Bill Miller and the Legg Mason Capital Management Value Trust mutual fund

Last week, Bill Miller of Legg Mason announced that he is stepping down as portfolio manager of that firm’s Capital Management Value Trust fund after 20+ years at the helm.

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.



brain drain in 2012

what it is

“Brain drain” is a term coined in the UK after WWII to describe the outflow of human intellectual/scientific/economic talent from a country.  Motivation for the outflow can sometimes be religious or ethnic persecution in the home country.  More benignly, brain drain is more likely motivated by economic prospects that are perceived to be significantly better away from the home country.  According to Wikipedia, the term may have been initially used to describe the movement of British citizens to the US, or to the inflow into the UK of citizens of India.

where is it happening today?

What forms of brain drain can be seen in today’s world?

the Eurozone

–I think we should watch the EU carefully, especially southern Europe.  On the one hand, government finances in Italy, Greece… can’t be fixed by raising taxes.  People will move into other parts of the Eurozone, for one thing,  History also shows that higher tax rates invariably trigger increased tax evasion.  So higher rates can end up generating lower revenue.  (This isn’t just a European phenomenon:  New Jersey has just released an economic study showing the state is suffering a net loss of $150 million in annual tax revenues as a consequence of two income tax rate hikes early in the last decade).

Even though cost-cutting will be the main tool European governments will use to balance heir budgets, the economic stagnation that austerity measures will produce may cause an outflow of intellectual talent from southern Europe to France or Germany, or outside the Eurozone to the UK.

the US

–Anecdotal evidence suggests there’s a budding trend toward emigration from the US to China, because of the latter’s superior economic prospects.  There’s also a movement on the Northeast to create publicly funded schools that emphasize Asian culture and history–and where instruction might be in Mandarin.

–a combination of high taxes, lack of home-grown engineering graduates and immigration restrictions that severely limit the number of Indian and Chinese engineers able to work in the US has meant a continual outflow of technology manufacturing away from the US.


–To my mind, the most curious case of potential brain drain is that recently reported by the Wall Street Journal It’s the potential outflow of wealthy Chinese from the mainland.  They’re not seeking political or economic freedom, or at least not simply that.  What’s prompting them to consider emigration–overwhelmingly to either the US or Canada–are social concerns, including:

–poor schools

–bad medical treatment


in that order.  Also:

–unsafe food (local municipal authorities sometimes offer industrial waste disposal sites for lease as agricultural land), and

–the one-child policy.

investment implications

At this point, these developments are more curiosities than anything else.  But events in southern Europe bear close watching.  That’s the place where emigration has the most potential for economic disruption, in my opinion.

the EU financial crisis won’t be over any time soon

how the EU got into this fix

1.  For many years the EU ran a money policy that was just right for a Germany struggling with the integration of the former East Germany, which had been run into the ground economically during Soviet rule.  But that stance was much too stimulative for peripheral countries like Ireland and Spain.  The extra money sloshing around there found its way into highly speculative real estate.  This ultimately resulted in lots of bad bank loans.

2.  The big commercial banks in the EU served as a dumping ground for large amounts of toxic sub-prime securities from the US.

3.  Rather than recapitalizing its banks in 2009, as the US did, the EU decided to paper over their losses and hope that economic growth would eventually restore the capital the banks had lost.  That has proved to be a big mistake.

These factors have been well-known for years, however.

What’s relatively new is concern about the EU’s “bad boys,”  Greece and Italy.

4.  It took several years of truly heroic economic reform for Italy to meet the minimum standards for approval to enter into the Eurozone.  The other members might have hoped Italy would continue to strengthen itself once it was in.  But instead, Italy used the borrowing power of the euro to avoid any further adjustment to a fast-changing world, preserving an increasingly non-competitive status quo by running up excessive government debt.

In hindsight, Greece seems to have gotten into the euro only because all parties decided to pretend it met the minimum criteria.  Once in, Greece borrowed up a storm and lied about it for close to a decade–both understating the amount of debt it was running up and overstating its economic growth.  That deceit ended only when a new party took power in Athens last year.  If that weren’t bad enough, the big EU commercial banks appear to be on the losing side of billions of euros of Greek credit default swaps.

where we are now


The EU and the IMF are trying to arrange a partial bailout of Greece.  They’re doing so in a way they think will avoid triggering the CDS payout provisions, even though Greece will only have to pay back half of the face value of the bonds it has issued.  This is not a move calculated to win friends (or trust) among those who have been betting on Greek default, implying that the amounts are large enough that the banks can’t afford to pay.

