Monday, November 30, 2009

Bill Miller Shareholder Report, Semi-Annual

Market Commentary

In my colleague Michael Mauboussin’s terrific new book, Think Twice, the opening chapter tells the story of Big Brown, the super looking colt who’d won such impressive victories in the Kentucky Derby and the Preakness, the first two legs of racing’s Triple Crown. This is a story with a lesson that directly relates to investing and to understanding the kind of recovery that appears to be getting underway in the U.S. economy.

After winning all five of his starts by a combined total of almost forty lengths, Big Brown was a 3-10 favorite to win the Belmont Stakes and become the first horse in thirty years to win the Triple Crown. Those odds indicated the “wisdom of crowds” putting a 77% probability on Big Brown’s winning the race and making horse racing history. Part of that was right: he did make horse racing history — by being the only horse to win the first two legs of the Triple Crown and finish last in the Belmont.

That so many were so sure of Big Brown’s success was due to a common analytical error that manifests itself in investing as well as horse racing. That error is the neglect of base rates. Psychologists call it the “inside” view, in contrast to the “outside” view. As Michael explains in his book:

The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view . . . asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

In the case of Big Brown, taking the outside view would be to see how many horses in the past had won the first two legs of the Triple Crown and then went on to win the third. The inside view focused on Big Brown, his history, the competition he faced, the tracks he ran on and their condition, his time between races, and so on.

The outside view revealed that twenty-nine horses had won the first two races of the Triple Crown in the 130 years it had been run, with eleven of those horses going on to win the third race. Parsing the data a little more finely showed a remarkable divergence in winning percentages. Before 1950, eight of the nine horses that had a shot at the Triple Crown won it. After 1950, only three of twenty were successful. Moreover, when Big Brown’s speed ratings were compared to the most recent six Triple Crown contenders (and not just to his competition in the race), he was the slowest by a wide margin. If those who were betting on the Belmont had used the outside view instead of the inside view, no one would have believed what everyone did believe — that Big Brown had a nearly 80% chance to win the Belmont.

Investors are faced with these sorts of problems constantly: if I put my money in bonds now, what rate of return should I expect over the next five or ten years? What is the outlook for stocks over the next twelve months? What are the chances of a significant rise in inflation over the next few years? What kind of economic recovery will we have? Should I fire my active money manager and replace him with a passive index product? What are the chances we have a “double-dip” recession? And on and on.

Faced with these sorts of questions, most people default to the inside view, and then augment its flaws with the usual assortment of behavioral biases long known to psychologists: they anchor on the most recent experience, they assume instances are representative of deeper patterns, they give more weight to vivid examples or dramatic outcomes, they place twice the weight on a dollar lost as on a dollar gained, etc.

The financial crisis that is now abating has created a near perfect environment for the admixture of all of the above, and that is perhaps why what Nobel winning economist Ken Arrow called the “clouds of vagueness” seem particularly thick and forbidding just now. Taking the outside view on some of the issues facing investors won’t make an inherently unknowable future predictable, but it can improve the odds of getting things right, or getting fewer things wrong.
The difference between the inside and the outside view is well on display in the different and, in some cases, strongly held views about what kind of recovery is now unfolding in the U.S. PIMCO’s Mohamed El-Erian is the most prominent advocate of the “new normal”, a term he coined to describe a recovery with real growth of 1-2%, persistently high unemployment and much greater government involvement in the economy. He has recently warned of a big letdown from the “sugar high” we are now experiencing in the market and the economy as the effects of the abatement of the credit crisis and massive government stimuli, both fiscal and monetary, begin to wear off.

He may be the most prominent, but he is not alone. In fact, it looks like he is the leader of a not so silent majority. The current consensus growth rate for the U.S. economy in 2010 is 2.4%. This is way below “normal” for the first year of a recovery, yet it is well above what most thought only six months ago. In April 2009, the International Monetary Fund (“IMF”) projected negative growth in world output of 1.3% this year, and only 1.9% growth in 2010. That included a projection of zero growth in 2010 for developed countries.

