Thursday, February 14, 2008

Bill Miller's Comments

This commentary is from Legg-Mason's fund manager - Bill Miller who has the reputation of being the manager with the longest track record of beating the performance of the S&P 500 with the performance of the Legg-Mason Value Trust fund - sold in Canada through CI Investments as the CI Value Trust Fund.

This commentary will be short and to the point:

We had a bad 2007, which followed a bad 2006. Over this two-year span, we underperformed the S&P 500 by around 2000 basis points, our worst showing since the two-year period 1989 and 1990, where we underperformed by 2500 basis points.

In the 25 years since we started the Value Equity mandate in 1982, we have had six calendar years of underperformance. Despite that 19-6 record against the market, all the losses are painful. They are also unavoidable and unpredictable. It would be great if we could figure out how to never underperform.

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About the only advantage of being old in this business is that you have seen a lot of markets, and sometimes market patterns recur that you believe you have seen before. It is not an accident that our last period of poor performance was 1989 and 1990. The past two years are a lot like 1989 and 1990, and I think there is a reasonable probability the next few years will look like what followed those years.

The late 1980s saw a merger boom similar to what we have experienced the past few years and a housing boom as well. In 1989, though, the merger boom came to a halt with the failure of the buyout of United Airlines to be completed. The buyout boom had been fueled by financial innovation. Then it was so-called junk bonds, which had been purchased by many savings and loans in an attempt to earn higher returns. Now it is subprime loans repackaged into structured financial products.

The Fed had been tightening credit to guard against rising inflation, which began to impact housing. By 1990, housing was in freefall, the savings and loans were going bankrupt (as the mortgage companies did in 2007), financial stocks were collapsing, oil prices were soaring in 1990 due to a war in the Middle East, the economy tipped over into recession, and the government had to create the Resolution Trust Corporation to stop the hemorrhaging in the real estate finance markets.

Eerily similar to today, the situation began to stabilize when Citibank got financing from investors from the Middle East. Although the overall market was down only 3% in 1990, we got trounced, falling almost 17%, the result of our large holdings in financials and other stocks dubbed “early cycle,” and which tend to perform poorly as the economy is slowing or when it sinks into recession.

If it were possible to forecast with any degree of accuracy, one might be able to descry a slowing economy from an examination of economic data and perhaps adjust portfolios accordingly. But unfortunately, as I have often remarked, if it’s in the newspapers, it’s in the price. The process works the other way: stocks are a leading indicator, so first they go down and then the data comes in.

In 2007, financial stocks began to decline in early February, before the market corrected in March. They then rallied into May, began a slow decline that culminated in an intermediate bottom in August when the Fed lowered the discount rate, rallied into early October, and then began the precipitous fall that appears to have made a bottom around the third week of January. The decline in financials reflected the freezing up of credit markets that began in August and which still persists, and was followed by a steep drop in consumer stocks in November that also may have seen their worst days now that the Fed has begun to aggressively cut rates. All of this was accompanied by the decline in the housing stocks, which fell almost continuously throughout 2007, ending with a loss of almost 60% on average.

The financial panic got going in earnest as we entered 2008; with global markets all dropping in the double digits or close to it as of this writing. The so-called decoupling thesis, which maintained that non-US and emerging markets and economies would be unaffected by a US slowdown, while not dead (yet), is severely wounded.

The monetary and fiscal authorities have now begun to move with alacrity, with the Fed cutting the funds rate to 3.0% (with likely more to come), and the administration and Congress coming up with a fiscal stimulus package estimated at around $150 billion dollars. Will it be successful? Yes. More precisely, if these measures aren’t enough to free up credit and stimulate spending sufficient to set the economy on a growth path, then additional measures will be taken until that is accomplished. The important point is that the monetary and fiscal policy makers are focused and engaged, and will do what is necessary to stabilize the markets and restore confidence.

This does not mean that the recovery will be swift, or seamless, or without additional trauma. But there will be a recovery, and I think the market abounds with good value. Those values may get even better if the markets get more gloomy, but they are good enough now for us to be fully invested.

I think the market is in for a period of what the Greeks refer to as enantiodromia, the tendency of things to swing to the other side. This is not a forecast, but rather a reflection on valuation.

All of the poorest performing parts of the market, housing, financials, and the consumer sector—with the exception of consumer staples—are at valuation levels last seen in late 1990 and early 1991, an exceptionally propitious time to have bought them. The rest of the market is not expensive, but valuations cannot compare to those in these depressed sectors.

Bonds, on the other hand, specifically government bonds, which have performed so wonderfully as the traditional safe haven during times of turmoil, are very expensive. (In bond land, the only values are in the so called spread product, and there are some quite good values there.) The 10-year Treasury trades at almost 30x earnings1, compared to about 14 times for the S&P 500. The two-year Treasury yields under 2%, and is thus valued at over 50x earnings!

The valuation disparity between Treasuries and stocks is as great today in favor of stocks as it was in favor of Treasuries 20 years ago. Just prior to the Crash of 1987, stocks yielded about 2% (same as today), but traded at over 20x earnings. The 10-year Treasury yielded over 10%, vs. 3.6% today. The two-year Treasury now has a lower yield than the S&P 500, and that is before share repurchases, meaning you can get a greater yield in an index fund than you can in the two-year, and a free long term call option on growth. Even more compelling are financials, where you can get dividend yields about double that of Treasuries, which only adds to their allure, with them trading at price-to-book value ratios last seen at the last big bottom in financials.