The big question is whether Greece will go along with the austerity measures the IMF is proposing in exchange for debt forgiveness.  Another new government is in place.  It’s made up of “technocrats,” which means roughly that they’re supposed to wield a cost-cutting axe and then withdraw from public life.  But will Athens actually do any of the things it has promised?  No one knows.

The EU is simultaneously preparing Plan B, which would be to expel Greece from the euro.


Greece is poor and too small to matter.  Italy, on the other hand, is wealthy and too big to fail.  Italy, too, has just installed a new government of “technocrats.”  It has also successfully gone through a severe restructuring in the past, just to get into the euro in the first place.  So history says Italy can (and will) do so again.

my thoughts

Good news on restructuring in Greece or Italy will be slow in coming, because political processes take time to work out.  Bad news, on the other hand, like that Athens refuses to do anything, tends to surface right away.  Because of this, I think the news flow from the EU for the next few months will be generally neutral to negative and will be a net drag on world stock markets.

My guess is that markets are now almost fully discounting the possibility that Greece will leave the euro and that Italian economic reform will be slow but ultimately successful.  For what it’s worth, that’s also my base case.

I’ve argued in previous posts that the EU as a whole is already small enough in world terms that its likely economic performance isn’t enough to move the global needle one way or the other.

The real worry for non-EU investors is that failure of a large EU financial institution as a result of the EU’s cumulative problems will happen–and that this will have a Lehman-like negative effect on world trade.  I think this outcome is highly unlikely.

If that’s correct, we have two potentially negative influences from the EU to deal with in the coming months:

–uncertainty about Italy, and

–bouts of panicky selling by Europeans, for whom the crisis is far more important than it is for the rest of the world.

On the other hand, I agree with Goldman that a self-sustaining economic recovery in the US  is already underway.

My conclusion?  …avoid the EU for now and watch for potential weakness elsewhere to upgrade your portfolio holdings.

cyclical real estate rhythms: where we are now in the US

I recognize that the internet is making important structural changes in the shape of the real estate market in the US.

The most clearly visible to me is that e-commerce is fast making lots of retail space superfluous.  Many strip malls seem to me to be today’s equivalent of the old ghost towns of the Wild West that were all that remained after the local gold or silver mine petered out.  At the same time, fast broadband communication means that a small, but increasing, number of workers are able to live where it suits them rather than near a specific piece of corporate property.  Hence, the rising value of “vacation” or “destination” real estate.  And, of course, in mega-cities like New York we’re beginning to see the presence of wealthy mainland Chinese buyers of second homes.

the business cycle development pattern

Longer term influences aside, there is also a distinct business cycle rhythm to the real estate industry, which is what I want to write about today.  I think we’re at a cyclical turning point.

My experience comes from watching publicly traded real estate companies in the EU and in Asia, where–unlike the situation in the US–they can be important factors in stock market performance.

The pattern is easiest to see with urban office buildings, but it holds for residential and commercial real estate as well.

1.  As the economy begins to expand, demand for space in prime office locations begins to rise.  Vacancy rates shrink.  Price discounting disappears.  Rents begin to rise.

2.  As rents continue to move up, new construction projects are launched.  Some of these will be in prime locations.  But builders also know that as prime areas are filled up, businesses will be forced to consider secondary areas.  Land is usually more easily available there–and it’s cheaper, to boot.  So the secondary locations are a big thrust of new development.

3.   Companies in the central business district respond to higher rents by shipping some employees off to new, lower-cost office space that’s springing up in the secondary districts.  Firms that formerly occupied the secondary districts respond to redevelopment and higher rents there by locating further afield.

4.  Seeing these successive ripples of outward movement, speculators begin to anticipate the next iteration of the process.  They acquire land and perhaps build in anticipation of a tide of firms moving farther and farther from the central business district in search of more reasonable rents.

5.  The outward ripples stop–and the whole process shifts into reverse.  At some point, the combination of new space developed in the central district + existing tenants shifting increasing numbers of employees to cheaper locations causes an excess of prime office space in the center.  The economy may by this time be in cyclical slowdown, as well.  Landlords in the central business district begin to lower rents to lure customers back from secondary locations.  This kicks off successive waves of contraction, as lower rents and greater space availability move firms back to more convenient space.

6.  On the extreme periphery, speculators are left high and dry.  They’re stuck with raw land and, possibly, completed office buildings that they will be unable to use until–at the very earliest–when the next business cycle starts another outward pulse of development.

where we are now

The Wall Street Journal published a front-page article on Monday titled “US Farmers Reclaim Land From Developers.”  In it, the newspaper reports that large amounts of peripheral agricultural land–it cites parcels lying 30 miles and 65 miles outside of Phoenix–are being rebought by farmers out of foreclosure at small fractions of what development speculators paid for them a few years ago.

