The Plight of the Value Investor

Legendary Legg Mason fund manager Bill Miller is in a long slump, as are other value players. Can their style make a comeback?

by Ben Steverman

This is a tough time to be a value investor.

The value philosophy tries to outsmart the stock market by investing in companies that are deemed undervalued, often trading at a low multiple relative to earnings. It was developed by Benjamin Graham and championed by Berkshire Hathaway's (BRKA) Warren Buffett, but one of its biggest successes has been—or rather, had been—mutual fund manager Bill Miller.

Miller's Legg Mason Value Trust (LMVTX) beat broader market averages every year for 15 years, from 1990 to 2005, providing his investors with huge returns and attracting billions of dollars to his funds.

Three Years in the Hole

Times have changed. Miller's fund is down 29.3% so far this year and 33.1% in the past 12 months. After barely beating the broad Standard & Poor's 500 index in 2005, the value fund underperformed the market by 10 percentage points in 2006, 12 points in 2007, and 16.6 points in the first seven months of this year.

Once one of the best funds in the world, Legg Mason's (LM) flagship fund is now the worst-performing in its category, according to Morningstar (MORN).

In a letter to investors July 27, Miller joked that he and other value investors need a Value Support Group. "It seemed like we needed a 12-step program to cure us of our addictions to buying beaten-up stocks trading at large discounts to our assessment of their intrinsic value," Miller wrote.

Miller lamented that, rather than being driven by fundamentals, today's stock market reacts to headlines. "Valuation appeared not to matter," he wrote. "It was all about momentum and trend."

Multiple Mistakes

Criticism of Miller by Wall Street commentators and bloggers has been harsh, and billions of dollars have been pulled from his fund. Investors have $9.7 billion in the fund, down from a peak of about $23 billion.

Morningstar analyst Greg Carlson summarized several of Miller's investing mistakes in a July 31 note: He underestimated the credit troubles facing financial firms. He failed to predict the extent of the housing decline and bought homebuilding stocks after their first drop in 2005. Miller has ignored energy stocks, one of the market's few bright spots in recent years.

Adding to Miller's problems, Carlson says, is his style of making bold, highly concentrated bets: With relatively few stocks in his portfolio, one sour investment—like Freddie Mac (FRE), which has tumbled 86% in the past year—can take a huge toll.

Other value managers are also having a tough time, but the size of Miller's losses is unique. Morningstar's category of large value funds is down 17.5% in the first seven months of 2008, about a point worse than the S&P 500's performance.

Hybrid Style

Other value managers point out that Miller, while donning the value mantle, doesn't always fit the value style. "I always felt Bill Miller stretched the definition of value," says Mark Travis, the manager of Intrepid Small Cap Value Fund (ICMAX). Morningstar rates the Legg Mason Value fund, despite its name, as a "blend" fund, meaning it has elements of both the value and growth styles. The fund has often invested in more expensively valued technology and Internet stocks, such as Amazon (AMZN), a top holding.