Bill Miller Q4 2006 Commentary: Discussing reasons for the 15 year streak.

Excerpts from Q4 2006 commentary of Bill Miller of Legg Mason Value Trust:

According to Bill Miller (BM) there were two fold reasons for his outperformance:
1. Security Analysis
2. Portfolio Management


Security Analysis:
BM highlights the following key factors related to security analysis:
1. Valuation is inherently uncertain, since it involves the future. However, in spite of this uncertainty, he states that 100% of the value of a stock is determined by its future (though this may be an exaggeration, as large number of asset play stocks have more than 50% of their value derived from their past, i.e., assets creation, which resides in their balance sheet)

2. According to BM, the market discounts whatever information is already available regarding the stock into its price (called as market efficiency). However, there are sometimes, when this ‘discounting’ may be optimistic, while other times it may me pessimistic, giving opportunities to create value for patient investors. BM tries to take advantage of such anomalies in his portfolio. Thus he buys things other people hate, like Kodak, or companies that they think will never conquer their problems, like Sprint. Sometimes it involves owning things people don’t understand properly, such as Amazon, where investors wrongly believe today’s low operating margins are going to be the norm for years.

Portfolio Construction:
1. BM constructs portfolio in a way that is defined in portfolio theories, i.e., on a risk-adjusted rate of return basis.

2. According to BM, a key reason for his streak has been factor diversification, which means he owns a mix of companies whose fundamental valuation factors differ. Thus BM portfolios have high PE and low PE, high price-to-book and low price-to-book. According to him, most investors tend to be relatively undiversified with respect to these valuation factors, with traditional value investors clustered in low valuations, and growth investors in high valuations.

3. According to BM, although funds are subject to requirements regarding diversification by industry or company, they do not have to be diversified by factor, that is, by PE ratios, or price-to-book, or price-to-cash flow. And it has been seen that they mostly are not: value funds tend to have almost all their money in low PE, low price-to-book or cash flow, and growth funds have the opposite. Thus, sometimes growth funds beat value funds and the market, as from 1995 through 1999, and sometimes value funds beat growth funds, as from 2000 through 2006, whereas BM funds which are factor diversified tend to do well in both markets.