This is typically the last shoe to drop in the real estate cycle.

I don’t imagine that a new outward pulse will begin in the US anytime soon.  But it also seems to me that there’s virtually no potential for further bad economic news coming from the real estate sector.

Warren Buffett and IBM + Intel

Warren Buffett on TV

Warren Buffett, an iconic stock market investor, announced two days ago on television that he has acquired a 5.5% interest in IBM, now worth about $12 billion.  He apparently began accumulating the stock–the 65 million or so shares he holds amounts to about two weeks’ trading volume–in March.

why the buy is notable

The announcement is notable in a few respects–two small ones and one large.

Let’s get the small fry out of the way first:

1.  No one in his right mind goes on TV and announces he owns a ton of a given stock unless he’s finished buying.  The implicit message is “Feel free to ride on my coattails (and raise the value of my stock) if you wish.”

2.  Portfolio investors are required to disclose their holdings in a public filing (a 13-f) with the SEC each quarter.  According to Dealbook in the New York Times, a portfolio manager can request that the SEC keep secret the names of stocks the manager is continuing to buy.   (I didn’t know about this provision, despite being in the business for over a quarter-century.  Shame on me.  I bet I’m not alone, though.)  Dealbook says that’s what Buffett did in March and the SEC said okay

Now the BIG one:

3.  The purchase represents Buffett’s first significant foray into the technology industry, a place he had previously shunned for lack of little investment appeal.  His explanation for the about-face?  …the world has changed, so he’s changing with it.

Actually, though, I don’t think IBM shows that he’s changed that much.  Buffett has also acquired a relatively small stake in INTC, which I think IS an eye-opener.  He isn’t trying to keep that one out of his 13-f filings, however.  I think this means one of his assistants really wanted to buy it and Buffett is simply watching to see how the stock turns out.  So I think it’s more a test of the assistant than a vote of confidence in INTC.

Buffett as icon

Buffett has an important place in portfolio investment history.  It comes from his being the first, a half-century ago, to understand the implications of an accounting paradox.

Long before anyone else, he realized that continuous spending on advertising to establish a brand name had an enduring positive value, even though this activity appeared in the firm’s financial statements only as a negative–as expense.  (Pick a consumer-oriented company and look at the advertising expense.  It’s mind-bogglingly high today–and it used to be a lot higher.)  Similarly, developing a strong distribution network of competent sales and delivery people also has an enduring value, even though the only reflection of this in financial statements is in (higher than normal) salary expense.

Together, a strong brand name and a top-notch distribution system form a powerful–if invisible–barrier to competitors entering a market.  They also offer the opportunity for operating leverage if the firm can push a wider variety of branded products through its network.

So while his Graham and Dodd competitors were looking for nameless/faceless companies that were piling up lots of working capital and had tons of plant and equipment, Buffett was snapping up branded firms that served recurring needs in service areas like newspapers and insurance, and strong brands like Coca-Cola…at bargain basement prices.  Geico is probably his most famous current holding.

As everyone knows, he made a fortune, both for himself and for his clients.

my (more or less random) thoughts

IBM has a powerful brand name and distribution network.  The industry it operates in aside, the purchase looks to me like vintage Buffett.

I don’t think the Buffett magic works as well as it once did, for two reasons:

–once the investment industry became aware of Buffett’s superior results, everyone studied his methods carefully and began to imitate them.  By the time I entered the business in the late 1970s the value of intangibles and of service firms was already beginning to become conventional wisdom. So Buffett’s edge gradually disappeared.

–the internet happened.  Getting distribution no longer requires years of heavy advertising expenditure; it takes good public relations and web design.

Buffett has transformed himself, consciously or not, into his own brand name.  For the performance of Berkshire Hathaway stock, the mystique of the “Sage of Omaha” is at least as important as perceived investment results.

Why IBM and not AAPL?

To my mind, INTC is the much more uncharacteristic purchase.  It’s still very cheap, I think (remember, I own the stock).  But it’s a capital intensive, research and development dependent, manufacturer of (arguably) business cycle sensitive, high-priced stuff.  It faces substantial competition from ARMH.  In other words, it’s just about everything Buffett has not wanted in a company.




thinking out loud about Euroland (III)

It’s possible that we’ll see prolonged economic and political stagnation in Europe of the type we’ve experienced in Japan since 1990 as the continent tries to decide whether the EU project will survive.

