US large-cap stocks are bargains of a lifetime

By Bill Miller

Published at FT: August 31 2010 17:25

The common view seems to be that the weak stock market reflects a weakening economy.

But we think the converse is more likely: the weak stock market is causing the economy to weaken. It is not a surprise that the recent US consumer confidence numbers were so poor; with the stock market having fallen so sharply since late April, they could hardly be otherwise.

Using the outlook for the economy to predict the direction of the stock market, which most appear to do, is to look at things the wrong way round. The stock market’s behaviour will predict the economy’s future behaviour. The market’s decline since late April foreshadowed the soft economic numbers now being reported, just as the market’s rally beginning in the spring of 2009 foretold the beginning of the recovery now under way.

Markets are all about expectations and the critical question for investors is always, what is discounted? Are the expectations reflected in market prices too high, or too low? One clue is to look at financial stocks. Financials tend to lead the market, both on the upside and the downside.

They have been market leaders off the bottom in March 2009, and they peaked in 2007 well before the market. They peaked about two weeks before the market in April and have led it down in this correction.

If financials begin to act better, the market should follow; and if they languish, then the market is likely to do no better.

Financials in particular and the market in general, have been plagued with a variety of worries since April, when concerns about the Greek financial situation led to a more generalised worry about sovereign debt. The BP oil spill, Goldman Sachs coming under fire from the Securities and Exchange Commission, gold’s relentless rise, the shape of the financial reform bill, the spectre of higher taxes as the Bush tax cuts expire, all weighed on the market during this swoon.

To say that they caused the market drop, though, is a stretch. “What will the stock market do, Mr Morgan?” someone asked JPMorgan over a hundred years ago. “Fluctuate,” he is said to have replied. That’s what markets do, and in late April after eight straight weeks higher, the string was broken. The news is always a mix of positive and negative. When markets decline, people point to the negative news; and when it increases, the positive news is emphasised.

This decline has led to elevated levels of bearish sentiment, and bearish activities, such as rising put call ratios, which is probably setting the stage for a rally. I hope so. But hope is not a strategy, as the saying goes.

Having a long-term strategy may seem quaint in a market dominated by high frequency trading, the 24-hour news cycle, the ubiquitous and shrill blogosphere, flash crashes, and where it is repeated as if divinely given that buy and hold is dead.

The summer of 2010, though, when most global markets are down, pessimism about the future is high, and macro concerns predominate, is one of those rare periods where one can reliably adopt a long-term strategy that promises (but of course cannot guarantee) returns superior to what just about everybody else is now doing.

The public’s distaste for equities is palpable and understandable. Negative returns for 10 years in stocks while “riskless” Treasuries have soared, and right after one of the best six months Treasuries have had in the decade, is more than enough to convince folks that stocks are not good long-term investments.

Then there is the really long term. Long-term Treasuries, as measured by the Barclays Capital Long Term Treasury Bond total return index, have beaten equities as measured by the S&P 500 in the year to date, and in the 3-, 5-, 10-, 15-, and 20-year time frames. It’s a tie at 25 years. More than 20 years of superior returns over stocks in an asset guaranteed by the US government seems to be sufficient to drive a stake through the heart of the idea that you want stocks for the long term.

It’s a truism in capital markets that the best investments are those that have previously done worst, where expectations are low, demand is down, and prospects appear at best highly uncertain. In 1980, bonds had been through a 30-year bear market relative to stocks, inflation was soaring, yields were at historic highs, yet expected to go higher, and a long bull market in bonds was at hand.

The idea that US interest rates would be near all-time lows 30 years later would have been dismissed as ludicrous. The situation is now reversed, with stocks having underperformed bonds for decades.

The point here is simple: US large capitalisation stocks represent a once-in-a- lifetime opportunity in my opinion to buy the best quality companies in the world at bargain prices. The last time they were this cheap relative to bonds was 1951. I was one year old then, but did not have sufficient sentience to invest. I do now, and if you are reading this, so do you.

Bill Miller is chairman and chief investment officer at Legg Mason Capital Management

Hersh Cohen Interview

The later part the interview where Hersh Cohen summarised his investment rules is very educational.

1. Always keep a record of your investment mistakes. That reminds me of another great comment on investment: "Investing is not an art, it is a trial and error."

2. Only buy what you can understand. The company must pass the "smell test".

3. Appreciate the expectation factered in the price. Be contrarian. The time to sell is when you feel good at yourself and the time to buy is when you are scared to death. Learn to manage the emotions. I think Hersh's degree in psychology certainly helps him greatly in this respect.

4. Emphasis on Fundamental analysis and only buy high quality business.

TED Talk - Chip Conley: Measuring what makes life worthwhile

Inspiring talk about the value of intangibles and the new application of Maslow's motivation theory!

Li Lu talk in Columbia

Li Lu is one of the candidates to succeed Warren Buffett as CIO of Berkshire. He is also a friend of Charlie Munger and reviewed the first Chinese edition of Charlie's Almanack. His experience as value investor is very illuminating and educational.

Clive Peeters

Clive Peeters recently fell victim to the soft consumer demand for big-ticket electrical appliances and called in voluntary administration. In the spirit of learning from vicarious experience, I prepared a quick post-mortem analysis in the following.

The company was floated in Sep 2005 issuing 40million shares at $1. The underwriter was Austock. Initial market cap was $127million. Raised capital was used to acquire Rick Hart Group in WA and the Michael King Store in Melbourne (total $10m), retiring existing debt and pay a dividend to existing shareholders (total $11m); remaining funds was used for further expansion. The company expected to make around $13million in FY2006 and had earning per share of 10cents.

Before listing, the business enjoyed 25.5% compound sales growth from 1993 to 2005 through expansion in Victoria. The business had only one store in 1993, located in Ringwood, Victoria.

As in the nature of things, the failure of a once successful enterprise is generally attributed to multiple factors:

1. Aggressive acquisition based growth results in poor operational integration and additional leverage. The number of stores grew from 23 in 2005 to 48 in 2008 (doubled in less than three years). The company reported a trading loss in 2009 and started to shut down stores.

2. The business’s expansion in a new geographic territory (NSW) failed to turn a profit. It is hard and takes time to build a national brand name. The NSW operation generated a trading loss of $6.5million in FY2007; $4.4million in FY2008. Turnaround of retail operation is extremely hard, as noticed by many investors.

3. A $20million embezzlement occurred by a senior accountant.

4. Loss of sales in high growth, high margin home entertainment and technology category, probably due to the expansion of category killer JB HiFi. The company’s traditional mix of sales (58% whitegoods and cooking, 42% home entertainment and technology in FY08) shifted to 64% and 36% in FY09.

5. Tough retail environment and global financial turmoil.

The share price of Clive Peeters had a fantastic run since listing and touched $3.50 in early 2007 (more than three-fold increase) after the company kicked start the acquisition program. After the problem of the NSW operation occurred, the share price dropped sharply then rebounded briefly (dead cat’s rebound) in late 2007 and resumed the relentless decline. The market basically priced in the bankruptcy after the share price dropped below 50c.

In my opinion, two key lessons can be learned from Clive Peeters’ five-years public market history:

1. Be aware of aggressive growth strategy of newly listed small cap companies. There are many cased of small businesses listed with the intention to consolidate and most is doomed to fail. Only a tiny number can grow big and dominate their respective industries. It is important to monitor closely and make a careful judgment whether the inflextion point has been reached.

2. Retail is a tough business and debt should only be used sparingly.

What drives people?

Munger on China