by Tom Sullivan (Barron’s)
DON’T WRITE OFF Bill Miller quite yet.
The aggressive manager of the Legg Mason Value Trust, whose remarkable run of success preceded a more recent patch of dreadful yearly returns, is again near the top of his peer group in 2009. Through last Thursday, the Value Trust (ticker: LMVTX) was up a whopping 37.52% so far this year, putting it in the fifth percentile (top 5%) of all large blended-fund returns. It’s an amazing about-face from early March, when his fund had lost 72% of its value in a matter of about 18 months.
“The shareholders who stuck with us believed in our process and have seen us underperform; it has happened before,” Miller told Barron’s in a recent interview. At least “we built up large tax-loss carry forwards, which will mean no capital-gains taxes, which may go up.”
Miller, 59, is best known as the only fund manager to beat the returns of the S&P 500 Index for 15 consecutive years. This unprecedented performance made him a financial-media star who was named “Fund Manager of the Decade” by Morningstar.com in 1999, the same year Barron’s selected him as a member of its All-Century Investment Team. In its best year, in 1998, the Value Trust gained 48%, topping the S&P 500′s 28.6% return. Among its big winners that year: AOL, Dell (DELL) and Danaher (DHR). By 2007, assets of Value Trust had soared to about $20 billion.
BUT MILLER’S WINNING streak actually ended the year before, followed by a precipitous fall from grace. Miller’s value style of investing — which he has referred to as “contrarian value investing” — didn’t do well in markets that favored oil and other commodity stocks. In 2006, the Value Trust rose 5.9%, lagging the S&P 500′s 15.79% gain; in 2007 it fell 6.7%, compared to the S&P’s 5.49% increase. And then, in 2008, Miller’s big position in financial stocks such as Lehman Brothers resulted in a 55.1% loss, well ahead of the S&P’s 37% drop.
Investors, not to mention financial publications like Barron’s (“Penthouse to the Outhouse,” Aug. 14, 2006), criticized his approach and commitment. Although we wouldn’t recommend chasing recent performance or making it a primary holding, Value Trust, as a small piece of a balanced portfolio, is worth revisiting.
Miller says his biggest recent mistake was misreading the financial crisis. He thought he was seeing a repeat of the liquidity crisis that precipitated the stock-market crash in 1987. “We bought financials after the Fed [first] injected liquidity” into the market by cutting the discount rate on Aug. 17, 2007, and then the fed-funds rate on Sept. 18, 2007, continuing into 2008. “That’s what you do in a liquidity crisis,” Miller says.
But this time was different. “This turned out to be a collateral-driven crisis caused by underperforming debt,” also known as toxic assets, Miller says. “We’ve analyzed that mistake and tried to make adjustments to risk management and the portfolio-construction process.”
His fund had 46 stocks as of June 30. Since 1991, the fund has had as few as 30 names and as many as 60.
Miller’s portfolio formerly included Bear Stearns, a long-time holding. “When it failed in March , it had the highest capital ratios ever. There was no rogue trader” like the one who caused the collapse of Barings Bank in 1995, nor the legal problems that eventually brought down Drexel Burnham Lambert in 1990, he says. “But that didn’t stop a run on the bank,” adds Miller. Bear was eventually purchased by JPMorgan Chase for $10 a share, leaving Value Trust with a huge loss.
Lehman’s collapse stunned the credit markets and undercut the money markets in particular. “Lehman was investment-grade Friday and worthless short-term paper on Monday,” Sept. 15, 2008, Miller notes. (Given the Federal government’s prior forced fire-sale of Bear, many thought Lehman would also be saved). Miller blames the feds for the Lehman debacle, saying their “pre-emptive seizure” of Fannie Mae (FNM), another ill-fated Value Trust position, and Freddie Mac (FRE) caused the other financial dominoes to fall.
The Bottom Line:
If you can live with a concentrated portfolio that tends to veer from index returns, Legg Mason Value Trust is worth a fresh look after a disappointing run.
“It was a gratuitous wiping out of equity capital,” says Miller, referring to the preferred shares issued by the mortgage giants as their troubles grew. The government, he adds, “told them to sell capital.” He bought the stock because they both met capital requirements and Fannie had been bailed out once before. “I expected forbearance like in the early 1980s, but they didn’t do it this time.”
THESE AND OTHER LOSING positions have given Miller a huge hole to climb out of. There has even been some speculation about Miller’s retiring after getting the fund on a better performance track. Miller brushes off the talk. “I should have retired three years ago,” he jokes.
Redemptions have continued this year, leaving Value Trust with just $4.7 billion in assets, down from its roughly $20 billion peak. For investors who held on during the markets’ collapse, a decade of gains was wiped out. The fund has a three-year annualized loss of 14.6% through Monday; its five-year return amounts to a decline of 5.92%, and its 10-year performance is in the red by 1.82% a year, on average. The three- and five-year returns put the fund in the 99th percentile (or lowest 1%) in its category. The 10-year performance inches it up to the 91st percentile.
