Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.

Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter.  In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate.  But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.

Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.

I wrote about this topic in mid-2010.  But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is.  Hence this post.

carried interest

A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs.  The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.

Carried interests aren’t just a private equity phenomenon.  They’re very common in the mining industry, which is where I first encountered them thirty years ago.  But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success.  In the extractive industries, holders of mineral rights may be carried.  The fund raisers or organizers of any sort of projects may be carried, as well.  So, too, famous actors or holders of key intellectual property.

variations on the theme

As with everything in practical economic life, there are myriad variations on this basic idea.  For example,

–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.

–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or

–the carried interest may only be paid if the project exceeds specified return criteria.

In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates.  This is ordinary income and taxed as such.  The private equity case is different.

private equity and carried interest

Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions.  It targets mostly badly run companies.  It spruces them up and resells them a few years later.  There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.

Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio.  What’s really unique about them is their pay structure.

Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful.  This bonus is structured as a carried interest (an equity holding) in each individual project.  Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income.  This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.

my thoughts

You’ve got to admit that turning investment management income into capital gains is a clever trick.  Should the loophole be closed?  When I first wrote about this I thought so.  I still do.  But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry.  I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.

Today’s Wall Street Journal tells about current SEC efforts to scan the hedge fund universe in search of  potential civil fraud.  The idea is to use computer analysis to identify hedge funds whose results are too good to be true–where the operators rarely, if ever, have a down month, or where aggregate results are sensationally good.  This new direction apparently comes as a result of the agency’s failure to detect the gigantic Ponzi scheme that Bernie Madoff ran for many years–despite being supplied continuous evidence of the fraud by investigator Harry Markopolos.

Markopolos, a financial analyst, was asked by his employers to “reverse engineer” Madoff’s returns and create a duplicate it could market to clients.  A quick look at the numbers was enough for Markopolos to suspect fraud.  It took him less than a day to develop conclusive proof, which he then tried in vain to present to the SEC for close to a decade.

The new SEC interest in hedge funds appears to mimic the Markopolos methods.  The agency is also extending its scrutiny to mutual funds and private equity.

it’s about time

For years, academic studies have concluded that the returns hedge funds report to the public are at best implausible, and most likely false.

My favorite is one led by NYU professor Stephen Brown.  He analyzed investigations done by a hedge fund due diligence firm, HedgeFundDueDiligence.com,  which was hired by potential institutional customers to check out new managers.  It turns out that about a fifth of the hedge funds misled HFDD.com, despite the fact they knew their assertions would be checked.  It also turns out that customers generally hired the dishonest hedge fund managers, despite the due diligence warnings.  Go figure.

The biggest reasons for falsifying returns, in my view, is that reporting is voluntary and that the databases which collect the numbers make no attempt to check the figures.

an example

The WSJ article cites the case of the now-defunct ThinkStrategy Capital Management.  TSCM reported a return of +4.6% for 2008 in its Capital Fund-A, a year in which the fund actually lost 90%.  Chetan Kapur, who ran TSCM, also reportedly inflated his assets under management in reports to shareholders and wrote about non-existent team of analysts supporting him.  Kapur also continued to manufacture and report performance numbers for Capital Fund-A, even after the fund was shut down.

The article says there are lots more where TSCM came from.

I believe it.

what it is

Crowd funding, in the sense I think Washington is talking about it, has several elements.  It intends to raise large amounts of money by:

1.  obtaining small amounts of money

2.  from large numbers of people

3.  using the internet as a device for information, solicitation, and payment, and

4.  giving an equity or creditor interest in a company or project in return for money received.

There’s also a sense in the name of counterculture and of a group of like-minded people banding together to get a common project accomplished.

examples

Fundraising by any non-profit cultural or religious organization fulfills criteria 1 through 3.  So, too, does President Obama’s fundraising during his first election campaign.

The Green Bay Packers’ recent $63 million stock offering fits the crowd raising bill pretty well, although as I understand it you had to stand in line at Lambeau Field to buy a share for $250.

The Wikipedia article referenced above contains accounts of a number of fundraisings by bands or movie makers.

plusses

Crowd funding is very cheap., especially compared with investment banking fees in the US.

Management doesn’t lose control of the company/project, as it would in venture capital funding.

In an IPO, shares end up in the hands of the favored clients of the investment banking syndicate.  The issuer may prefer that the shares be sold instead to people who are committed to the products/services of the company or to its corporate culture.  This may only be a philosophical preference, or it may be the belief (well-founded, in my experience) that individual shareholders will become dedicated customers and will strongly support management in any corporate votes.

