Legendary Value Investing Fund Managers Getting The Sack!

Last August, Henry Blodget wrote, "Bill's not the first legend to get hammered by mean reversion, and he won't be the last" in his article, Legendary Fund Manager Bill Miller Fired By Client

• A few years ago, Legg Mason Value Trust manager Bill Miller was revered the world around for outperforming the S&P 500 15 years in a row. Now, after a couple of horrible years have wiped out almost all of that outperformance, he's getting fired by state pension funds:

Do see also Bill Miller Featured on WSJ: The Stock Picker's Defeat

Yup, how ironic is that Bill Miller isn't the last!

Last week, Grantham Fired by Massachusetts Pension After Losses

• April 8 (Bloomberg) -- The Massachusetts state pension system fired Jeremy Grantham’s firm as manager of $230 million in emerging-markets debt after losses from asset-backed securities dragged down returns.
  
  The pension system’s board voted at a hearing in Boston today to pull its money from developing-nation debt investments managed by Grantham, Mayo, Van Otterloo & Co. The firm continues to run a $500 million emerging-markets stock fund for the state....

And also gone was the legendary 'contrarian' David Dreman!

And NY Times columnist, Floyd Norris, wrote the following David Dreman, Contrarian Fund Manager, Exits Unbowed

• David N. Dreman was a star mutual fund manager. Then he bought bank shares and held on as the financial crisis grew.
  
  Now he has been fired from the flagship fund that bears his name, despite what remains a good long-term record. The fund’s name will be changed, and the fund will take fewer risks. A drab industry will become a little drabber.
  
  In the past, the firings of once-celebrated fund managers have sometimes provided a market signal of its own — that the trend that led to their poor performance was about to end. If that were to happen this time, there could be a revival for so-called value stocks, and particularly for the beaten-down and almost universally disdained financial stocks.
  
  “The success of contrarian strategies requires you at times to go against gut reactions, the prevailing beliefs in the marketplace and the experts you respect,” Mr. Dreman wrote in his best-selling 1998 book, “Contrarian Investment Strategies.”
  
  Mr. Dreman rose to fame in the 1990s, when the fund he began in 1988 amassed an impressive long-term record. But he had been preaching, and practicing, the gospel of investing in unpopular stocks with low price-earnings ratios since the late 1970s. He has been a columnist for Forbes Magazine.
  
  As the fund industry concentrated, the Dreman fund family was bought by Kemper, which was bought by Scudder, which was bought by Deutsche Bank. Last week the fund board installed by Deutsche quietly filed with the Securities and Exchange Commission a disclosure that Mr. Dreman’s firm would no longer manage what is now called the DWS Dreman High Return Equity Fund.
  
  On June 1, Deutsche will take over the management, and assign the job to a team of managers based in its Frankfurt office. The fund will become known as the DWS Strategic Value Fund. Mr. Dreman’s firm will continue to manage three smaller Deutsche funds, but don’t be surprised if those relationships eventually end.
  
  Mr. Dreman, who is 72, did not sound bitter when I spoke to him this week. “The board of directors is obviously entitled to do what they did,” he said. But neither was he repentant. “Low P/E has worked well over time,” he added. “There will be years that we are very out of favor, but we make it up.”
  
  You wouldn’t have known that the fund’s long-term record remained better than the market from reading what Deutsche officials had to say. “We had seen very weak performance for the fund over every major time horizon,” David Wertheim, the bank’s project manager for equities, told Bloomberg News. He declined to speak to me.
  
  Those time frames are one year, three years and five years, the periods that are used by fund raters like Morningstar and Lipper. Just now they are dominated by last year, which was a horrid one for the Dreman fund. Even so, it still has a superior long-term record.
  
  There are few celebrity mutual fund managers any more. Fund groups prefer to promote themselves rather than a manager who could leave to start a hedge fund. In an age when holding on to assets is the way for a fund family to profit, they may well prefer a fund that sticks close to its peers. The new fund managers plan to own more stocks, with less concentration in any one stock, and a broader definition of value investing. They are far less likely to stand out from the crowd.
  
  Mr. Dreman often stood out. I checked the fund’s last 14 annual reports, each of which showed its performance relative to Lipper’s group of equity-income mutual funds. In seven of those years, it was in the top quartile. In four of them, it was in the bottom quartile. Only in three of the years did the fund end up in the middle 50 percent of funds.
  
  The recent bad performance has been costly for Deutsche Bank, as well as the fund investors. Because of a combination of poor performance and investor withdrawals, the fund had $2.4 billion in assets on March 31, down from $8.3 billion in late 2007.
  
