Markets & Finance

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?

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.

"This is a Bill Miller problem and not a value problem," says Adam Bold, chief investment officer of the Mutual Fund Store.

Still, the same problems that have tripped up Miller in the past couple years have hurt a wide range of value investors. Repeatedly, investors hunting for bargains have purchased financial stocks, only to see the shares' value plummet even further. It was a classic "value trap," says Matt Kaufler, manager of Touchstone Value Opportunities Fund (CCEVX).

Allure of Financials

Many value managers are saying, "These are the best valuations on financials I have ever seen in my whole life," Bold says. Even if you acknowledge the problems facing banks and other financial firms, the sector seems priced for "absolute disaster," an unlikely outcome, he says.

Miller's holdings include JPMorgan Chase (JPM), down 5.5% this year; and insurers Aetna (AET), off 31%; American International Group (AIG), down 54%, and UnitedHealth Group (UNH), which has fallen 51% this year.

In his recent letter to investors, Miller said he was "quite aware of our mistakes, both of commission and omission," but he also argued for some optimism about the financial sector. "It is obvious the credit crisis will end, and it is obvious the housing crisis will end, and that credit markets will function satisfactorily and house prices will stop going down and then start moving higher," he wrote.

Is Value Passé?

If Miller and other value investors appear out of step with the times, it may be because of this hopefulness. Value investing is fundamentally an optimistic philosophy, believing, as Miller puts it, that "stock prices will be higher in the future than they are now."

But stocks are trading below not only their recent records, but also their values in early 2000—meaning that stocks as a class have been a lousy investment for the entire decade so far. Meanwhile, home values are falling, commodity prices have risen, and inflation worries are heating up.

In such a pessimistic environment, many may wonder if the value philosophy still works. In the past month alone, investors have pulled more than $1 billion from large cap value funds, a larger percentage than outflows from growth or blend funds, according to TrimTabs Investment Research.

Patience Required

But value managers claim to see gloomy times like this as a great opportunity. "We tend to be pretty active when the environment is ugly," Intrepid's Travis says. For investors obsessed with the fundamental value of stocks, a market correction can offer shares at long-term bargains.

For the time being, however, a persistent downturn could mean more mediocre returns for Miller and value funds in general. "With value, sometimes you have to be more patient," Bold says. It can take a while before Wall Street comes around to a value investor's point of view on stocks that have been overlooked, or in some cases decimated, by the market, he says.

It's inevitable that rough periods hit investors who make bold bets that differ from the market's conventional wisdom, says Karen Dolan, director of fund analysis at Morningstar. "The more important thing is, 'How do they do over the long term?'" she adds.

Bruised But Not Beaten

For Miller, the question may be more specific, relating to his abilities as a manager. Is the magic gone?

Miller still has the confidence of Morningstar's fund analysts. Miller seems to have learned some lessons, but he and his associates are "not panicking and veering from their successful long-term strategy," Morningstar's Carlson wrote after a visit with Miller and his staff. "We wouldn't be surprised to see the fund go from worst to first again."

But Miller has his doubters, to say the least. Miller's losses are so large, and his underperformance so persistent—stretching back to 2006"that it's past time to give him the benefit of the doubt, Bold says. "Enough's enough."

Kaufler, however, defends his fellow value manager. "I would not count him out," he says. "I know some people are starting to write his epitaph. I would not be one of them."


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