Jonathan Davis: The sign of these times is risk

Bill Miller, a well-known American fund manager, had some interesting observations in his recent presentation to investors in London. Mr Miller is the only US general equity fund manager to have beaten the S&P 500 index in each of the past 12 calendar years, which shows he is very lucky, or very smart. His Legg Mason Value Trust has grown at a compound rate of 14 per cent over the past 10 years, though it is inevitably down from its peak three years ago.

Mr Miller is billed as a value investor, but in practice adopts a pragmatic, probabilistic approach to investment. Others pay homage to the likes of Ben Graham and Warren Buffett as mentors, but he draws his inspiration from a world poker champion, Puggy Pearson. "There ain't but three things to gambling," Mr Pearson is fond of saying. "Knowing the 60-40 end of a proposition, money management and knowing yourself."

Investment, Mr Miller says, is not much different. Nobody knows for certain the way the world is going to turn out. Investors need to marshal their capital with care, place their bets on an assessment of what the probable outcomes are, and know themselves sufficiently well to control their reactions at times of euphoria and stress.

Professional investors, he adds for good measure, are far too busy in their portfolios. Mutual fund managers in the United States (as here) tend to turn over their entire portfolios more than once a year. This puts an impossible drag on their ability to outperform the market over time.

You may be relieved to know Mr Miller is bullish about shares again, though it has to be said (as he admits) that he has called the bottom of the bear market three times. He thought markets had bottomed the first time in September 2001after the immediate shock of the terrorist attacks in America, and in July last year. Now he says he is confident the stock market did in fact bottom out in October last year (unlike the UK market, which hit new lows only last week. The US market has not retested its October levels since).

History is one reason he gives for thinking more positively about shares. All the conditions that typically mark the start of bull markets – dropping interest rates, easy money, investors redeeming equity holdings, profits falling – are falling into place, he says. The stabilisation of investment-grade and junk-bond markets started in the final quarter of last year, a further indicator that a strong rally is possible. Looking back on history, you can see 2002 was among seven years in modern financial history, he says, when the stock market ended the year showing a five-year loss. Every time this has happened, the subsequent five years have produced an average return of more than 15 per cent a year compound.

Even if you assume that the 10 years from the market peak in 2000 are going to be as bad as the worst 10-year period for shares (which was 1928-1938), it would still mean that investors can look forward to a return of more than 5 per cent compound from holding shares over the next seven years. That may not be great shakes – like many others, Mr Miller predicts that equity returns in the medium term are unlikely to be much higher than 6 to 8 per cent per annum – but it does provide a measure of confidence that the balance of probabilities is back in positive territory. This is doubly so when you consider that risk-free assets, such as Government bonds, to which equities are routinely compared by investors, are looking overbought. Mr Miller says short-term and 10-year Government bonds are as overvalued as equities were at the height of the bubble in March 2000. He points out that investors in six-month Treasury bills for security are, in effect, settling for negative real returns.

The implication of this is that investors who can handle the risk of seeing their equity portfolios decline further in value in the short term, which many cannot, should be adjusting their weightings in favour of more risk exposure. Mr Miller says his personal asset allocation today is 100 per cent equities, and for the first time in five years he has opened a new brokerage account to buy shares on margin.

On the US economy, Mr Miller had two thoughtful observations. One is that, if the Iraqi war goes well, he expects that President George Bush's much-derided dividend tax-cut proposal will sail through Congress. That will be positive for equities and reinforce the trend towards income as the primary driving force of equity returns for the next few years. A big impetus here will be the behaviour of managers of large corporations, many of whom have acquired large shareholdings through the exercise of stock options.

"The one thing that is very clear about CEOs is that despite their fiduciary duties, they have an overwhelming interest in their own personal wealth," he says. "Many who have large stockholdings have said they will declare a meaningful dividend when that passes, because it means tax-free income to them. That is what I expect to happen."

His second interesting observation was that most professional investors are still not ready for the revival of a bull market. In surveys of fund-manager opinion at the start of the year, the majority said they expect the market to rise by between 5 and 15 per cent yet, Mr Miller says. They continue to hold the kind of defensive stocks unlikely to deliver those kind of returns if the market does revive. As always happens at turning points, the bulk of professionals will miss the start of the next big move.

At times like the present, when the uncertainties of war are clouding the immediate picture, and markets are extraordinarily volatile, it is not easy for investors to anchor their feet on the ground and hold to a medium-term investment perspective. As Mr Miller says, anything can happen. But the underlying odds are finally beginning to shift a little.

davisbiz@aol.com