  What went wrong? You can get a hint from part of the fund’s most recent annual report, for the year that ended last November. “The cornerstone of our contrarian value investing philosophy is to seek companies that are financially sound but have fallen out of favor with the investing public,” it said.
  
  With too many financial companies, among them Washington Mutual, Citigroup and Fannie Mae, Mr. Dreman and his colleagues did not realize until too late that the companies were not financially sound, no matter what their books seemed to say.
  
  Buying stocks with low P/E ratios can make sense only if the earnings — the “E” — are real. “The E was much worse than anyone thought,” Mr. Dreman told me. “The banks themselves had no idea of how bad the E was.”
  
  He still thinks his strategy will work, and told me he thinks the market may well have hit bottom. As that last annual report put it, “The last few months have provided many opportunities to buy strong companies with good long-term prospects at the lowest prices we have seen in many decades, and we have taken advantage of what we regard as incredible bargains.”
  
  My suspicion is that Mr. Dreman could have saved his job if he had been more willing to bend with the times and go along with the current investment consensus. After all, this is a market where Citigroup and Bank of America could see their shares collapse after the government made it clear they would not be allowed to fail. How could any rational investor want to own a bank stock in that environment?
  
  Of course, what is obvious is sometimes wrong. In February 2000, George Vanderheiden retired at the age of 54 from Fidelity Investments, where his sparkling long-term record at the Destiny Fund had been tarnished by underperformance caused by his refusal to jump on the technology stock bandwagon.
  
  His successors knew a trend when they saw one. They managed to get in on the tech stock boom just before it ended. The fund lost big, when it would have done well had his successors stayed with Mr. Vanderheiden’s stocks.
  
  The people who run mutual fund companies, it turns out, are very much like other investors, something Mr. Dreman well understood.
  
  “The major thesis of this book,” he wrote in 1998, “is that investors overreact to events.”
  
  

Bill Miller Featured on WSJ: The Stock Picker's Defeat

Posted last week: Bill Miller Claims That A Market Bottom Has Been Made!

Today Bill Miller is featured on WSJ.com. The Stock Picker's Defeat

Some of the points highlighted.

• Mr. Miller was in his element a year ago when troubles in the housing market began infecting financial markets. Working from his well-worn playbook, he snapped up American International Group Inc., Wachovia Corp., Bear Stearns Cos. and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying.
• What he saw as an opportunity turned into the biggest market crash since the Great Depression. Many Value Trust holdings were more or less wiped out. After 15 years of placing savvy bets against the herd, Mr. Miller had been trampled by it.

Yes, the chart of his fund, LMVT, was highlighted in my posting last week here

• "The thing I didn't do, from Day One, was properly assess the severity of this liquidity crisis," Mr. Miller, 58 years old, said in an interview at Legg Mason Inc.'s Baltimore headquarters.
  Mr. Miller has profited from investor panics before. But this time, he said, he failed to consider that the crisis would be so severe, and the fundamental problems so deep, that a whole group of once-stalwart companies would collapse. "I was naive," he said.

• A year ago, his Value Trust fund had $16.5 billion under management. Now, after losses and redemptions, it has assets of $4.3 billion, according to Morningstar Inc. Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index.
  
  These losses have wiped away Value Trust's years of market-beating performance. The fund is now among the worst-performing in its class for the last one-, three-, five- and 10-year periods, according to Morningstar.

• "Every decision to buy anything has been wrong," Mr. Miller said over lunch at a private club housed inside Legg's headquarters. In the 16th-floor dining room, Mr. Miller sat with his back against the wall, a preference he says he picked up as a U.S. Army intelligence officer in the 1970s. "It's been awful," he said.

Bill Miller Claims That A Market Bottom Has Been Made!

On Reuters, Legg Mason's Miller: "Bottom's been made" in stocks

• NEW YORK, Dec 3 (Reuters) - Legg Mason's Bill Miller, a celebrated investor but whose stock picking is far off the mark this year, said on Wednesday the "bottom has been made" in U.S. equities.
  
  He recommends that the Federal Reserve buy stocks and junk bonds to avert a deeper financial crisis, adding "the taxpayer would make a killing" as markets rebound.
  
  Speaking at Legg Mason's annual luncheon for media, Miller said that all long-term investors believe that stocks today are cheap, but credit markets must regain health before equity markets can rally.
  
  It "looks as if the bottom has been made" in U.S. stocks, he said.
  