The company may be able to get a higher price for stock by avoiding the conflict of interest an investment banker has between the company (which wants a high price) and its brokerage clients (who want a low one).

There’ll be less obligatory disclosure of corporate strategy and of financial condition–meaning both less corporate expense and less leakage of information the company considers proprietary.

minuses

from the issuer’s point of view

1.  SEC regulations limit the amount of money a company can raise, its asset size and the number of shareholders it can have, without complying with the agency’s reporting requirements.  These rules were created after the stock market collapse of the late 1920s and are intended to protect investors from fraud.

There are also a multitude of state laws to comply with.  Some deal with the dissemination of information across state lines, so they’re a particular concern for any firm wanting to use the internet as its distribution channel (meaning everyone).

2.  Without a clear commitment to an IPO, a company may not be able to recruit the most talented staff.  This may change, however, if the crowd funding route shows itself to be equally lucrative.

for investors

1.  It’s not clear how investors will get reliable information about a company both before they invest and while they are shareholders.  Companies having an IPO create a registration statement/prospectus that must contain all material information about the firm.  The underwriting syndicate has (more or less) professional securities analysts who prepare periodic reports on the firm that they distribute to clients.

Private deals, on the other hand, typically have a large “trust me” element to them, at least in my experience.  Hedge funds are an interesting example because a lot of academic research has been done about them.  The general finding is that a considerable number of them falsify reports of their assets under management, their performance results and/or their managers’ qualifications.

2.  A second main concern is the creation of a secondary market in the securities.  This is also an area of heavy regulatory concern, again in order to prevent fraud.

3.  We know that fraud occurs even in the highly-regulated public markets.  Enron, for example, is a name everyone remembers.  Less information, less regulation and unclear penalties all suggest that the danger of fraud in crowd funding securities may be very high.

Congress

Right now, any company with more than $10 million in assets and with more than 500 shareholders has to file financial statements with the SEC.  This is a plus for shareholders, since they can find out stuff about company operations, but a considerable cost for tiny companies.  The thrust of legislation now circulating in Congress is to stimulate small business growth by creating exceptions to this rule.

The initial proposal is the Entrepreneur Access to Capital bill, reviewed in the Securities Law Professors blog.  It has already been passed by the House.  It allows companies to raise $1 million per year without having to file financial statements with the SEC.  Each investor would be limited to sending in the lesser of $10,000 or 10% of his income.  The limit would be $2 million yearly if the firm files financials with the SEC.  Issuers would have to use a crowd funding website (details = ?).

So far there have been tweaks to the idea that would, for example, limit investments to $1,000 per person and the total raised to $1 million.

At this point, it’s only clear to me that something will happen in Washington to allow some sort of SEC-exempt crowd funding.  My guess is that, absent widespread fraud, the law that is passed will simply be a foot in the door.  Larger exemptions will follow.

my thoughts

Crowd funding may come to nothing.  On the other hand, it may well be the latest example of the internet destroying a traditional distribution network–in this case the existing venture capital and IPO apparatuses.  The obvious strategy for VCs and investment bankers is to seize control of the crowd funding movement by providing their own crowd funding networks.

Cannibalizing your own business is always preferable to having someone else do it to you.  But internal advocates of the (lucrative for them) status quo will typically fight this strategy tooth and nail. In bad firms, the latter will win.

No investment conclusion yet, other than that I think the whole movement bears watching.

There are three recent or current IPOs that I find potentially interesting:

–Chow Tai Fook Jewelry  (1929: HK), a  Hong Kong-based jewelry chain that specializes in chuk kam (pure gold) gold jewelry, but which is expanding its offerings to include Western-style fine jewelry as well,

–Nexon (3659: JP), the Korean company that started the casual gaming craze with Kart Rider–and who, oddly enough, just listed in Tokyo, and

–Zynga (ZNGA), the creator of the Facebook game Farmville (although my interest is mostly in the fact that it’s going public at close to 100x historic earnings).

how to buy them

Suppose you want to buy one of these–or shares in any “hot” IPO.  How do you go about it?

Let’s take it as given that no ordinary retail investor is going to get an allocation of stock in the IPO itself.