Projections such as these follow the classic inside view pattern: they look at current conditions, current trends, anchor on the most recent data and adjust from there. Since the economy bottomed in March, almost all time series forecasts of economic improvement have been adjusted higher as the year wore on. They are still well below “normal.”

A recent Bloomberg story noted that, in the second quarter of 2009, almost 75% of companies in the S&P 500 Index beat consensus expectations, which were then revised upward. Now, the consensus is for profits growth in 2010 to be up about 25% from 2009; yet, economic growth is expected to be only 2.4%, a ratio of profits growth to gross domestic product (“GDP”)C growth of about 11. The outside view would show that the ratio historically has been around 6x, indicating either profits expectations are way too high or growth expectations way too low. The outside view would favor the latter, as both time series have been steadily revised higher, and the early indications are that third quarter earnings are also coming in better than expected.

What does the outside view say about what we should expect? In an article in The Wall Street Journal (“From Bear to Bull,” September 19, 2009), Jim Grant quotes economist Michael Darda as follows: “The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period.” In the first year of the recovery from the bottom of the Great Depression, the economy expanded 17.3%. If one adjusts for the drop in output in this recession, the outside view would put 2010’s expected growth rate at around 8%.

Is the “new normal” wrong? No one knows, yet. The core of the argument in its favor is an inside view: the consumer is over-leveraged, savings rates have risen from negative to positive and may stay elevated or go higher, balance sheets have been shocked by home price declines and the stock market collapse and need to be rebuilt. A mountain of corporate debt has to be refinanced, banks are not disposed to lend and capital requirements are going higher, and corporations will be cautious about hiring or expanding due to pervasive uncertainty.

A variant of the argument is that with consumption elevated at 70% of GDP and the consumer retrenching, growth must be sluggish, profits will disappoint, and it will be hard for the stock market to make any headway. The outside view helps here, too. In 1933, consumption as a percent of GDP was even higher than today, at 83%, and the savings rate was negative. The consumer deleveraged aggressively, pushing consumption as a percent to 73%, while the savings rate rose; yet, unemployment fell sharply, output grew rapidly, and the stock market went up over 100% from 1933-1937. There have been eight times the consumer has deleveraged, and the market rose in six of those periods, with an average gain of 39%.

As of this writing, the S&P 500 Index is up over 60% since its bottom in March and up over 20% since the beginning of the calendar year, yet skepticism (if not downright pessimism) remains high. This judgment is not based on sentiment readings or surveys. As market veteran John Mendelson often points out, it is not what people say that matters, it is what they do. What they are doing is buying bonds and selling stocks. Through the first nine months of 2009, domestic equity funds had net outflows of $8 billion. During the first week of October, another $5 billion was redeemed. Bond funds, in contrast, had inflows of nearly $300 billion in the first nine months of this year. Of the top ten selling funds in America this year, nine are bond funds and only one is a stock fund, and that one is the Vanguard 500 Index Fund.

Stocks are pretty unpopular, despite having had a decent year so far, and why not? “Riskless” Treasuries have trounced stocks over this decade, having risen 85%, while if you’d bought the S&P 500 Index at the end of 1999 and held it through September 30th of this year, you’d have lost 14% over the same period. No profits at all for a ten-year period of investing in the biggest U.S. stocks! Buy and hold is dead is a common refrain. Who wants to own a risky asset that does not go up, and one denominated in a currency that will surely go down? (We “know” the dollar will go down because it is on the front pages of the financial papers and magazines that it will do so. Everyone knows that — the only question is how far and how fast and will it collapse?)