My conclusion, based on the prior two posts on this topic, is that–like Japan–Europe by itself is too small in the global terms for its problems to derail economic progress elsewhere.  Market volatility, yes; global recession, no.

In a nutshell, that’s my base case.


Nevertheless, even an investor who is not directly involved in Europe nor compelled by customer mandate to invest there faces two issues:

–the fact of continuing European selling of equities, both in Europe and abroad, as EU investors rebalance their portfolios and make themselves more liquid in response to developments there, and

–the possibility that the European financial situation is much more dire than we now suspect and/or the global banking system will transmit part of that damage to the rest of the world.

what to do?

I’m writing under the assumption that we’re not yet anywhere near either the end of the EU crisis, even though it has been dragging on for more than a year.  Nor am I willing to bet that we’re at or near the low point in stock market terms.

These are very important assumptions.   As a result of them, I want to protect myself from bad news coming out of Europe  I don’t think we’re at the equivalent of late-March 2009 for Europe.  So I don’t want to bet against the prevailing sentiment and hold already severely beaten-down beneficiaries of the dissipation of storm clouds.  But–as with everything in the stock market–I could easily be wrong.  So I’ve got to keep these assumptions in the forefront of my mind.

Three cases:

–a professional equity investor with a US-style mandate from institutional clients to remain fully invested.  Here the portfolio composition is straightforward.

One choice is to “neutralize” the EU by looking exactly like the index and trying to achieve outperformance elsewhere.

That’s the conservative choice.  My personal preference would be to underweight Europe, avoid the banks and choose stocks that are listed in the EU but which have the largest part of their operations in other parts of the world.  I’d look for growth names and avoid companies that depend on a robust worldwide economy.

–an EU-based balanced (i.e., a portfolio of stocks +bonds) investor, maybe with predominantly high net worth individual clients.  This investor will have a strongly European focus.

He is probably being required by the rules set up in his contracts to sell stocks because his bond losses have made his equity allocation too big.  He’s probably also being bombarded by negative news–and by customer inquiries about whether his strategy (no matter what it is) is too aggressive.  So he’s feeling the need to become increasingly more defensive.

He is probably selling stocks in peripheral markets, especially if they have done well; selling smaller capitalization stocks to buy larger; selling growth names to buy defensives like utilities and consumer staples. He is probably heavily tilted toward large cap names in northern European markets.  He probably has raised some cash (this may give him emotional satisfaction, but won’t affect his returns unless he’s raised a huge amount).

I think much of the selling in places like Hong Kong, and even the US, is emanating from Europe, and from the kind of professionals I’ve just described.  I think such selling will prove to have been the wrong move, but I suspect that I would be doing some of the same if I were in the position of this investor.  Ideally, I’d have the same strategy here as in my first case.

The world may also have to wait for this guy to run out of stuff to sell before markets take on a healthier tone.

–you and me.  …or rather, what I’m thinking/doing now in my own portfoli0.

The sound bite form of my central case is, as I wrote above, that Europe is the new Japan. That’s probably too pessimistic, but it’s going in the right direction.  Once the market settles down, there’ll be the opportunity to pick stocks (I do own one individual stock in Europe now through an ADR–IHG).  But there’s no rush.  In the meantime, I’m content to watch from the sidelines.

My guess is that worries about contagion through greater exposure by US banks to Europe than we now know about–or that bank hedging won’t work at all–is wildly overblown.  But I’ve never been a fan of banks in any case–and I know very little about financials, so I’m happy to continue to avoid them.

I’ve begun to take some profits on big multi-year winners and reinvest the proceeds into semi-defensive stocks.  DeNA (2432:JP) and WYNN are examples of the former; INTC and (believe it or not) LVS are instances of the latter. Part of this is pure tactics, not strategy.  Part of this is that the slow growth emphasis I’ve had for a couple of years has worked too well for too long, so I should probably reduce my heavy emphasis.

These are only changes on the margin, however.  I still think that we’re in a slow-growth world where there isn’t enough demand to satisfy all the firms in a given industry.  This means the important distinctions to make are between best of breed vs. the rest, and between niche players that serve hot spots of demand vs. everybody else.

I think continuing troubles in Europe will offset the good news coming from the US economy, at least until the situation in Italy and Greece develops further.  Therefore, the overall environment hasn’t changed much, in my opinion, other than short-term volatility is increased.  And, unless there’s a very compelling counterargument, everything in Europe is now in the minus column.  But most of it was already there, anyway.