Those shares normally go to the most important customers of the brokers who take the company public, not to retail investors or small institutions.  In fact, unless you’re very close relatives or friends of the top management of the company going public–and they use their influence to direct shares your way (how likely is that?)–being offered shares in an IPO in the US as a retail investor is probably a red flag.  It suggests no one higher up in the food chain wants them.  So, to mix metaphors a bit, the underwriters are forced to reach down to the bottom of the barrel to get the deal sold.  In other markets, Hong Kong, for example, there can be special tranches of stock reserved for retail investors.  But the amount of stock you will receive in a “hot” IPO is likely to be very small.

So, to participate we have to buy shares on the open market.

my rules

While every situation is a little different, I’ve found that the rules I developed for myself while I was running a tiny mutual fund in the 1980s (too tiny to get many IPO allocations) have served me well over the years.  They are:

1.  Read the offering documents carefully and try to calculate the rate of growth of future profits.  this is how you decide what price is reasonable to pay. Like any other kind of investment, understanding valuation is by far the most important factor in success.  For a US investor trying to buy a foreign stock this can be a problem, since the documents won’t be available to you (even on the internet) until after the IPO.

2.  If the stock goes down on day 1 (as ZNGA is doing while I’m writing this), that’s a very bad sign.

3.  First day trading can be very volatile.  Use limit orders, not market orders.

4.  Don’t buy the entire position on day 1.  Three reasons, two relating to attempts by institutions to game the IPO system to get better allocations of future issues:

–retail investors may place market orders, driving up the stock price

–some institutions want to be seen by the underwriters as buying stock on the first day.  They think this establishes them as serious long-term shareholders and not “flippers” (people who only want to make a quick profit on getting an IPO allocation and who dump the stock on the market as fast as they can).  Underwriters generally hate flippers, since a large amount of flipping threatens to depress the stock price on day 1, making the issue seem less successful.  So, rightly or wrongly, buying institutions hope they’ll get larger allocations of future issues as a reward.

–institutions that want to be seen as regular supports of an underwriters IPOs (i.e., they’ll take anything) and as long-term holders of everything may start to sell after a week or two, when they think underwriters won’t notice, thus preserving their A-list status.

3.  A week or two after the initial trading day, after the IPO hoopla is over and when the institutions I describe in my last point above begin to sell, there may well be a chance to buy the stock at a lower price than on day 1.

4.  Keep a list of interesting stocks you might like to buy but think are too expensive now.  Every so often–too often nowadays, in my opinion–stock markets get frightened and sell off in a crazy way.  Everything goes down; small stocks can go down a lot.

I’ve found these to be excellent times to buy the formerly hot IPO stocks.

venture capital

Venture capital is a form of private equity financing.  VCs support early-stage companies that they think have substantial growth potential, but which are too small, and too risky, to get conventional bank financing.  Their small size and immature businesses also rule out the possibility of a conventional IPO.  Again, the risk it too high.  In addition, if the company wants to raise, say, $10 million, fee income would at most be $1 million–too little to interest most reputable investment banks.  (The only time I can recall seeing brokerage houses reaching down into venture capital territory in a big way was in the latter days of the internet bubble in 1998-99–and we all know how that turned out.)

In the US, venture capital is typically associated with Silicon Valley in California.  In their search for start-ups with explosive growth potential, they have acquired deep knowledge of technology-related industries (where that potential resides) and of skilled entrepreneurs who can turn that potential into a fast-growing firm.  So they feel comfortable there.

VC activity isn’t always in the tech world.  But you won’t see venture capitalists backing firms in, say, furniture retailing, where it’s difficult to see earning several times your initial investment in a reasonable period of time.

funding rounds

Venture capital financing isn’t a one-shot deal.  It typically occurs in a number of stages, or “rounds,”  where a company gets more money, so it can move to a higher level of development.

Stages might correspond to company needs for:

–seed money, where the VC firm supplements funds committed by the entrepreneurs themselves, or their friends and family.

–product development

–manufacturing and marketing

–working capital

–expansion.

If everything is going smoothly, each round of funding will be at a higher stock price.  The funding may be done through convertible securities rather than straight equity.  This gives the venture capitalist some income while he waits for the company to mature.  Convertibles can also give the VC a stronger claim on company assets than ordinary equity holders in the case that things go badly.

exit strategy

The venture capitalist has traditionally expected to cash out of the company he has invested in thorough a conventional IPO–at which time he will have the option of selling some or all of his shares.  In today’s world, however, it’s equally possible that a private sale to a much larger firm in the same industry will happen instead.

pluses

Venture capitalists are willing to invest in companies at a much earlier stage of development than others.

