Bill Miller’s First Quarter Investor Letter

Legendary investor, Bill Miller’s quarterly commentary is required reading at Madison, as his insights into the markets and long-term perspective help contextualize today’s volatile markets. Miller started his career as a military intelligence officer before leading Legg Mason’s Value Trust fund to a record-beating 15 consecutive years of outperformance versus the S&P 500 from 1991 through 2005. Miller is known as having one of the most analytical minds on Wall Street and as a creative thinker, making his comments about the current market conditions well worth considering.

There have been 4 great stock market buying opportunities in my lifetime. The coronavirus has given us the 5th. The first was in 1973-74. The Vietnam War was still underway. Then war broke out in the Middle East in October of 1973. Oil prices soared, inflation hit double digits and so did interest rates. The economy went into recession and a constitutional crisis culminated in the resignation of President Nixon. I was a young first lieutenant in the Army making around $400 per month and putting $25 per month into the Templeton Growth Fund. In the fall of 1974, I went into the Merrill Lynch office in Munich, Germany and bought shares near the market bottom. The second was in the summer of 1982. We had started our value strategy in the spring of 1982 and kept it mostly in cash as the market continued a decline that had begun a year earlier. Mexico then defaulted on its debt, the market fell sharply, and we got fully invested in July. In August, Paul Volcker cut rates and the great bull market was underway. The third was in October of 1987 when the market crashed 22.6% on October 19th, nearly twice the previous biggest single day decline in 1929. We had raised cash in the summer, as the market got very expensive relative to bonds. Stocks peaked in August and began to fall. By the end of September, 30-year bonds yielded over 9%, a cash return roughly equal to the average annual return of stocks since 1926. The market collapsed and we put all of our 25% cash position into stocks. Our value strategy was the single best performing fund of 1988 as most others maintained high cash positions due to fears about the health of the economy. The fourth was 2008-09. We did not navigate that period well. The strategies I then managed all went down much more than the market. We made changes to our positions that we thought would provide the best upside in the inevitable recovery. We stayed fully invested throughout the 10-year bull market and Opportunity Equity was one of the best performing of all US equity strategies since the market low in March 2009 through calendar year 2019.

We have been hit about as hard as anyone in this decline because we have been overweight in higher beta names (i.e., those that are more volatile than the S&P 500) believing (correctly) that since the financial crisis people have been risk- and volatility-phobic and that perceived risk has consistently been greater than real risk. Going into 2020, I thought that economic risk was low and that if the market was going to decline it would be because of either geopolitical events or some exogenous shock to global aggregate demand or aggregate supply. We got that exogenous event in the form of a global pandemic that took stocks from all-time highs to a bear market decline of over 30% in the shortest time in history. As is typical in these sorts of egregious declines, we are down a lot more than the market.

In times such as this, I am reminded of what Keynes wrote to his board when he was managing money during the 1937 market collapse. As you may know, in addition to being the most influential economist of the 20th century, Keynes was also an outstanding investor. The board had been urging him to sell as the market went down and he refused. He told them that it was “the duty of every serious investor to suffer grievous losses with great equanimity.” He went on to note that their advice to increase his selling as stocks went down, if practiced by everyone, would be economically disastrous for the country. It would also mean, he went on to point out, that he would own little or no stock when the market bottomed, whereas his strategy involved being fully invested when stocks were cheap and the market was at its lows.

The market’s behavior since the current low of 2191 on March 23 gives a good indication that this recovery from the inevitable recession now underway will follow the pattern of every other recovery since at least 1973-74. The stocks that have led since the bottom have been low PE/cyclical names with operating or financial leverage, viz., the exact names that were clobbered the most in the decline. Those names were also the worst performers when recession fears were high — fall of 2018, first six weeks of 2016 — yet where no recession materialized. And they gained the most when those fears proved unfounded. The reason why is fairly straightforward: Prices and valuations are highly sensitive to the marginal return on invested capital and to business risk. When the economy is declining, or there are fears that it will, valuations on those companies whose return on invested capital (ROIC) is most sensitive to economic change (mostly traditional cyclicals) will decline more than those that are more resistant such as consumer staples, utilities, bond proxies, and many recurring revenue businesses. Companies with high debt leverage and economic sensitivity fare the worst as the market discounts the possibility they will experience financial distress. When the market sees a recovery, the exact reverse occurs, which is what we saw in the week ending April 10, one of strongest weeks in market history.

It appears that most equity strategists think that the March 23 low may be “retested” in the coming weeks as the global economic shutdown drags on. If so, last week’s leaders, and our Strategies, will also likely lag, although perhaps not as much as they did during the initial collapse. I am agnostic on that as my ability to forecast the market’s short-term path rounds to zero. So does everyone else’s, by the way.

Listening to the financial commentators on CNBC and elsewhere, I hear many, if not most, of them advising investors to use the decline to “upgrade” their portfolios. They say to “buy quality names on sale,” but avoid or reduce exposure to names that are riskier. Typical issues in the quality bucket include companies such as Alphabet, Disney, Nike, Amazon, Facebook, Procter & Gamble, and Clorox. Now these are all very fine companies and we own several of them. I think, though, that a portfolio comprised of all “quality” names, names that have been among the best performers in this dramatic decline, will almost certainly be a portfolio that underperforms the market as the economy and the market recover. In big market declines, the prices of stocks fall more rapidly than long-term business values. We try to use these opportunities to “upgrade” our portfolios as well, by which we mean replace names that have held up reasonably well with those whose price declines now offer much greater long-term upside when the economy comes back.

Sir John Templeton advocated buying at the point of maximum pessimism. The problem is that point is only known in retrospect. There is much pessimism and little optimism evident now, and it is impossible to tell if stocks have declined enough to discount what the future holds with regard to the economic damage that the pandemic will inflict. In October 2008, Warren Buffett wrote an op-ed saying he was buying US stocks and urging others to do so as well. A few years later he was asked how he knew that was the time to buy. He said he did not know the time, but he did know the price at which stocks were a bargain. They were a bargain then and, in my opinion, they are a bargain now, albeit not as great a bargain as they were a few weeks ago. The market may have bottomed at an intraday low of 2191 on March 23 or it may not have. I do believe that shares bought at these prices will prove to be quite rewarding over the next few years, and perhaps a lot sooner. If you missed the other 4 great buying opportunities, the 5th one is now front and center.

Bill Miller, CFA

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written.  Actual economic or market events may turn out differently than as presented. © 2020 Madison Wealth Management
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