Bill vs Bill.
Bill Miller the Sultan of stock vs Bill Gross the bond king.
>>Bill Miller: The Sultan of Stock
Miller, who oversees Legg Mason Value Trust fund, is the only manager to have beaten the S&P 500 for 11 years in a row.
FORTUNE: Is the selloff almost over?
MILLER: Look, you can never call a bottom. We began buying some of the telecom equipment names in spring and summer of 2001 because we thought more than a year into the decline a lot of those stocks were within maybe three to six months of bottoming. We were early. It was a mistake. But there are a whole host of things going on now that tell me that the market is in a bottoming process. Take the duration of the decline--22 months. That's equal to the '73-'74 decline. Go back to the Great Depression, and that market was 30 months from the peak in 1929 to the bottom. What we're seeing is something the vast majority of people haven't seen before because this is a once-in-a-generation--or once- or twice-in-a-century--type of event. What's good is that the levels of pessimism reflected in a lot of the technical indices, the outflow of mutual funds, the declining retail participation, the significant decline in speculative activity, the drying up of the new issue calendar--these all indicate a bottoming process.
FORTUNE: So is this a golden opportunity?
MILLER: Not really. If the market's valuations were seven or eight times earnings, or even ten times earnings [the S&P 500 is trading at an average 2002 price/earnings ratio of about 22], I'd say it was a golden opportunity. There is an opportunity to do quite well, but overall market valuations are not compelling. Even if we are right that the equity market is attractive right here, that doesn't mean that the difficulties that led to this situation have disappeared and that we'll have 15% returns. We're in the camp of 6% to 8% annual returns--not thrilling, but wonderful compared with losing money.
FORTUNE: Then what will it take to beat the S&P 500?
MILLER: The key is avoiding the areas that have been terrible. Most stocks, something like 60%, are outperforming the market. Sometimes the market is a democracy, meaning everything goes up. Sometimes it's a meritocracy, and few things go up. In all markets I look for very high rates of return over my forecast time horizon. A stock may be performing very poorly in this environment and still be a great investment over a number of years. We want to know how stock prices depart from underlying value and why. That can be on the upside as we saw with the Internet, when most companies weren't worth anything like the market thought they were worth. What we want is the reverse--tremendous pessimism, people believing that a business is broken, scandal, something everybody is fleeing from--in short, what we're seeing today. That has pointed us to business models that are in the process of changing and that people don't fully understand, like Barry Diller's USA Interactive, or companies that are right in the cross hairs of what everyone is most afraid of, like Tyco.
FORTUNE: Tyco? Why would you go near something that radioactive?
MILLER: What's so radioactive about Tyco? We own a lot of it. We bought it in the first quarter, which was obviously early, but have been buying 500,000 shares a day for quite some time. Tyco's problems, so far, are not Tyco's problems. They are [ex-CEO] Dennis Kozlowski's personal problems. There is no ongoing SEC investigation of Tyco's accounting--not yet, at least. The SEC conducted such an investigation in 1999 and found there wasn't any issue with Tyco's acquisition accounting. What's scaring people right now is that they look at what WorldCom did and wonder if Tyco didn't do the same. We are not in that camp. As we go through the company, our central valuation is about $30, twice where it's trading. With a better environment, we could see it go to the mid-40s. We think there's a big margin for safety in the stock.
FORTUNE: You've been particularly vocal about stock options.
MILLER: Yes. The promiscuous issuance of options creates a serious problem for the equity investor because the equity investor is suffering substantial yearly dilution of his future returns as a portion of those returns are transferred to management and employees. In that environment bonds have the great advantage that management cannot take those returns away, whereas the equity investor has been a full participant on the downside but only a partial participant on the upside.
FORTUNE: What's to be done?
MILLER: If stock options cannot be honestly accounted for, then they should be eliminated. Companies that lobby to keep the estimated expense of stock options off the income statement are advertising their intent to deceive and contributing to--almost causing--the crisis of confidence. We're systematically paring down or eliminating positions in the portfolio where we have evidence that the management manipulates the stock option program to their advantage or ignores shareholders' majority votes on resolutions. We're really raising the threshold for managements. Now, if I'm so interested in corporate governance then why am I buying Tyco? Tyco is going to get a lot better corporate governance than it has had, and so are a lot of other companies. If we believe there is going to be better responsiveness to shareholders, that is a big plus.
FORTUNE: Other than Tyco and USA, where do you see opportunities?
MILLER: We've ramped up some of the more speculative names like Nextel and AES. I also think some of the financials are well positioned: Fannie Mae in the low 70s, Citigroup below $40. [Mortgage insurer] MGIC is another value. Here's a company that earns 25% on equity every year and has grown its earnings every year for ten years at 15%, has a sterling balance sheet, is overcapitalized, and trades at nine times earnings. For people with an appetite for scarier things, Lucent and Qwest are attractive.
FORTUNE: You've said the guy with the lowest average cost wins. How so?
MILLER: A lot of people will pay $30 for a stock, and it goes to $20 and they wait for the stock to act better before they buy more. But if it goes from $20 to $30 and you doubled the position at $20, now your average cost is $25. If you wait you gain nothing. We would prefer to buy stocks at the exact low, but as Bernard Baruch said, "Nobody buys at the low or sells at the high except liars." We know that when we buy them they're going lower, and we should be willing to continue buying.
FORTUNE: So what's the bottom line?
MILLER: The second half of the year is going to be much better than the first.
FORTUNE: Will bonds beat stocks again this year?
MILLER: At the beginning of the year, I thought stocks would outperform bonds. I've been wrong, since bonds are about 2,500 basis points ahead of the S&P 500. Given the wide gap, I believe bonds will outperform stocks this year. Looking out three to five years, I think stocks will outperform bonds from here.