  Miller told Reuters the year has been "terrible, a disaster and awful," yet he held out his past performance in down markets as a reason why he should not be counted out.
  
  "We've performed in most of the financial panics that we've had -- the last one being the three-year bear market ending in 2002 -- we outperformed all the way through that," he said.
  
  "So even though we lost money, we lost a lot less money than the market did," Miller added.
  
  However, Miller acknowledged that his performance has been worse than in past downturns.
  
  "When you're underperforming and losing more money than the market in a down market, then that's a much more problematic situation. We've performed far worse than I would've predicted we would," he said.
  
  For the year, Miller's flagship Value Trust LMVTX.O fund was down 59.7 percent as of Tuesday, compared to a 41 percent decline in the reinvested returns of the S&P 500 index, according to Lipper Inc., a unit of Thomson Reuters.
  
  Performance over the year-to-date, one-, three- and five-year periods for Value Trust put it at the bottom of the barrel among its peers, Lipper data shows.
  
  The severe sell-off has provided ample opportunities.
  
  "This market is very unusual because since the end of the second quarter, it has been a pure scramble for liquidity which accelerated obviously post-Lehman Brothers and people sold without regard to value at all," Miller said.
  
  "So at the end of the end of this quarter, every sector in the market has companies that represent what we think are exceptional value."

I don't get the rationale for asking the Feds to buy stocks and junk bonds!!! I seriously don't!

Anyway, I have featured Bill Miller many times on this blog before. Here are some selected postings.

• Bill Miller's Letter to Shareholders 2007
• Bill Miller again
• Poker and Investing!
• Stocks Are Cheap!
• Bill Miller's Q3 Shareholder's Letter

So Bill is calling that the market has made the bottom.

However, I would like to point out this posting of mine made on August 2007, Stocks Are Cheap!

• According to data compiled by Bloomberg, stocks are now the cheapest they have been in 16 years. The S&P 500 is valued at 15.4x estimated earnings, the lowest since January 1991. Again, a pretty good time to be a buyer of stocks!
  
  Even after this decline in the stock market, over the past 12 months the market is up 17% with dividends reinvested, which is well above the long-term average.
  
  I began the year quite bullish and remain so. ( here is the source link to Bill's comments: here )

Yup. Bill has been calling that the stocks a cheap for so long.

And if you ask me, this is exactly why his fund is doing so poorly now.

The following chart of his fund, LMVTX, says it all.

Bill Miller's Q3 Shareholder's Letter

Highly recommended reading: http://www.leggmason.com/individualinvestors/documents/insights/D6485-MillerShareholder.pdf

I would highlight two passages. Firstly his apology.

Guys like Bill Miller are true legends. He acknowledges his mistakes made. Unlike some other delusional investment advisers/fund managers.

• The Current Crisis
  
  The current crisis is in its second year, and it is only in the past 30 days that effective policies to deal with it are finally being implemented. The policy response prior to this can only be described as disastrous, culminating in the decision to let Lehman Brothers go bankrupt, a decision widely and, we believe, correctly seen to have been a mistake of historic proportions. This decision created a whole new crisis in the global credit markets, which, combined with the existing housing-related crisis, brought the financial system to the point of collapse.
  
  I think the Treasury, up until very recently, must have been operating under the motto of Boris Johnson, mayor of London, who said, “My friends, as I have discovered myself, there are no disasters, only opportunities. And, indeed, opportunities for fresh disasters.”
  
  That of course, applies to us as well. General Douglas MacArthur has famously remarked that every military disaster can be summed up in two words: “Too late.”
  
  That certainly applies to this crisis and to our response to it. The authorities and we were too late to recognize the scope and seriousness of the unfolding crisis, and too late to take the appropriate action. When Federal Reserve Board Chairman Ben Bernanke and others repeatedly said the crisis was contained, we thought that the probabilities were that it was—they had far more information and far more resources than anyone in the private sector to make that judgment. We were both wrong.
  
  This is not the venue for a complete analysis of policy failures, nor is it my desire to blame policymakers for their errors. I have made enough mistakes in this market of my own, chief among them was recognizing how disastrous the policies being followed were, yet not taking maximum defensive measures, believing that the policies would be reversed or at least followed by sensible ones before things got completely out of control. In this market, our long-term orientation and optimism about the future have not served us well.
  
