The following is an excerpt from the Legg Mason Value Trust's Quarterly Report from Q4 2006. Bill Miller was portfolio manager for this fund which outperformed the S&P 500 index for 15 consecutive years from 1991 through 2005. Here he talks about his definition of value and how he expressed it during the 15 year run (it having just concluded).
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 relativelyundiversifedwith respect to these valuation factors, with traditional value investors clustered in low valuations, and growth investors in high valuations. For most of the 1980’s and early 1990’s 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 was in the mid-1990’s that we began to create portfolios that had greater factor diversification. In the mid-1990’s, many cyclical stocks were down and acting badly, just the sort of thing we tend to like. I looked at steels, and cement companies, and papers and aluminum, all things being bought by classic low PE, low price-to-book, value investors.
At the same time, though, technology stocks were also selling atvery cheap prices. Dell Computer was selling at about 5x earnings. Even Cisco could be had for about 15x earnings. I could not see why one would own cyclical companies that struggled to earn their cost of capital when you could get real growth companies that earned high returns on capital for about the sameprice. So we bought a lot of tech in the mid-1990’s.
Buying tech was not something value investors did back then. That was because tech was not thought to be predictable in the way something likeCoke was, for example, since technology changes rapidly. But we had learned from Brian Arthur at the Santa Fe Institute about path dependence and lock in, which meant that while technology changes rapidly, technology market shares oftendon’t, so they were much more predictable than they looked. We bought them andgot lucky when tech values turned into a tech mania in 1998 and 1999.
The result was we did well when first-rate value investors such as Mason Hawkins and BillNygrendid poorly. They had almost no tech, and if you didn’t have it, you had almost no chance to outperform.
We realized that real value investing means really asking what are the best values, and not assuming that because something looks expensive that it is, or assuming that because a stock is down in price and trades at low multiples that it is a bargain. Federal regulations mandate how concentrated a mutual fund can be; they require a certain amount of diversification even in funds called non-diversified. Diversification has rightly been called the only free lunch available on Wall Street. It follows from the fact that the future is uncertain that one should multiply independent bets. Indeed, the Kelly formula, discussedin Bill Poundstone’sFortune’s Formula, would indicate that if you were certain about something earning an excess rate of return, you should put 100% of your money in it.
Although funds are subject to requirements regarding diversification by industry or company, they do not have to be diversified by factor, that is, by PE ratios, or price-to-book, or price-to-cash flow. And they mostly are not: value funds tend to have almost all their money in low PE, low price-to-book or cash flow, and growth funds have the opposite. Sometimes growth funds beat value funds and the market, as from 1995 through 1999, and sometimes value fundsbeat growth funds, as from 2000 through 2006. Sometimes growth is cheap, asit was in 1995, and is today in my opinion, and sometimes so-called value is cheap, as it was in 1999. The question is not growth or value, but where is the best value?
We were fortunate to recognize that so-called growth was cheap in the mid-1990’s and so avoided the extended underperformance of many of our value brethren in the late 1990’s. We were also fortunate to recognize it was expensive in 1999and sold a lot of those names reasonably well. We were not so smartas to have realized we should have sold them all, so we did less well than many of our value friends during the bear market that ended in March of 2003.
We continue to be factor diversified, which I think is a strength. We own low PE and we own high PE, but we own them for the same reason: we think they aremispriced. We differ from many value investors in being willing to analyze stocks that look expensive to see if they really are. Most, in fact, are, but some are not. To the extent we get that right, we will benefit shareholders and clients.