Legg Mason ‘s (LM) share price has also suffered in recent years, along with many asset managers’. The stock closed Thursday at 31.64, after having traded as high as 140 in the past five years.
Miller says he’s been through this kind of snapback before. His previous consecutive years of underperformance relative to the S&P 500 came in the 1989-1990 period. Overall, he’s beaten the benchmark in 20 of his 27 years running the Value Trust (He began managing it at its inception in 1982.) “We’re coming off a financial crisis; those things do end. Then we’ll have a recovery,” he says. He points to 2003, when the Value Trust rebounded 43.5% after a selloff in markets that bottomed in 2002. The downturn was sparked, says Miller, by Fed Chairman Ben Bernanke, who vowed to throw cash from helicopters to boost spending. He calls that statement “a preview of the motion picture,” referring to the Federal Reserve’s current policy of quantitative easing, or printing money.
Miller’s timing was also much better in late 1999, just prior to the dot-com bust, when Value Trust got out of technology positions it had established in 1995. But “if you do this long enough, the market has a way of making you look stupid from time to time,” Miller says.
Professor George Comer of the McDonough School of Business at Georgetown University, and the chief academic officer at MUTUALdecision, an online tool that ranks 3,000 equity mutual funds, calls Miller’s recovery this year and his previous 15-year run “amazing.” His firm gives Miller an “A” for investment skills, its highest grade. “Even the best have bad stretches,” Comer says. “The bounce back is no fluke.”
Miller has “always had clunkers, but his winning stock picks always made up the difference in the past,” says Bridget Hughes, senior analyst at Morningstar. “He’s an aggressive, bold manager. A lot of research goes into the portfolio, which is very concentrated. He has high conviction,” she says.
But Hughes doesn’t see signs of a fundamental shift in management. The portfolio “may be a bit more diffuse than in other times,” she says, but “he hasn’t changed his approach. He went back into financials, but this time they didn’t blow up on him.”
Still, “a little bit of Bill Miller goes a long way” in a portfolio, Hughes says. “He will perform differently than the indexes and that comes with risk.”
Miller says his form of value investing takes “both words seriously.” He invests “in businesses, not just stocks” and tends to hold shares for a long time — usually about five years. His portfolio, he explains, consists of names that are “cyclically mispriced” (traditional deep value) as well as stocks that are “secularly mispriced.” All the securities trade at a discount to the firm’s assessment of their intrinsic business value. He defines that as the present value of the future free cash flows.
Miller notes that one observer has said Value Trust’s investment style is to be “long headline risk and short conventional thinking,” a description that he claims is apt.
SO WHAT STOCKS DOES MILLER like right now? A little more than 25% of the portfolio remained in financials as of June 30, 2009. Positions included State Street (STT), NYSE Euronext (NYX) and Goldman Sachs (GS).
But he also is enamored of Aetna (AET), UnitedHealth (UNH) and Aflac (AFL).
“This is the best time to buy health care since HillaryCare,” in the early 1990s when the prospect of national controls on the industry sent the stocks reeling, says Miller. The possibility of a public option in ObamaCare, where the federal government competes with private insurers, is receding. At the same time, more people will be getting managed care.
Aetna, trading around 26 with a price-to-earnings ratio of 8.1 times forward earnings, is a top pick. “It has a great balance sheet, it is buying back stock, and it has good management,” he says.
Another favorite is eBay (EBAY), the online-marketplace operator, which also sells online payment and communications services. Barron’s profiled the company favorably in a cover story in the summer (“Make a Bid!” Aug. 3, 2009). It trades around 24, or about 15 times forward earnings. Miller has faith in the new management and sees the beginning of a turnaround. “It’s more buyer-centric than seller-driven; it has a dominant position and no inventory risk,” he says.
He’s also a big fan of IBM (IBM), which he likens to Edgar Allan Poe’s “The Purloined Letter,” hidden in plain sight. “It’s cheap and safe and grew 15% during the financial crisis,” he notes, adding that its dividends nearly doubled since 2006. IBM also has “a dominant global position and isn’t levered” with debt. The stock trades around 124, or 11 times forward earnings. Another tech play Miller likes is Hewlett-Packard (HPQ), trading around 47, also 11 times expected earnings. It has “great free cash flow and a strong balance sheet.”
AES (AES), the global power company, is Miller’s biggest single holding. It trades around 15, or for 12 times forward earnings. “It’s had lots of ups and downs,” Miller says. “It was one of our favorites in the 1990s but after the Enron collapse at the start of this decade, it fell out favor. But it is widely diversifying, including into wind and solar power, and most of its earnings are locked into growth contracts.”
Overall, Miller believes the market in the next five to 10 years will see “a long-lasting rally in very high quality mega-caps after this one-year ‘dash to trash.’” He still sees bargains despite the incredible run-up since March. “You can buy the best in the market and still outperform for many, many years,” he says.
If Bill Miller is right, that’s wonderful news — for him and most investors.