  I believe the present phase of the crisis was initiated by the politically popular but, in my judgment, economically disastrous decision to nationalize Fannie Mae and Freddie Mac (the GSEs)1 on September 7. The best analysis of this, in my view, has been done by famed economist Anatole Kaletsky of GaveKal Research, whose two papers, “The Unintended Consequences of Mr. Paulson” and “The Financial Doomsday Machine” are required reading, in my opinion. Some of the more historically minded of you may recognize the title of the first as harking back to John Maynard Keynes’s 1925 work, “The Economic Consequences of Mr. Churchill.”
  
  The stock market had been recovering from its July 15 low, with the S&P 500 Index rising nearly 100 points by the end of August. Even the GSE’s stocks had been rising. Then the seizure happened, and a bit over a week later Lehman went bankrupt, Merrill was sold to Bank of America, and AIG was “rescued,” again nearly wiping out shareholders. The day after the GSEs were seized, AIG stock was $24. Eight days later it opened at $1.85.
  
  The GSE nationalization created what Karl Marx would have called a “contradiction” in the capitalist system. The contradiction was that the government repeatedly said financial institutions needed more capital, and that it wanted private capital to solve the problem. But the government also indicated that if it needed to provide additional assistance in the future, then shareholders who had provided capital should be completely or mostly wiped out. Private capital will not be forthcoming if it believes it is the policy of the government to wipe it out should intervention later be necessary. Still, prior to the seizure, there had been enough private capital around to put large amounts of money into Merrill Lynch, AIG and Lehman. But when the government preemptively seized the GSEs, not because they needed capital and could not get it (Fannie Mae had $14 billion in excess capital, and Freddie Mac several billion above regulatory requirements), but because the government believed they would run out in the future, then shareholders of every other institution that needed or was perceived to need capital did the only rational thing they could do — sell, in case the government decided to preemptively wipe them out as well.
  
  This made it effectively impossible for any institution, except those who manifestly did not need it, to raise capital. John Thain at Merrill recognized this immediately and salvaged something for Merrill shareholders. The bankruptcy of Lehman, though, ushered in a whole new stage of the crisis.
  
  Heretofore, when financial institutions failed or were seized, their creditors suffered no losses. Bear Stearns creditors were protected, as were those of the GSEs. Lehman, though it was twice the size of Bear Stearns, was allowed to go bankrupt. Creditors who had investment-grade paper on Friday had worthless paper on Monday, leading the oldest money market fund, the Reserve Fund, to “break the buck,” and precipitating a complete freezing up of all short-term credit markets as no one knew whose paper could be trusted.
  
  As I noted earlier, this now seems to be recognized by many as a monumental policy error. (I think it is still widely held that the GSE seizure was good policy, though. If so, it is awfully difficult to account for the financial collapse of all those institutions so close on the heels of what was supposed to be a confidence-building policy decision.) This is not the place for further discussion of the aftermath of Lehman. The question for investors is, where are we now and what of the present policy?...

Lastly, the following passage is probably what most investors seek and want to read about.

• The Current Investment Environment
  
  What should one make of an investment environment where the major indices are down 40% to 50% or more, credit markets are completely disrupted, housing prices are falling for the first time in 70 years, bond spreads are at record highs, consumer confidence has plunged, and fear is palpable? If you have been hoarding cash waiting for the collapse, you feel vindicated, maybe even gleeful. If, like many of us, you have been carefully acquiring assets, building up capital, investing for the long term, trying to ignore market fluctuations, you feel sick, maybe even disillusioned, at the scale of the losses to date.
  
  There is little dispute among knowledgeable investors that U.S. (and global) equities are extraordinarily attractive on a wide variety of measures based on historical standards. The worry is they may go a lot lower before they eventually recover, as the current crisis unfolds and as the economy undoubtedly gets worse. This worry is legitimate. After all, to most of us, stocks seemed quite cheap at the end of September, and now they are a whole lot cheaper. So what to do? The data indicate there is now a mountain of cash on the sidelines, enough in money market funds to buy about half the market capitalization of the S&P 500.
  
  One of the most important bullish signs has been little remarked upon. The monetary base, which consists of cash in circulation or in banks, had been decelerating during the entire time the Fed had supposedly been injecting liquidity into the system since last August. Thus, the amount of what economist Milton Friedman called high-powered money to stimulate the economy was decelerating, and so was the economy as the crisis continued. Now, though, the base is exploding as the Fed has finally turned up the liquidity pump. Since just after the GSE seizure, the Fed began expanding the monetary base, so far by over $300 billion, an unprecedented increase. It takes a while for all that liquidity to find its way into the system, but find it, it should, and the transmission mechanism is typically through capital markets first. As it does so, the odds are very good credit spreads will begin to decline sharply and equity prices rise.
  