VCs also typically provide organizational help, management and technical expertise that may be sorely needed by a fledgling company but which may not be available any other way.

minuses

If you don’t have stellar growth potential, VCs probably aren’t interested.  Simply getting their money back, with interest, isn’t enough.

At some point, usually very early on, part of the price for additional financing will be that the entrepreneurs cede control of the business to the VCs.  In most cases, this is probably a good thing, since risk-taking visionaries don’t often make great managers (look at the early Steve Jobs).

That’s it for today.  More tomorrow.

going public through a traditional IPO

This is still the best way to raise LARGE amounts of money for expansion.  That’s not the only reason for going public, however.

One of the many clichés on Wall Street is that small companies should raise equity capital when they can (in other words, when investors would kill to acquire shares in a hot new concept), not when they absolutely need to.  Better to have cash you don’t have a present use for than to find the equity market closed to IPOs in a recession.

A public listing will probably be seen by potential business partners as a sign of company maturity and stability.

A public listing allows a company to pay employees in stock and stock options rather than cash.  For techy start-ups, it’s the possibility of making a fortune on stock options by being in on the ground floor of the next Google or LinkedIn that lets the fledgling firms attract top-notch talent.

the IPO process

Anyway, let’s say a firm decides to go public through a traditional IPO.  What happens next? The firm contacts an investment bank.  It may be that the company’s CFO already has connections on Wall Street.  It may be that brokerage house securities analysts (who in many ways are marketing agents for the bank) have already been calling on the firm for a while and the company selects the firm the most influential of them works for.  Investment bankers may have made marketing pitches as well.

The investment bank performs several functions:

1.  it helps the firm gather the materials it needs to file a registration statement with the SEC

2.  it performs its own investigation that allows it to vouch for the company with its clients

3.  it forms an underwriting group and a selling syndicate to market the issue.  The salespeople will already have the necessary national and state licenses to sell equities; the firms will already have established that the securities are suitable investments for the clients they sell them to.

4.  it prepares a preliminary prospectus (called a red herring in the US because the fact it isn’t final is highlighted in red print) to circulate within its client network and obtains informal indications of interest

5.  it arranges a sales campaign that may include meetings between management and potential buyers

6.  it recommends the final issue size and price.

Until the past few years–when the big brokerage houses laid off most of their experienced analysts–the investment bank would also commit itself to have continuing analyst coverage of the firm.

there are lots more ins and outs, but that’s the basic process.

plusses

The traditional IPO route gives a firm access to the investment bank’s distribution network.

It also gets the company a lot of publicity.

In normal equity offerings, the underwriters buy all the stock from the issuer and take the (usually negligible) risk of selling the issue to investors.  At the very least, the issuing company gets a specified price on a given date.

minuses

The traditional IPO is expensive.  The investment bank may charge as much as 10% of the issue for its services.

In pricing the issue, the investment bank’s loyalty is divided.   The issuer wants a high offering price, so it gets the most money.  The bank’s biggest customers, on the other hand, want a low offering price so the stock will go up a lot on opening day.

Many small companies are below the minimum size that will interest an investment bank.

That’s it for today.  More tomorrow.

In an odd article at the top of the front page of  the December 1st Greater New York section of the Wall Street Journal, the newspaper heralds NYC’s hiring of Kevin Davis, a former CEO of MF Global, who was replaced there in late 2008.  Mr. Davis has been overseeing commodities investments for the city’s Bureau of Asset Management for about three months.   Lawrence Schloss, himself a former director of MF Global, selected Mr. Davis for the job, saying he has 26 years of experience and was the best candidate to apply.

details

The article goes on to to relate, without analysis or comment, that:

–Mr. Davis is earning a salary of $175,000–which is less than 1% of his compensation during his last full year at MF

–MF Global’s stock lost over 90% of it value during his tenure

–MF was subsequently sued by pension funds for misrepresenting its risk management practices, a case that MF recently settled by paying $90 million.

any significance?

There’s nothing in the article, other than its prominent placement, to indicate that there’s anything amiss with the hire.  And the placement may be more the result of political differences between the city Comptroller and News Corp than of anything else.

Two things strike me, however:

1.  NYC, like many government bodies, seems to be an advocate of the penny-wise-pound-foolish school of investment manager compensation.  A competent commodities person would make many times what the city is offering.  Mr. Davis may have been the only candidate to apply.

