Bill Miller 1Q 2008 Commentary

Legg Mason released Bill Miller's first quarter 2008 commentary for his mutual fund shareholders and, in line with what he has been saying over the last few months, he thinks the worst of the credit crisis may be over. The big wild card, according to him, is commodities. If commodities rise much further, they can wreck the world economy; but if they decline, they will provide relief to the markets. He suggests that the Federal Reserve should avoid further rate cuts (his view is that further rate cuts won't help with the credit problems.)

(source: Bill Miller April 2008 Commentary - April 23, 2008. Legg Mason)

For investors who are trend followers, or theme driven, or who primarily build portfolios around forecasts, or who employ momentum strategies, price is dispositive. When they do badly, it is because prices moved in a direction different from what they thought. For value investors, price is one thing, and value is another. When prices move against us, it usually means that the gap between price and value is growing, and our future expected rates of return are higher.

This is especially the case in momentum-driven markets, such as we have been in for the past two years. In such markets, price trends persist, and wide gaps open up between price and value. That is why fertilizer stocks such as Potash can go from the $20s to the $200s in two years,
and why Microsoft can bid over 60% more than where Yahoo! was trading and still be getting a great deal.

The problem for newbies like me is identifying when the share price decline isn't implying a drop in actual value. I'm sure there is a big gap between value and price in many stocks but one needs to avoid those who actually lost their value along with price. As stockpickers, that's our goal--and that's what I'm trying to learn.

Momentum strategies typically dominate when there is perceived distress, such as the past year or so in credit and financials and this year in equities globally (in the first quarter, not a single S&P sector was up), or there is euphoria, such as tech in the late 90s or commodities and materials today, or when valuation spreads between industries are narrow, as has been the case for most of the past two years. So it’s been a great time for momentum and a lousy time for value.

The problem is that momentum strategies (such as trending) can go on for much longer. The Potash (fertilizer company) example cited by Miller before kind of points out the effect of momentum. No doubt Potash is a great company but I find it hard to believe that Potash will become the largest company on the Toronto Stock Exchange soon (it needs to rise a little bit more than others like Royal Bank of Canada). I never would have expected a fertilizer company to be worth more than the Canadian big banks or oil&gas companies. Potash is a top-notch company in its industry but it is in a cyclical industry. Once the current food price ascent declines, it's all downhill. The market has the company valued with a current P/E of around 60 and forward P/E of around 16--this for a cyclical company. Anyway, this isn't to bash Potash (I don't follow it closely) but to point out the performance of momentum investing.

I think we will do better from here on, and that by far the worst is behind us. I think the credit panic ended with the collapse of Bear Stearns, and credit spreads are already much improved since then. If spreads continue to come in, the write-offs at the big financials will end, and we may even have some write-ups in the second half instead of write-downs...Most housing stocks are up double digits this year despite dismal headlines, a sign the market had already priced in the current malaise. I think likewise we have seen the bottom in financials and consumer stocks, but not necessarily the bottom in headlines about the woes in those sectors. Although the economy is likely to struggle as it did in the early1990s, the market can move higher, as it did back then.

The wild card is commodities.

I wouldn't put much faith on his predictions. As Bill Miller himself says, forecasts are useless. But getting others to confirm my thinking is benefitial.

What we are seeing are diverging opinions regarding the future of the stock markets. If we just look at value investors, those on the bearish side (who expect financial conditions to deteriorate further) include Prem Watsa (Fairfax Financial), William Ackman (Pershing Square), while those on the bullish side (think financial crisis is near a bottom) include Bill Miller (Legg Mason), Martin Whitman (Third Avenue) and Bill Nygren (Oakmark). My impression is that Warren Buffet is neutral (he says deleveraging will be sizeable but doesn't think the market is overvalued as a whole). Master contrarian investor David Dreman thinks the worst may be over regarding the credit crisis. Other types of investors have differing views as well. Macro/trend investor/trader Jim Rogers thinks the worst is still in front of us (particularly with respect to a massive dollar crisis--which will cause a collapse in US$-denominated assets). Contrarian investors Marc 'Dr Doom' Faber thinks the situation will also get much worse but he seems more sanguine about the US markets (I've seen him lately imply that the US$ and US$ assets may be more attractive than the rest of the world).

One of the huge risks with relying on any successful investor is that their strategies that worked in the last 20 years may not work as well in the future (this can be true given that we were in a huge bull market in bonds (i.e. interest rates falling) while that is unlikely to be true for the next 20 years). Although value investors don't succumb to this problem as much as other type of investors, those with a contrarian focus can easily pay a price. For example, Bill Miller is very contrarian and buys beaten-down stocks, often with seemingly weak moats and competitive strength (eg. Kodak, Countrywide Financial, Yahoo). If the situation in the future is nothing like the past 20 years, these companies may go nowhere or actually fail. Similarly, David Dreman, being a contrarian, is favouring companies like Fannie Mae and Freddie Mac. If we actually enter a massive housing bust (like Japan; or USA/Europe in 1930's) then I can easily see Fannie and Freddie investors losing everything (government will bail out the companies but equityholders get close to zero).

Investors like Bill Miller are well versed in history and would know the past but I just wonder. I notice a lot of those on the bullish side expect a scene that resembles the early 90's. Those on the superbearish side, in contrast, are almost of the opinion that the current situation is similar to the 1930's or the Japan in 1980's (or the inflationary 1970's).

I get this feeling that the times are changing... it is quite possible that no one will make much money for a long period of time (i.e. possible sideways bear market.) None of this means that one should not invest, but just that it is going to be much tougher than the past 20 years. Nobody said investing was supposed to be easy anyway ;)


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