  It is an old cliché that they don’t ring a bell at the tops and bottoms of markets, but it is not entirely true. Occasionally someone climbs up in the belfry and does just that, as a public service, but knowing that few are likely to heed the bell. That someone is Warren Buffett, and the reason he is one of the richest men in the world is that he understands asset values and human behavior as it relates to those values better than anyone. In 1974, which prior to now was the worst bear market since the 1930s and the best buying opportunity since then, he recognized that the values were compelling and advised that the time was right to start investing. In 1999, he warned that prices were very high and future rates of return likely to be far below normal. Sure enough, the trailing 10-year return on stocks is now negative, something seen only a few times in history, and an event that has historically heralded strong returns over the next 10 years. Mr. Buffett has returned to the belfry to ring the bell again, with his October 17 New York Times piece saying to buy American stocks, that the values are once again exceptional. His partner, Charlie Munger, has also recently remarked that we are setting the stage for a 10- or 15-year bull market. Once again, few are paying heed.
  
  We are.

Stocks Are Cheap!

Here's link to legendary investor, Bill Miller, commentary for Q2 2007. http://www.leggmason.com/funds/knowledge/management/2007MillerCommentaryQ2.pdf

Ah, given the extent of the woes around the global markets, I'm ass-u-ming that most would like to know what's Bill Miller's opinions on the market outlook. (see page 3)

• I am constantly asked for my market outlook, so I will give one, not because I know but because I am asked.
  
  The market last week had its worst week since the fall of 2002, which was a pretty good time to buy stocks. Other things equal, lower stock prices mean values are better and future rates of return higher. This latest sell off to 1458 on the S&P 500 — from a high of 1553 reached only a few weeks ago — puts us still above the 1449 level of February 26, which preceded the sell-off in early March that occasioned much angst but, of course, should have been bought. We are now trading just about the same level after this sell-off that marked the high before that sell-off.
  
  The proximate cause of this sell-off is a reappraisal of risk in the credit markets, starting first at subprime but now having spread to the riskier parts of corporate credit, namely high-yield bonds and loans to finance buy-outs. Many high-profile deals are being delayed, and banks have been unable or unwilling to sell bridge loans into the secondary market, raising fears about future credit problems. While all this is understandably unnerving, there was a lot of sloppy underwriting in subprime, and risk premiums in deals were too low, in my opinion. The current problems in the credit markets are a prelude to sounder lending in the future.
  
  Stocks are lower in the claim chain on corporate assets than bonds, so when bondholders demand better returns, stocks suffer in the short run. In the intermediate or long run, stock returns depend on valuation relative to fundamentals such as growth rates and return on capital.
  
  According to data compiled by Bloomberg, stocks are now the cheapest they have been in 16 years. The S&P 500 is valued at 15.4x estimated earnings, the lowest since January 1991. Again, a pretty good time to be a buyer of stocks!
  
  Even after this decline in the stock market, over the past 12 months the market is up 17% with dividends reinvested, which is well above the long-term average.
  
  I began the year quite bullish and remain so.

Bill Miller again

My Dearest Moo Moo Cow,

Saw your postings on Bill Miller: http://whereiszemoola.blogspot.com/search?q=bill+miller

Bloomberg has a new article on Bill: Bill Miller, Mired in Worst Slump of Career, Embraces AES, Tyco

• On board, Legg Mason Inc. money manager Bill Miller was bracing for the blow: The market, he knew, had beaten him at last. His streak -- 15 years of besting the Standard & Poor's 500 Index -- had come to an end. The final numbers showed he'd returned 5.9 percent in 2006, trailing a 15.8 percent gain by the S&P 500.

I will take his track record anytime, wouldn't you? And I have nothing but admiration for what he has achieved. Listen to his following set of comments.

• ``We are paid to 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.''
  
  Miller says he has no plans to change tack just because he's had one bad year. He realized as early as July 2006 that his streak was in jeopardy. All year, nervous clients kept calling.
  
  ``I got asked, `How do you go about analyzing your mistakes?''' Miller says. ``I said, `I don't. I don't analyze my mistakes.' We will analyze spectacular errors, but not garden variety errors.''
  
  His record puts him in the same league as his friend Buffett, whose Berkshire Hathaway Inc. delivered an average annual return to shareholders of 18.8 percent from 1991 to 2005. Buffett, unlike Miller, beat the S&P 500 in 2006, with a 24.2 percent return.