2.  The event that ultimately led to Mr. Davis’s demise at MF was discovery of $141 million in losses from unauthorized wheat trading by a broker in MF’s Memphis, Tennessee office.  According to theFinancial Times, the trader wasn’t a “rogue” who evaded management controls; the company’s computer systems weren’t programmed correctly.

Two years later, we’re finding again that MF Global’s computer recordkeeping systems are inadequate.  In fact, the records are in such a shambles that no one has been able to figure out how much customer money is missing from the firm–other than it’s a lot–or where it went.  I doubt Jon Corzine found top-notch recordkeeping systems when he arrived at MF and dismantled them (for what it’s worth, he doesn’t strike me as the kind of guy who would have looked in the first place).  My hunch is that they’ve been inadequate for a long time and that no one investigated properly, or extensively enough, after the 2008 trading losses.  There may well be much more to the MF Global story today than deficient computers.  But I think anyone using the in-house systems should have immediately realized their inadequacies and at least insisted they be fixed.

moral hazard

Moral hazard in finance is the situation where the existence of an agreement to share risks causes one of the parties to act in an extra-risky manner, to the detriment of the other.   In a sense, the willingness of the party who ultimately gets injured to enter into the agreement causes, or at least allows, the bad behavior by the other to occur.  He inadvertently sets up a situation where the bad behavior is rewarded, not punished.

examples

–Systematically important banks have been able to take very big proprietary trading risks, knowing that they are “too big to fail” and will ultimately be bailed out by the government if their risky bets don’t pan out.  The rewards of such risk-taking go as bonuses to the bankers; the cost of bets gone bad is borne by the general public.

–One of the reasons Germany is so hesitant to bail out Greece is that doing so rewards the latter country’s reckless borrowing behavior over the past decadeand shifts the costs of cleaning up the resulting economic mess onto the citizens of the rest of the EU.

the Rakoff case and moral hazard

Judge Rakoff has just rejected a proposed settlement of a case involving Citigroup and the SEC, on what appear to me to be similar moral hazard grounds.

The settlement involves Citi’s creation and sale of $1 billion in securities ultimately tied to a pool of sub-prime mortgages selected by the bank.  Citi neglected to tell the buyers of the securities that it wasn’t simply an agent.  It was making a $500 million bet that the securities would decline in value sharply–which they subsequently did.  Investors who bought the securities from Citi lost $700 million.

I don’t know precisely how much money Citi made on this transaction.  But I think I can make a good guess.  To make up rough numbers, collecting a 2% fee for creating and selling the issue would bring in $20 million or so.  A 70% gain on its negative bet on the issue would yield $350 million.  If so, the much more compelling reason for creating the issue would be to design it to fail and then short it.  In any event, let’s say Citi cleared $370 million before paying its employees who thought up and executed the total deal.

The proposed settlement?

–fines and penalties totaling $285 million

–Citi doesn’t admit or deny guilt, which means

——the settlement doesn’t create any evidence to support a lawsuit by the investors who lost money, and

——the settlement doesn’t trigger the sanctions against future illegal conduct that are contained in prior settlements with the SEC.

–only low-level Citi employees are reprimanded.

Assume the SEC allegations are all true.

If so, what a deal for Citi!  The SEC “punishment” is that the bank keeps $85 million in profits and gets a slap on the wrist.  Who wouldn’t agree?

What would make this moral hazard is that this is is the worst case outcome for Citi.

And, if you figure that the SEC looks at one suspicious deal out of ten, the situation is even less favorable for investors.  The decision whether to create another issue like this one is a layup.

Would it be so easy if Citi stood a chance of losing money?  …or of triggering clauses in prior settlements prohibiting illegal behavior?

What about the legal team that decided what he minimum disclosure in sales materials should be?  Would they have insisted that Citi must reveal its proprietary trading position in those materials if fines were larger, or if they could be held professionally liable for the information’s exclusion?

What if the Citi executives that okayed everything risked being barred from the securities business for a period of time–would they have acted in the way they did?

grandstanding?

I don’t think critics are correct that Judge Rakoff is trying to raise his public profile by insisting that the SEC either obtain a better settlement or go to trial with its case.  Others are saying that the SEC takes settlements like this because it doesn’t have the legal skill to get anything better.  But these are ad hominem arguments  –like saying the parties are wearing ill-fitting clothes, they’re distracting, but irrelevant.

But it is true that this case comes at a time of growing public anger that bank executives are showing few ill effects from the devastating economic damage they helped cause.

It will be interesting to see what new settlement the SEC and Citi come up with.