I think enantiodromia has already begun. What took us into this malaise will be what takes us out. Housing stocks peaked in the summer of 2005 and were the first group to start down. Now housing stocks are one of the few areas in the market that are up for the year. They were among the best performing groups in 1991, and could repeat that this year. Financials appear to have bottomed, and the consumer space will get relief from lower interest rates.

Oil prices have come down, and oil and oil service stocks are underperforming in the early going. Investors seem to be obsessed just now over the question of whether we will go into recession or not, a particularly pointless inquiry. The stocks that perform poorly entering a recession are already trading at recession levels. If we go into recession, we will come out of it. In any case, we have had only two recessions in the past 25 years, and they totaled 17 months. As long-term investors, we position portfolios for the 95% of the time the economy is growing, not the un-forecastable 5% when it is not. I believe equity valuations in general are attractive now, and I believe they are compelling in those areas of the market that have performed poorly over the past few years. Traders and those with short attention spans may still be fearful, but long-term investors should be well rewarded by taking advantage of the opportunities in today’s stock market.


S2 said...

Yes we can because we didn't buy a house or a condo.

S2 said...

Oops, I meant to put this in the Can you afford to retire post. Kind of loses something when posted in the wrong spot. I guess I'm not smart enough to retire.

Swirlyman said...

Yes I can [be a long-term value investor in stocks] because I didn't buy a house or a condo.

jesse said...

There still is some wishful thinking priced into the equity markets. Sage advice perhaps, as long as one's time horizon is suitably long.

Panda said...

On a few occasions this year I've seen terrified people selling stocks at any price they can get, and the buyers purchased at fire-sale prices. These market participants would benefit a great deal by reading Bill Miller's comments, or should re-evaluate their risk tolerance.

Radley77 said...

Anybody been looking at Bank of America lately?

With a dividend of 6%, it's looking very attractive.

Anyone currently looking at buying American financials, or is it still too early to call a bottom?

So far, Bank of America is kind of my favourite.

Warren said...


I've been looking at US Banks as well, although I prefer Citi. They are also at around 5% dividend (after a big cut). They've also written off a lot of sub prime already, on 2 occasions. A lot of their business comes from outside the USA, but you can debate the importance of that since nobody is de-coupled from them yet anyway.

Overall it seems like Citi has bitten the bullet with respect to the economy and not continuing to tow the line. At $25 I think they are a good buy, I'm going to put some in my RRSP because they are US.

Panda said...

My banking experience with Citi at the retail level was poor. On the other hand, my experience with BofA was good. Just my two cents.

Sam said...

It was my impression that Citi might go out of business. Of course, they will get a buyer, but it still seems incredibly risky when we haven't even seen CDOs blow up yet, nor the Ambac and MBIA blow up, nor the biggest wave of ARMs reset.

Mish is particularly hard on Citi:

Of course YMMV but I would stay well away from Citi for another year or two. This mess is only just beginning, not ending.

mohican said...

Bill Miller isn't calling a bottom here but he is saying that he sees value in a lot of the names he follows. I think the value investment style will be very well served by the latter half of this year and Bill Miller's fund will likely do extremely well as it has in the past.

patriotz said...

None of the big US banks are going away, but don't think that their shareholder equity can't go away.

Northern Rock, anyone?

Sam said...

This is apropos to my earlier post on Citi:

"UBS (UBS), the second-biggest underwriter of auction-rate securities, will no longer buy deals that fail to attract enough bidders, joining a growing number of dealers stepping back from that $300 billion market.

The largest underwriter of those instruments is Citigroup (C).

According to a report by Bank America (BAC), 80% of all auctions of bonds sold by cities, hospitals and student loan agencies were unsuccessful yesterday."

Warren said...

By no means am I a Citi booster, however:

They are the biggest financial services company in the world, in both revenue and profit, only beaten by oil companies, as of 2007 Forbes numbers of course. They are the biggest company in the world measured by assets ($2.7 Trillion Sept 2007).

Given this, its no surprise they are the biggest underwriter, etc.

BofA is the biggest bank in terms of customer deposits and market cap, as of late 2007 I think. Take what you will from that.

Sam, I don't disrespect your opinion, but I wouldn't make significant investments on advice from a blog, unless maybe its this one. Actually he has analyzed both banks in the past and points to a similar buy price.

Citi has dropped significantly and cut their dividends, while BofA hasn't, but will they? I'd consider both if BofA wasn't about 40% more expensive.

Warren said...

Well that link didn't work. I was trying to plug

Tony Danza said...

I know everyone is probably sick and tired of hearing WWWBD? (What Would Warren Buffett Do) but seeing as how is he is heavily invested in Wells Fargo/BoA I am closely watching these stocks as the financials continue to price in the housing fiasco and the long term fallout.

At a time like this you want to be looking at companies with a trustworthy/conservative management team, this is one of the criteria that Buffett uses when deciding which companies to buy. I'm not so sure that Citi falls into the trustworthy management team category. Caveat: I'm a long time coattail investor and this is just MHO.

Bud said...

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Here is the review that George at and did on my book.

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The book also strives to prove that Buffett and Munger invented a Behavioral Finance Formula composed of three qualitative steps and one quantitative step, that is underappreciated by the
business and academic communities. In that respect, Buffett and Munger will have a greater long term impact on academics than the Efficient Market Hypothesis.

While my book is concentrated on Munger and Buffett’s approach to framing, this book contains the best of Graham, Carret, Fisher, Buffett and Munger. Read the summary a few times, and you will be motivated and hypnotized into thinking about ways you “frame” your important decisions. This is a subtle peek into sensible and optimal thinking within Behavioral Finance.