Friday, August 1, 2008

Legg Mason's Bill Miller shareholder letters

Despite getting kicked in with his stock picks, his shareholder letters are always a good read. Here's some highlights from the Q1 and Q2 shareholder letters for the Legg Mason Value Trust:

After an awful quarter in which our fund dropped 19.7% compared to a loss of 9.4% for the benchmark S&P 500, we have begun to perform better. In the first few weeks of the quarter, the S&P 500 is up just over 5% and weare up a bit more. Our lead widens if you look back to the Monday the Bear Stearns rescue by JPMorgan was announced. 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.

Because when you are doing poorly, the question always comes up: Is this normal and expected, or is something wrong and should changes be made to the portfolio or the investment process? Every investor goes through periods of poor relative results. Remember the Barron's cover story on whether Warren Buffett had lost it in the tech-driven market of the late 1990s? Statistically, our results, while disappointing -- and few are more disappointed than the team here at LMCM, as we are substantial investors in our products -- are consistent with what one would expect given our process, style, and historic results.

One of the more common issues clients have raised during this period is that of risk controls, given that we have had several companies suffer dramatic and highly publicized declines, such as Countrywide Financial and Bear Stearns. Are we taking more risk than usual, or is our research not as rigorous as it used to be? Some insight into this can be gleaned by looking at the 1998-2002 period. That period is instructive because it began and ended with financial panics, similar to the credit panic today. In 1998, Russia defaulted on its debt and the hedge fund Long-Term CapitalManagement collapsed. In 2002, high-yield bonds did likewise, and fears of deflation were rampant. During that period we had 12 stocks that declined more than 80%, including three bankruptcies. The difference between then and now is that we were outperforming then, and are not now. When you are doing poorly, the scrutiny is higher and the questions more pointed, as its hould be.

What makes things difficult is that when you look at performance you are observing the results of price changes in the securities held in our portfolio. You are not observing the value of the businesses whose shares you own, merely how the market is pricing those shares at a point in time. Price and value are not only different, it is precisely that they can differ widely that creates the opportunities for value investors to earn excess returns. The greater the difference, the greater the potential return.

I think the credit panic ended with the collapse of Bear Stearns, and credit spreads are already much improved since then. If spreads continue to come in, thewrite-offs at the big financials will end, and we may even have some write-ups in the second half instead of write-downs....I think likewise we have seen the bottom in financials...

In Q2, Bill Miller was much more circumspect:

A group of us were standing around a few weeks ago when Warren Buffett wandered over. Chris Davis had dubbed us the Value Support Group, as we all adhered to that approach to investing. We were commiserating over how badly we had done in this market, how valuation appeared not to matter and had not for the past couple of years, how it was all about momentum and trend, and how we were all losing clients and assets over and above our losses inthe market. It seemed like we needed a 12-step program to cure us of our addiction to buying beaten-up stocks trading at large discounts to our assessment of their intrinsic value.

A point he made that I have likewise noted to our staff is that this is the only market I have seen where you could just read the headlines in the papers, react to them, and make an excess return. I have used the mantra to our analysts that if it's in the papers, it's in the price -- which used to be correct. Indeed, it borders on cliche in the business that by the time something makes the cover of the major news or business publications, you can make money by doing the opposite. There is solid academic research to back this up. But in the past two years, you didn't need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).

Is it obvious financials should be bought now, having reached the most oversold levels since the 1987 Crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?

Is it obvious energy stocks should be bought on this correction in oil prices from $147 to $123, a correction that has wiped 25 points off the prices of companies like XTO Energy and Chesapeake Energy in just a few weeks? Or is it obvious that oil had reached bubble levels at $147, and that buying the stocks here, down 30% from their highs, is akin to buying homebuilders down 30% from their highs in 2005? If you had bought Tesoro Petroleum or Valero Petroleum when their prices broke late last fall --remember the Golden Age of Refining story that took Tesoro from under $4 to over $60? -- you would be looking at losses in this year greater than ify ou had bought Citibank or Merrill Lynch.

He's made some blunders-wanting MSFT to pay 40 for YHOO instead of 33, and saying CFC was worth in the 30's, when the stock was 5, and his performance lately has just been terrible.

But his fund owns some beaten down stocks that should come back.

In fact, he also said this:

The best time to buy our funds or to open an account with us has always been when we've had dismal performance, and the worst time has always been after a long run of excess returns. Yet we (and everyone else) get the most inflows and the most interest AFTER we've done well, and the most redemptions and client terminations AFTER we've done poorly. It will always be so, because that is the way people behave.

You could do worse than buying this fund, especially now that it has been crushed. And the businesses that make up the portfolio look to be discounted too much by the marketplace.


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