Bill Miller’s 30-year tenure as manager of the Legg Mason Value Trust is one of the most celebrated runs by a mutual fund manager in investing history, and for good reason. From May 1982 to April 2012, the Value Trust outpaced the S&P 500 Index by an average of 1.3 percent annually (including dividends). And the Value Trust famously beat the S&P 500 for 15 consecutive years from 1991 to 2005.
But there’s a catch. As of one of Miller’s former colleagues put it, the downside of Miller’s approach is the potential for “big mistakes.”
The Value Trust declined 55 percent in 2008, while the S&P 500 declined 37 percent that year. This was no fluke––the Value Trust’s standard deviation was 23 percent higher than that of the S&P 500 during the Miller era, which means investors had to have the stomachs for enduring very bumpy rides when they traveled with Miller.
Miller is now fixing to smooth out those bumps, according to my Bloomberg News colleagues. He's launching a new hedge fund that will attempt to dodge extreme market movements using a physicist-designed model that calculates the “probability of seismic activity.”
Oy, that sounds complicated.
According to Morningstar, Miller’s modus operandi at the Value Trust was to look for “stocks where the market is missing a significant source of value” and hunt for companies “able to generate sustainably strong returns on invested capital.”
In other words, Miller invests in value stocks of companies with high profitability, which is the classic Ben Graham approach, of course.
We have good data on simple value and profitability strategies courtesy of financial researchers Eugene Fama and Ken French. The value strategy selects the cheapest 20 percent of U.S. stocks by price-to-book ratios, and the profitability strategy selects the most profitable 20 percent of U.S. stocks by return-on-equity.
It turns out that a 50-50 blend of the value and profitability strategies would have gone a long way to achieving Miller’s current objective.
The value-profitability strategy would have returned 14.1 percent annually from May 1982 to April 2012, as compared to the Value Trust’s return of 12.8 percent over the same period. Granted, the value-profitability strategy does not reflect fees and expenses, which would reduce the return, but an excess average return of 1.3 percent annually on a value-profitability strategy leaves plenty of room for a reasonable management fee and other expenses.