials appear to have bottomed, and the consumer space will get relief from lower interest rates. Oil prices have come down, and oil and oil service stocks
are underperforming in the early going.

Investors seem to be obsessed just now over the question of whether we will go into recession or not, a particularly pointless inquiry. The stocks that perform poorly entering a recession are already trading at recession levels. If we go into recession, we will come out of it. In any case, we have had only two recessions in the past 25 years, and they totaled 17 months. As long-term investors, we position
portfolios for the 95% of the time the economy is growing, not the unforecastable 5% when it is not.

I believe equity valuations in general are attractive now, and I believe they are compelling in those areas of the market that have performed poorly over the past few
years. Traders and those with short attention spans may still be fearful, but long-term investors should be well rewarded by taking advantage of the opportunities in today’s stock market.

I spent some time online conducting an informal survey of who’s taking potshots at Miller and others of his caliber, and found that the most vociferous critics are non-professionals with a distinctly trading mentality.

There are two points to keep in mind when reading most criticisms of Bill Miller and others at the top of the investment field:

  • The dearth of respected professionals in the lineup speaks to the weakness of the charges. You won’t find seething commentary from the likes of Warren Buffett, Jack Bogle, Seth Klarman, Charlie Munger, Bill Nygren, Richard Pzena, Mason Hawkins, Eddie Lampert, John Templeton, Marty Whitman, or others at the top.

    No, you’ll read it from people who go by tptrader, zmaster, user9321, hipshooter, or similar handles.

  • The lack of accountability from part-time online ranters like zmaster and friends reduces their observations to chatter. Blasting off a quip between meetings at work in a field unrelated to investing is a far cry from amassing a multi-decade track record of market beating performance. I suggest paying closer attention to comments from proven market beaters.

The reason seasoned experts don’t take potshots at their temporarily underperforming colleagues is that they understand cycles of the market. Even Miller pointed that out in his February letter. The last two-year down cycle of his was followed by the history making 15-year winning streak. Something tells me Miller will regain his stride.

So, beware the hoi polloi online. They’ll kill your long-term performance with their short-term trading blinders. Besides, you have no way of knowing if they’re even any good at trading. Odds are, they aren’t. It’s probably just a hobby that creates for them more tax deductions than new cars or vacation homes.

Limit yourself to reading only respectable voices. Life’s too short and money’s too important to do otherwise.

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