That is the inside view, anyway. The outside view provides a different perspective. According to data compiled by Jeremy Siegel at the University of Pennsylvania, stocks have provided average annual real returns (after inflation) of 6.66% for all ten-year periods going back to 1871. (It is a curious coincidence that stocks bottomed on March 6th, at an intra-day low of 666 on the S&P 500 Index). There have been fourteen ten-year periods where stock returns have been negative, including this one. In every one of the previous thirteen, the subsequent ten-year returns have exceeded 10% real, about 50% more than average, and more than double the return of government bonds. So while no future outcome is certain, every other time stocks have performed poorly for ten years, they have performed better than average for the next ten years, and they have beaten bonds every time by an average of two to one, yet investors can’t put money fast enough into bond funds, and continue to redeem equity funds.

As we sit at our desks pondering the myriad questions we’re faced with as investors, questions of great complexity, and ones of undeniable importance to our future well-being, it probably makes sense to get up and go outside, where the view is likely to be different, and clearer, and better.

Value Trust Portfolio Commentary
For the six months ended September 30, 2009, Class C shares of Legg Mason Capital Management Value Trust, excluding sales charges, returned 54.35%. The Fund’s unmanaged benchmark, the S&P 500 Index, returned 34.02% for the same period. The Lipper Large-Cap Core Funds Category Average returned 33.67% over the same time frame. Security selection was responsible for the majority of the outperformance, and the biggest contributions came from names in the Utilities, Information Technology, Financials and Consumer Discretionary sectors.

Following the second quarter of 2009, during which The AES Corp.’s stock doubled in price, the company continued to perform well making it the single biggest contributor to the Fund’s performance during the third quarter and since the beginning of the year. Stabilization of the credit markets as well as increased guidance from the company for the year helped propel the returns this year. While the share price of the company has risen considerably over the past year and strongly off the lows in March, in our opinion, it trades at under 12x next year’s earnings and should grow nicely over the next five years. The company owns and operates power plants and utilities in twenty-nine countries on five continents and a recent Fortune article pointed out that global investors, including China’s sovereign wealth fund, China Investment Corp., have approached AES about taking a stake in the company.

Online auction company eBay Inc. also performed well during the second and third quarters of the calendar year, as the company’s CEO, John Donahoe, continues to move the company to a more customer-focused model which centers on the core auction and payments business. Donahoe negotiated the sale of 65% of Skype in a deal that increased eBay’s cash while retaining upside in the company.

Credit card issuer Capital One Financial Corp. rose during the second calendar quarter on the wave of investor confidence. Capital One announced shortly after the bank stress tests that it would seek to raise additional capital to repay government funds received through the Troubled Assets Relief Program (“TARP”) facility as quickly as possible. The issuance saw great investor demand. Good news on net charge-offs in April bolstered the stock further as consumer confidence continued to rise, helping to encourage spending by Capital One’s customers. Shares of Capital One also rallied over 60% during the third calendar quarter as the company returned to profitability after two quarters of losses. The firm also repaid the funds it received from TARP. Recent data on the bank’s delinquencies and charge-offs also suggested that expectations were too pessimistic which likely contributed to the recent performance.

Eastman Kodak Co. was the largest detractor from Fund performance in the second quarter of 2009. The company reported a wider-than-expected loss for the first quarter on depressed sales, while also suspending its dividend. This news drove the stock lower and set the tone for the rest of the quarter. In spite of paltry demand, we were heartened that the company aggressively cut spending and expenses, saying that its first quarter spending should be the peak for this year. Kodak also stood behind its guidance for 2009, saying that it still thinks it can achieve adjusted EBITDAD well ahead of the consensus estimate. We believe Kodak will be able to meet its EBITDA goal and continue to see significant upside for the company.

The only meaningful detractor from the Fund’s performance in the third calendar quarter was Electronic Arts Inc. (EA), which dropped over 12% during the three-month period. While it is up close to the market’s rate of return year-to-date, it struggled during the quarter as the company posted disappointing results that showed falling profitability and a deteriorating cash position. We are encouraged by their recent commitment to reduce costs given the misalignment in their cost structure during the downturn in the economy. The company has over $7 per share in cash and no debt, and we believe it has significant upside.


