We review Bill Miller's Legg Mason US Equity.
After a tumultuous 2008, can Miller make a comeback?
The name Bill Miller might not be instantly recognisable amongst UK retail investors but in the US he is as prominent as Anthony Bolton is in the UK. Miller is famed for beating the S&P 500 Index for 15 consecutive years while at the helm of the US-sold Legg Mason Value Trust fund but investors in the UK are more likely to have familiarity with the manager through Legg Mason US Equity which is sold here in the UK and is a near-clone of Value Trust. Although Miller’s prominence grew and he gained ‘star manager’ status through his long-term winning streak versus the index, more recently, he has become known for suffering a staggering reversal of fortune.
During the past three calendar years the Legg Mason US equity fund has ranked in the bottom decile of its Morningstar US Large-Cap Blend category. If an investor held Legg Mason US Equity since its early 2003 inception, he would currently be nursing a loss of 4.8%. However, 2008 was particularly painful as the fund lost a staggering 42.4% in GBP terms. Miller has also undone most of his previous good work at Value Trust and investors who held the fund over a period of ten years to the end of 2008 would have lost 4.21% (in USD terms), compared with the loss of 1.38% posted by the S&P 500 Index.
Where did the poor performance emanate from?
The fund’s blight started back in 2005 when Miller sat out the energy rally. He looks for stocks which can earn more than their cost of capital over the course of a business cycle and energy stocks have historically failed in this requirement so Miller did not buy into high-flying energy issues. We like to see managers sticking to their knitting - even if it does lead to bouts of underperformance – rather than chasing hot sectors and there was logic in his choice not to partake in the energy rally.
Looking back more recently, however, he made glaring stock picking mistakes in 2008, in particular within the financials sector; AIG, Countrywide Financial and Freddie Mac, to name but a few, are examples of purchased stocks that eventually imploded, but again there were valid reasons for buying these stocks. Miller’s strategy is to buy stocks that are trading cheaply in relation to what he thinks they are worth which can often lead him to beaten-down turnaround plays. However, he underestimated the extent to which the sub-prime crisis would reverberate through the financials sector as he also bought into doomed stocks such as Merrill Lynch and Wachovia at the beginning of 2008. Those stocks played to his strategy but he, along with many other managers, did not predict that bankruptcy or a forced buyout would ever be a possibility for such well-established financial institutions.
These errors were compounded by the fact that the fund's portfolio is highly concentrated. Miller often runs with more than 50% of assets in the fund's top-10 holdings, and large positions are commonplace. This leaves the fund little room to hide should a few key picks head south.
So what’s being done?
We are glad to say that Miller is merely tweaking his strategy, rather than completely overhauling it. We think this shows the confidence Miller has in the strategy, but also a willingness to adapt when things aren’t working out. Indeed after a period of underperformance in the late 1980’s and early 1990’s, Miller made a few changes to the strategy which contributed to the fund’s stellar performance over the following 15 year period. Learning from the lessons of missing out on the energy rally, Miller will now invest in those sectors which have not traditionally earned above their cost of capital, such as commodity stocks, if the valuations are attractive enough. He will, however, be keeping a close eye on capital expenditure during commodity booms to ensure a company does not over-invest during the good times. He is also putting greater emphasis on dividends and cash on the balance sheet in an effort to control risk. We’re confident that the tweaks to the strategy will ultimately benefit fund shareholders – they should add some sector diversification and help limit exposure to financially questionable companies. That might not be much consolation for those who have bore the brunt of the fund’s dire performance, but we think it's a good step in the right direction.
