Warren Buffett likes to say that when the tide goes out you can see who is swimming naked. That was Buffett's clever way of saying a money manager's true talent is proved in adverse markets. Now that the metaphorical tide has gone out — way out — Bill Miller of Legg Mason — the once-revered manager who amassed an enviable record of beating the S&P 500 for over 15 calendar years, from 1991 to 2005 — was swimming naked. Is his recent underperformance merely an aberration, or was he just lucky for all those years?
Investors don't seem to care; they're not waiting around to find out. With the his fund, the Legg Mason Value Trust (LMVTX), down 58 percent over the last year, assets have plummeted from $16.5 billion to close to $4 billion. Morningstar analysts still like the fund (not as a core holding, though), but we're going to argue that Miller was plain lucky — yes, lucky that his rather volatile, concentrated portfolio happened to show outperformance when judged by calendar years. Mathematically speaking, over any period of time, someone is bound to be lucky and beat the market, fund experts say.
At first glance, Miller's Value Trust hardly seems like a bull market creation: Rather than loading up on go-go growth stocks, Miller consistently bought cheap stocks, and focused on established companies suffering through periods of poor performance that he deemed to be temporary. Much of the time, these judgments seemed correct. But the companies he invested in often had high levels of debt and poor financials, causing them to be volatile despite their cheap valuations.
Let Volatility Be Your Metric
For many mutual fund experts, high volatility can be an ominous sign that a fund manager's outperformance is not the result of good stock picking, but merely the result of taking on greater risk than the market as a whole.
“My analysis gives LMVTX [Value Trust] at 7.1 volatility, about 50 percent greater than the S&P 500,” says Stephen McKee, editor of the well-regarded mutual fund selection newsletter, No Load Mutual Fund Selections & Timing. “He is underperforming the value style and doing so with more volatility. Not a good combination and he is ranked 30th out of the 47 value funds I track.”
Jason Brown, editor of No Load Fund X newsletter, offers a similar critique. “It has been several years since we last owned LMVT. This fund ranked highly for many years in the 1980s and 1990s, and briefly in 2003. It now ranks very near the bottom, at number 313 versus 315 funds with similar downside risk. Again, based on CPR [relative strength] score. This implies that 312 funds are more attractive to us at this time.”
What led to Miller's underperformance? A heavy bet on beaten down home-building and financial stocks hurt him. Miller was a large holder of Freddie Mac when it was seized by the government; he also held stakes in horrendous disasters, such as AIG, Countrywide, Washington Mutual and Bear Stearns.
In essence, Miller made the classic mistake of a value investor: He fell into a “value trap,” mistaking a more or less permanent change in value or industry conditions for a temporary one. Like many managers focused on low valuations, he had long been enamored of both homebuilding and financial services stocks, as stocks in these industries tend to trade at low valuations. Miller failed to anticipate the impact of the mortgage bubble on these stocks, and improperly judged them to be fully discounting future events.
A post facto analysis of his losses is only partially useful. Looking at his wins is more instructive. Miller runs a concentrated portfolio, holding 25 to 35 stocks at a time, versus a typical manager's 50 to 100. And his long favored industries, such as homebuilding and financial services, had served him well — for a while. In the past, Miller's performance seemed immune to the volatility of some of his stinkers (he held both Enron and WorldCom in the late 1990s, yet still managed to performed well). What killed him this time was the atypical cycle — which is far more protracted and severe than past credit cycles. Well, that and the size of his bets. He also failed to identify secular growers in other industries, staying with bets on energy and Amazon.com even as they declined. Much of Miller's success has been based on an optimistic view of the resilience of the American financial services industry seems, in light of recent events, rather Pollyannish.
A Random Walk
Given the concentrated nature of his portfolio, his long outperformance can be seen as a random variable, or put another way, “luck.” In essence, making 25 bets a year is very different than making 100; it is a lot easier to get lucky for a similar period of time when making fewer bets. Matthew Rothman, a quantatitive finance professional with a PhD in statistics from University of Chicago, was one of the few skeptics. Rothman noted during Miller's streak that it is not hard to make the case that his outperformance was largely “luck.”
There were approximately 8,044 mutual funds being run at the end of 2004, Rothman says; of these, 4,600 were U.S. equity mutual funds. “There are approximately 6,500 ‘dead’ U.S. equity mutual funds. So, in total, some 11,100 mutual funds have ever existed,” Rothman says. “There is a 50 percent chance of beating the market as most people define it each year. Given that, we have had 11,100 mutual funds exist, and have had 4,600 of funds still existing, what number should we expect to have beaten the market for 15 years in row, by pure chance? Five.” Rothman argues that what is more amazing about Bill Miller's performance is that there should have been more Bill Miller-like outperoformers out there! “Why aren't there?” Rothman wonders.
These days it seems difficult to separate Miller from the large pack of money managers who have prospered in good times only to suffer in the bad. Investing in Miller's fund now seems more a bet on further good times than on any objectively high chance that Miller can outperform the S&P during good and bad climates.