Thursday, February 15, 2007

Bill Miller's 4Q 2006 Commentary

At the end of 2006, one of the most talked-about streaks in value investing (heck, in any kind of investing) came to an end. Bill Miller's Legg Mason Value Trust failed to outperform the S&P 500 Index for the first calendar year since he took over sole management of the fund in 1990. Rumours about the end of the streak led to a lot of publicity and commentary and only added fuel to the fire when the firm announced in late October that they expected 2Q 2007 net income to come in below analyst estimates.

In the letter, Miller acknowledges the streak right up front. Making use of both a priori and a posteriori probabilities, he demonstrates the odds that one could replicate his success. Needless to say, "there was probably some skill involved". That said, he doesn't allow himself to be satisfied with having done something that most probably could not, and in doing so, demonstrates the kind of character that is difficult to find in an industry where "just getting by" still compensates you pretty darn well.
Active managers are paid to add value over what can be earned at a low cost from passive investing ... We are paid to a do a job and we didn't do it this year, which is what the end of the streak means, and I am not at all happy or relieved about that.
The remainder of the commentary is spent on reviewing Miller's investment principles and singling out a few of the reasons why the streak lasted as long as it did. Two sources of outperformance for those 15 years that he finds applicable to investing in general: valuation and portfolio construction.

On valuation:
Valuation is inherently uncertain, since it involves the future. As I often remind our analysts, 100% of the information you have about a company represents the past, and 100% of the value depends on the future
And on portfolio construction:
We construct our portfolios the way theory says one should, which is different from the way many, if not most construct their portfolios ... We want our clients and shareholders to own a portfolio actively chosen based on long-term value, not based on index concentration.
He touches on other topics that helped the outperformance, such as factor diversification and concentration, and on being willing to take advantage of errors made by others, due to social psychological cognitive errors (read: behavioural finance).
It is trying to invest long-term in a short-term world, and being contrarian when conformity is more comfortable, and being willing to court controversy and be wrong, that has helped us outperform.
Miller's letters are always a treat, but this one serves both as a nice summary of his thoughts on investing to date, as well as an example of the type of humility that true investors always possess, even if their results do have odds of 1 in 2.3 million.

eta: actually putting a link to the letter in the post would probably help. it can be found here [warning: .pdf]