After taking advantage of twenty names and eliminating five for the six-month period ended March 31, 2009, subsequent activity has been fairly modest by comparison. As fears receded in the Financials sector following the earlier calls for the nationalization of Citigroup and Bank of America, we added only two names during the second quarter and eliminated a modest position in MetLife Inc.

At the end of the third quarter, we initiated modest positions in five new securities: The DIRECTV Group Inc., Genzyme Corp., QUALCOMM Inc., Safeway Inc. and Yum! Brands Inc.
DirecTV provides digital television entertainment in the U.S. and Latin America. The company acquires, promotes, sells and distributes digital entertainment programming via satellite to residential and commercial subscribers. DirecTV has been able to add subscribers and pay down debt through this recession. The important strategies at both AT&T and Verizon have shifted to video and we believe DirecTV could be a target of a takeover by either AT&T or Verizon in the next couple of years. Liberty Media Chairman John Malone controls the company and he is simplifying the ownership structure by folding Liberty Entertainment into DirecTV. They have had an aggressive stock buyback program which is currently on hold until the integration with Liberty is complete. Ultimately, John Malone believes there may be a bidding war for the company and he has indicated he is ultimately a seller at the right price.

Genzyme is a global biotech company that develops therapeutics and treatments for various genetic disorders and other chronic disease conditions. The company’s flagship product, Ceredase, was launched in the U.S. in 1991 and was followed in 1994 by the next-generation Cerezyme, which helped to solidify the company’s position in enzyme replacement therapy. Genzyme has been under pressure because of issues surrounding manufacturing contamination and capacity constraints. We believe it is at an important inflection point in improving operating margins given the scale in profitability recently achieved in several of its businesses. The stock is currently at a free cash flow yield of close to 7%, but we believe the normalized level is closer to 10%, and it has been able to maintain double-digit growth rates for both revenues and earnings. We expect a significant M&A wave in healthcare as soon as there is clarity from Washington on the Healthcare Reform Bill.

QUALCOMM is a dominant company in semiconductor chipsets for wireless handsets and infrastructure vendors, and they license their intellectual property to handset vendors. The company has a near monopoly of third generation (“3G”) wireless technology patents and receives royalties on all 3G devices sold. With the migration from 2G to 3G, QUALCOMM is uniquely positioned to benefit. The company has no debt, is generating about $1 billion per quarter in free cash flow and has nearly $10 billion, or $6 per share, of cash on its balance sheet. We believe the market is currently underestimating the growth of the company from network migration and continued movement in mobility.

Safeway operates a retail food and drug chain in the U.S. and Canada. The company also has a network of distribution, manufacturing and food processing facilities. Safeway recently reported earnings that were better than consensus expectations and they maintained their guidance for the full year. The company’s price reduction program is 80% complete, and they expect price cuts to slow materially in 2010. Safeway expects to generate over $3 per share in free cash flow, representing a yield of nearly 14%. Backing out an unusual tax benefit places their normalized free cash flow yield closer to 10-11%, and yet the company trades at about 12x next year’s earnings. The company has continued to buy in shares and they have reduced their shares outstanding 5.5% over the past twelve months.

Yum! owns and franchises quick-service restaurants worldwide. They have the dominant franchise in China with Kentucky Fried Chicken (“KFC”). The company has indicated that the opportunity for KFC and Pizza Hut brands in China is at least as big as the U.S. market. Yum! recently announced a 10.5% dividend increase and a $300 million share repurchase authorization. This brings the current dividend yield to 2.5% for the company. Shares outstanding shrank 8% in 2008 and almost 6% in 2007. The company believes it can grow at a minimum of 10% per year for the foreseeable future.

In general, we expect that as we add names to the Fund, or as names come out of the Fund once they’ve reached fair value or another opportunity emerges that offers a better risk-adjusted return alternative, the overall market capitalization average of the Fund will likely move higher. All of the names we purchased are small positions and, depending on price movements, we may build them up quickly or move into other opportunities that offer better risk-adjusted return potential.

Bill Miller, CFA
Mary Chris Gay