Stay tuned.

Mr. Miller was once the envy of equity portfolio managers everywhere for the fame and fortune his beating the S&P 500 for 15 years in a row brought hi.  In recent times, he has become the embodiment of very pm’s worst nightmares, however.

His previously hot hand–which had earned him designation by Morningstar as a “Manager of the Decade” turned icy-cold in 2006.  Ensuing weak performance erased the gains in relative performance his portfolio had made since “the streak” began in 1991.  The assets in his fund fell by almost 90% from the peak of $21 billion +.

my thoughts

I should say at the outset that I don’t know Mr. Miller and that I haven’t studied his portfolio composition carefully.  And I’m not interested enough to look up his past SEC filings to try to document my impressions.  With that warning, here’s what I think:

1.  It took Legg Mason a very long time–and the loss of the vast majority of Value Trust’s assets–before it made the change.  At the asset peak, the fund was generating management fees for LM at a $140 million annual clip.  It’s now generating under $20 million.

Why not act sooner?

Part of the reason is likely that after sagging in 2006-2008, the Value Trust outperformed in 2009.  More important, I think, is that the fund’s marketing has been all about “the streak” and the extraordinary investing prowess of Mr. Miller.   It’s a good story and an easy sell.  But it’s a risky strategy.  If it’s all about the numbers, and someone with even better results comes around–and invariably someone will–what do you do? You’ve already made the argument to your client to switch into the Value Trust because of the numbers; how can you now argue against numbers that tell him to switch out?

This selling direction also gives the manager himself a huge amount of power.  What’s the Bill Miller show without Bill Miller?  So if Mr. Miller wants to continue to run a concentrated portfolio with a strong emphasis on financials, despite steady underperformance, how do you stop him not to?

2.  I’ve never regarded Mr. Miller as a typical value investor, although he’s always described as one and the Value Trust (note the name) is classified with other value vehicles by rating services.  I have two reasons:

–Value investors are belt-and-suspenders kind of guys.  They run highly diversified portfolios, typically with 100-200 names–sometimes more.  Growth investors, in contrast, typically hold 50-60.  Looking up the Capital Management Value Trust on Google Finance told me it has only 46 names. (By the way, in my experience ratings services never pick up high concentration as a source of risk.)

–Both value and growth investors look for “undervalued” securities (only shortsellers want to find overvalued stocks).  That isn’t what the “value” in value investing signifies.  It means a certain approach to finding undervaluation.

Value investors look at the here-and-now.  Their holdings are typically asset-rich companies that have encountered temporary difficulties, which have been crushed by Wall Street and which are now trading at unduly depressed valuations as a result.  Growth investors, in contrast, look for companies whose future earnings prospects are being underestimated by the market.

In this sense, too, I don’t think Mr. Miller is a plain-vanilla value investor.  He has been happy to hold large positions in stocks like Amazon or AOL (in its heyday)–names I think other value practitioners wouldn’t give a second look because the whole story has been the rate of future earnings growth.

I have no idea how Mr. Miller squares this circle.  (The fund’s largest positions are now in technology, according to Google Finance.  But it’s not the same thing.  Today’s stocks are eBay and Microsoft.  Apple, the largest holding, is still a growth stock, unlike the others.  But AAPL trades at a very low PE multiple of current earnings.)

3.  Despite this flexibility, and the issue of heavy concentration aside, it seems to me that classic value behavior has been the Value Trust’s recent problem.  Relative to history, financials were trading at low price to book value (i.e., the balance sheet value of shareholders’ equity) ratios when Mr. Miller bought them.  In hindsight, that was a mistake.

There may have been a second.  If the stocks a growth investor buys underperform, he typically stops buying or lightens up.  Value investors tend to do the opposite.  They regard such stocks as being even cheaper than when they initially bought–and double up.  I suspect the latter is what Mr. Miller did.

two oddities

1. In the early part of my career, alternating cycles of outperformance by value and growth stocks were relatively brief.  Given a year, or two at the most, there would be little to chose between the numbers generated by one style or the other.  The 1990s, however, saw a multi-year value cycle in the early part of the decade, followed by a massive multi-year growth cycle–culminating in the Internet Bubble–at the end.  Despite the fact that the tide was running strongly against value during the latter years, Mr. Miller continued to outperform the S&P 500.  If he did so with value stocks, that’s his crowning achievement.

2.  After creating a strong business franchise under the Miller name, neither he nor Legg Mason did much to protect it.