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April 24, 2008
Miller’s Bull Market Brainpower

Bill Miller, Chief Investment Officer and Portfolio Manager of Legg Mason Value Trust, released his quarterly letter yesterday.  Not surprising, Mr. Miller attempted to frame his ‘awful quarter’ in the context of his more exciting long-term track record versus the S&P 500:

“To put our results in some context, in our 26-year history, we have outperformed our benchmark 20 calendar years and underperformed 6 calendar years. Since I assumed sole management of the fund, we have outperformed 15 years and underperformed 2 (the last 2 obviously).”

With Miller’s fund now trailing the S&P 500 on a 1, 3, and 5-year basis and barely ahead over the last 10-years (annualized), his recent bout of underperformance is (obviously) becoming a more difficult sell to potential investors.  Regardless, the supposedly value minded Miller adds:

“While neither I nor anyone else knows if our period of underperformance is over, it ought to be, if valuation begins to matter more and momentum less in how the market behaves.”

Let’s take a quick look at what the word ‘valuation’ means to Mr. Miller. His funds top holding, Amazon.com, currently trades at more than 42 times free cash flow, 67 times trailing EPS (54 times FY08 EPS) and has $1.078 billion tangible equity (with $1.077 billion in inventories) contrasted against a $33 billion market cap.  Whether or not Amazon is a solid company is not the question. Rather, on what planet this man can utter the word ‘valuation’ with a straight face when his top holding offers absolutely no attractive valuation story is (even AMZN’s PEG ratio is dangerously high at 2.26). Similar valuation nightmares are seen in many of Miller’s other top holdings, many of which are dividendless and very expensive, with the exceptions being AES Corp. and JP Morgan (or a couple ‘value’ orientated candidates).

Unable or unwilling to explicitly point out why his darts have not been hitting the board in recent years, Miller vaguely talked about ‘tangible value’ and ‘intrinsic’ worth to close out his optimistic letter. He also completely glossed over his Bear Stearns position because, in his mind, all of the company’s ‘tangible value’ has been transferred to JPMorgan.

“Our portfolio, in my opinion, is in excellent shape, despite, or more accurately because of, its performance. Prices have declined substantially more than business values. On the Monday Bear Stearns opened for trading after its sale to JPMorgan, the stock of the latter increased in value by the rough difference between the price agreed to (then $2 per share) and the mark-to-market book value of Bear Stearns, about $90 per share including the value of their building. While the price of Bear was around $2, the market understood the tangible value was about $90, all of which accrued to JPMorgan’s shareholders. While the press focused on our ownership of Bear Stearns, our position in JPMorgan was nearly three times larger.

Many of our top 10 holdings sell at less than half our assessment of their intrinsic business value (defined as the present value of their future free cash flows), an unusually wide discount.”

Is Miller A Bull Market Memory?

By default some money managers will outperform the markets, but this doesn’t necessarily mean that their choices represent sound investment decisions.  Liken this situation to that of 10,000 people repeatedly flipping coins and after 15-flips only 10 individuals are left owning a perfect heads or tails flipstreak.  Should we applaud these 10-individuals as having a gift?

Bill Miller selected companies that tended to ‘outperform’ during the ‘good times’.  However, his more recent track record and his increasingly wishful thinking on the U.S. economy and financial markets leave much to be desired.  Quite frankly, and remembering that Miller starts out each year losing money because of fees, that he continues to be heavily positioned for a rebound in the U.S. economy and financial markets could be dangerous given that he is taking this position as the U.S. economy battles a recession and before U.S. stocks enter a traditional bear market.

“Despite moving higher over the past month, the U.S. market and most others around the world are down for the year, and fear and risk aversion still predominate. Yet valuations in general are not demanding, interest rates are low, and corporate balance sheets, especially in the U.S., are in excellent shape. That sets the stage for what should be an improving environment for investors in stocks and in spread credit products, if not in government bonds where risks are high and opportunities low, in my opinion. With most investors being fearful, I think it makes sense to allocate some capital to the greedy side of that pendulum, and that means putting cash to work in equities.”

After reading the above you can not help but wonder if Mr. Miller will ever conclude that it is a good time to put less capital into equities.  After all, Miller ended 4Q07 and entered his ‘awful’ quarter with only 1.89% in ‘cash’ and ended 1Q08 with only 3.59% in cash.  Do these cash tallies contradict Miller’s suggestion that now is the time to be greedy and put ‘cash to work in equities’?

Suffice to say, as Miller attempts to exploit Buffett-spun logic and insists that he has been pummeled by an increasing gap between value and price (yet another Buffett theme), the really value minded investor gets a severe headache when he states the following:

“Although the economy is likely to struggle as it did in the early 1990s, the market can move higher, as it did back then.”

But what if the U.S. economy really goes to crap, the markets move lower, and investors need absolute not relative performance?  Are your capital allocation and company choices well prepared for this outcome Mr. Miller?

Obviously they are not.  Rather, the potentially overly optimistic Miller has doubled down, and the Pitt boss is watching the situation very closely. The recovery Miller is gambling on had better arrive soon or his chip pile risks being further depleted: Miller’s ‘Value Equity’ assets under management crashed by $11 billion from 4Q07 to end 1Q08 at $29.7 billion.
 

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