On a day when two of the industry's silliest personalities are slinging arrows at one another, I wanted to call your attention to an investor that actually deserves some recognition. Unlike Jim "Mad Money" Cramer and Henry "Internet Bubble" Blodget, Bill Miller has actually proven himself to be a sterling investor; one of the industry's best.
For those who don't know Miller, his $21B Legg Mason Value Trust (LMVTX) fund had beaten the S&P 500 return for FIFTEEN (15) consecutive years until he fell short of the mark in 2006. This streak is absolutely astounding and one that's made Bill respected throughout the industry.
Miller addressed the end of his streak in his quarterly newsletter and it's a fantastic read.
Active managers are paid to add value over what can be earned at low cost from passive investing, and failure to do that is failure. We underperformed the S&P 500 in 2006 and did not add value for our clients and shareholders. It is little consolation that most mutual fund managers failed to beat the index in 2006, or that most managers of US large- capitalization stocks fail to outperform in most years, or that under 25% of them can outperform over long periods such as 10 years, or that the next longest streak among active managers going into 2006 - 8 years - also ended this year, or that it is believed that no one else has outperformed for 15 consecutive calendar years.(1) We are paid to do a job and we didn't do it this year, which is what the end of the streak means, and I am not at all happy or relieved about that.
It's very easy to want to make excuses when you fall short of your benchmark, and Miller has built up enough goodwill to simply say "we'll get them next year." Yet, he's set an expectation of excellence for himself and his team that makes excuses unacceptable.
There was, of course, a lot of luck involved in the streak...What are the chances it was 100% luck? There are two broad ways to look at it, one involving a priori, and the other a posteriori, probabilities. If beating the market was purely random, like tossing a coin, then the odds of 15 consecutive years of beating it would be the same as the odds of tossing heads 15 times in a row: 1 in 215, or 1 in 32,768. Using the actual probabilities of beating the market in each of the years from 1991 to 2005 makes the number 1 in 2.3 million. So there was probably some skill involved. On the other hand, something with odds of 1 in 2.3 million happens to about 130 people per day in the US, so you never know.
...On the definition of value investing
Analytically, we are value investors and our securities are chosen based on our assessment of intrinsic business value. Intrinsic business value is the present value of the future free cash flows of the business. I want to stress that is THE definition of value, not MY definition of value...
...Trying to figure out the present value of the future free cash flows of a business involves a high degree of estimation error, and is highly sensitive to inputs, which is why we use every valuation methodology known to assess business value, and don't just do discounted cash flow analysis. We pay a great deal of attention to factors that historically have correlated with stock outperformance, such as free cash flow yield and significant stock repurchase activity. It all eventually comes down to expectations. Whether a company's valuation looks low or high, if it is going to outperform, the market will have to revise its expectations upward.
While Miller's observations relate to his take on value investing, his conclusions hold true for growth oriented investors, too. As any technology investor can attest, a company's stock performance is often as much about the direction of expectations [most commonly expressed as the direction of revenue, cash flow and earnings estimates] as anything else.
...On taking advantage of long-term trends in a short-term world
It is trying to invest long-term in a short-term world, and being contrarian when conformity is more comfortable, and being willing to court controversy and be wrong, that has helped us outperform. "Don't you read the papers?" one exasperated client asked us after we bought a stock that was embroiled in scandal. As I also like to remind our analysts, if it's in the papers, it's in the price. The market does reflect the available information, as the professors tell us. But just as the funhouse mirrors don't always accurately reflect your weight, the markets don't always accurately reflect that information. Usually they are too pessimistic when it is bad, and too optimistic when it is good.
The market is extremely efficient, and trends including globalization, increased use of derivatives, more advanced trading algorithms and advancements in technology have all helped to further remove short-term arbitrage opportunities. Finding the long-term signals amid the cacophony of short-term noise is one of the few ways to sustainably outperform, in my opinion.
...On the importance of factor diversification
A key reason for the streak has been our factor diversification. By that I mean we own a mix of companies whose fundamental valuation factors differ. We have high PE and low PE, high price-to-book and low price-to-book. Most investors tend to be relatively undiversifed with respect to these valuation factors, with traditional value investors clustered in low valuations, and growth investors in high valuations. For most of the 1980s and early 1990s we did the same, and got the same results: when so-called value did well, typically from the bottom of a recession to the peak of the economic cycle, so did we. And when growth did well, again usually as the economy was slowing and growth was harder to come by, we did poorly, along with other value types.
It's very difficult to comfortably own stocks across multiple factors; because it requires one to have equal confidence in a myriad of valuation methodologies. Where this really falls apart is when the chips are down. If you have made most of your money as a growth investor, it's only natural that any "value" investment you've made is going to have a shorter leash. You're going to lack conviction.
...On the fallacy of naive concentration
It has been wrongly suggested that concentration, owning fewer rather than many stocks, is a strategy that adds value. Studies have shown that concentrated portfolios typically outperform others. All true, but an example of what Michael Mauboussin would call attribute-based thinking. The real issue is the circumstances in which concentration pays, not whether it has in the past.
...Concentration works when the market has what the academics call fat tails, or in more common parlance, big opportunities. If I am considering buying three $10 stocks, two of which I think are worth $15, and the third worth $50, then I will buy the one worth $50, since my expected return would be diminished by splitting the money among the three. But if I think all are worth $15, then I should buy all three, since my risk is then lowered by spreading it around. For much of the past 25 years, there were those $10 stocks worth $50 around. For the past few years, they have been largely absent, as inter-industry valuations have only been this homogeneous about 2% of the time.
If you haven't guessed by now, I have an immense amount of respect for Bill Miller and think his partner letter should serve as a lesson to investors everywhere. Maintain an investment discipline, but never stop re-evaluating yourself and your methodologies. Don't make excuses, find answers. Understand what's working, what's not and how much of that relates to factors you can actively manage. Thanks for the lessons Bill, not get back to work starting a new streak.