Or will bonds beat stocks? See Bill Gross: The Bond King.
Bill Gross: The Bond King
Gross manages Pimco's Total Return bond fund, which boasts a ten-year average gain of 8.3%.
FORTUNE: Can bonds beat stocks for a third year in a row?
GROSS: Oh, yes. You know, there have been other periods when that happened. To my way of thinking we are definitely in one of those periods in which over a number of years--and it doesn't have to be a three-peat or a four-peat, it can be five out of six or six out of nine--bonds should do better than stocks. I can tell you high-quality bonds will only give you 4%, 5%, and 6% returns over the next few years. We continue to like the mortgage market. It's a safe haven. It provides yields of 6% with triple-A quality. We've also moved selectively into the corporate market over the past few months. And there are even some good plays in the emerging-markets sector, such as Mexico, that should benefit from a mild global recovery and should boost total returns.
FORTUNE: What's your take on the stock market?
GROSS: Obviously, the euphoria is turning into despair. To the extent that investors are afraid of their shadows as well as CEOs and other goblins in the night, there is a positive for stocks. But as that is happening, there's a problem that no one is talking about. And that's that all the corporate pension funds that have benefited in the past few years simply because stocks had done well didn't need to put money into their own funds. Now, as stocks sink, there will be a need for companies to put money into their pension funds, and that will hurt earnings. It's a huge negative. That's why I think over the next five years bonds will probably outperform stocks by a few percentage points, but both will return much less than double digits.
FORTUNE: So should we be buying bonds?
GROSS: Buying a bond is to a considerable extent buying a safe haven. When the storm is brewing, bonds are relatively stable in terms of their value. Now, examples such as WorldCom are disproving that, but the high-yield and the corporate-bond markets have always been sort of volatile. High-quality bonds are anchors that let investors sleep better than they would if they were holding only stocks. The current market only proves that in spades.
FORTUNE: You're known for having a keen eye when it comes to the economy. What are you seeing?
GROSS: We've got an economic recovery. We had a 6% first quarter for GDP. We're probably going to have 3% in the second and third quarter. It's just that when you look at the Dow and the Nasdaq every night, you figure we've got to be in a depression. Well, we're not. The economy is improving and earnings are recovering. The problem for a lot of investors is that the prices of stocks were so high that they're still in the process of adjusting toward the new world reality of 2002. The new reality is one in which there is more risk from the standpoint of simple security (I'm talking about Sept. 11 and the potential for another event). Plus there's risk from the process of globalization that was the foundation of the 1990s. Companies are wondering whether or not they should be expanding as opposed to hunkering down or pulling back. The budget is going from a surplus to a relatively large deficit, and we face obvious problems in terms of accounting and credibility on top of a weakening dollar. All that could have implications for foreign institutions that own lots of dollars and lots of U.S. securities.
FORTUNE: That sounds bleak. Is there opportunity in disaster?
GROSS: At some point. But when do we step in? We did buy some telecom bonds. We didn't buy WorldCom, thank goodness. We have bought other telecom bonds like Sprint, AT&T, and AT&T Wireless that haven't done very well either. It's not like these are triple-A companies, but they are survivors, and they're earning their yields of 10%. We've been a little premature entering the telecom market. If we hadn't, we'd be kicking the competitors by that much more.
FORTUNE: How much of a problem is the lack of corporate credibility?
GROSS: Huge. We have to determine who we can trust and what numbers we can trust, because we rely on 10-Ks and 10-Qs and Arthur Andersen opinions as well. Hopefully, we have a different slant. But the numbers are the numbers, and if you can't trust the numbers it becomes very difficult for Pimco.
FORTUNE: So what are you doing about that?
GROSS: All lenders have a sacred trust. If lenders can't trust companies, then the game of money exchange is over. So we have a huge responsibility to investigate and to speak out. What I tried to do with General Electric [in March, Gross rebuked GE for carrying excessive short-term debt and for lack of financial disclosure] was not to pillory the company but to use them as an example and to suggest that, hey, if the pinnacle of American corporations is playing tricks and games with income statements and balance sheets and is relying too much on short-term debt, then perhaps much of the rest of corporate America is doing the same. I wanted to keep the ball rolling in terms of this need for corporate disclosure and this need to straighten up, to become more conservative, more ethical, and more reasonable in terms of the investment and lending process.
FORTUNE: What portion should bonds occupy in investors' portfolios?
GROSS: It all depends on age and what the money is needed for. An old maxim says that if you hold onto stocks for 30 years you can't go wrong. I agree ... the riskier asset should return more. But it usually takes longer periods of time for that maxim to be proven. In the late 1990s investors went too far with the belief that only stocks would provide a nest egg for their retirement years. That illusion allowed investors to fill up their 401(k)s with portfolios of 100% stocks. That was never justified because of exactly what we've seen over the past few years. Things can go wrong. Things can change. Because of that you need to be diversified. The older you are, the more bonds you need, and the younger you are, the fewer you need. But any age group needs a relatively healthy dose of bonds [Gross declined to give specific percentages] if only to allow the investor to sleep at night and to survive shorter periods--namely two years, five years, ten years--of underperformance. Many of these investors are not only saving for retirement but have college for their kids to keep in mind and other shorter-term goals.
FORTUNE: What should an individual investor be doing?
GROSS: Investors need to diversify. The key will be safe, stable, and secure streams of income. I would emphasize high-quality corporate bonds as well as mortgages and stocks with relatively high dividends. Treasury yields are too low, and I wouldn't be a buyer right now.
FORTUNE: What's your bottom line?
GROSS: The next six to 12 months are going to be stinkers for most stocks and for high-risk bonds that depend on hope. |