And the issue of luck or skill?

• Luck or Skill?
  In his January letter to investors, Miller said that if beating the market were purely random, like tossing a coin, then the odds of beating the S&P 500 for 15 consecutive years would be the same as the odds of tossing heads 15 times in a row. Using the actual probabilities of beating the market in each of the years from 1991 to 2005, he put his odds at 1 in 2.3 million.
  ``So there was probably some skill involved,'' Miller said. ``On the other hand, something with odds of 1 in 2.3 million happens to about 130 people per day in the U.S., so you never know.''

Absolutely class!

Articles on Bill Miller

Found some articles posted on Wallstraits on Bill Miller. ( http://school.wallstraits.net/hallguru.php?id=5 )


INVESTMENT FABLES: HIGH DIVIDENDS
Many conservative investors seek out high dividend paying stocks in place of bonds, but is this wise...

BILL MILLER: A PHILOSOPHICAL INVESTOR
Like so many great value investors, including Lynch, Munger and Neff, Bill Miller studied philosophy not finance...

MAUBOUSSIN ON DECISION-MAKING
Legg Mason strategist Michael Mauboussin discusses the reasons why most investors make such poor decisions...

BECOMING A VALUE INVESTOR III
Managing Money the Warren Buffett Way, Part III...

BECOMING A VALUE INVESTOR II
Managing Money the Warren Buffett Way, Part II...

BOOK REVIEW: THE ESSENTIAL BUFFETT
Robert Hagstrom of Leg Mason Funds follows up The Warren Buffett Way and The Warren Buffett Portfolio with The Essential Buffett, a deep look at focus investing methodology...

GORILLA-STYLE INVESTING: GROWTH, PROFITS, BRAND & VALUE
WallStraits’ oldest portfolio (and most successful) is the Singapore Gorilla Portfolio. Even during this bear market, our total investment of S$34,000 over the last 3 years is worth $126,000 today. To refresh our memories on selection of winning Gor

Bill Miller, the philosophical fund manager!
Who has the best record of any mutual fund manager in America? Most people would guess Peter Lynch. Not so. Bill Miller is the title holder. Bill has outperformed the S&P 500 each and every year since 1991. (Peter Lynch only managed a record of 7 stra

Bill Miller's Letter to Shareholders 2007

Found this posting. Give it a read, it's about the legendary investor, Bill Miller, Legg Mason's money manager: 'We made some mistakes,' Miller says of streak's end

I found the following comments worth noting:

His definition of Value:

• Looking at the sources of our outperformance over those 15 years yields some observations that I think are applicable to investing generally. They fall into two broad categories, security analysis and portfolio construction. Analytically, we are value investors and our securities are chosen based on our assessment of intrinsic business value. Intrinsic business value is the present value of the future free cash flows of the business.
  
  I want to stress that is THE definition of value, not MY definition of value. When some look at our portfolio and see high-multiple names such as Google residing there with low-multiple names such as Citigroup, they sometimes ask what my definition of value is, as if multiples of earnings or book value were all that was involved in 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. There are some things you can say about the future with a probability approaching certainty, such as that Citi will make its next dividend payment, and some that are much iffier, such as that the present value of Google's free cash flows exceeds its current $150 billion market value. Some value investors such as those at Ruane Cunniff have a high epistemic threshold and do exhaustive analysis to create near certainty, or at least very high conviction, about their investments. Others such as Marty Whitman take a credit-driven approach and ground their margin of safety by insisting on strong balance sheets or asset coverage. What unites all value investors is that valuation is the driving force in their analysis.
  
  Trying to figure out the present value of the future free cash flows of a business involves a high degree of estimation error, and is highly sensitive to inputs, which is why we use every valuation methodology known to assess business value, and don't just do discounted cash flow analysis. We pay a great deal of attention to factors that historically have correlated with stock outperformance, such as free cash flow yield and significant stock repurchase activity. It all eventually comes down to expectations. Whether a company's valuation looks low or high, if it is going to outperform, the market will have to revise its expectations upward.
  
  Being valuation driven means that we minimize our exposure to the panoply of social psychological cognitive errors identified by the behavioral finance researchers. I think those are the source of the only enduring anomalies in an otherwise very efficient market, since they cannot be arbitraged away.
  
  What we try to do is to take advantage of errors others make, usually because they are too short-term oriented, or they react to dramatic events, or they overestimate the impact of events, and so on. Usually that involves buying things other people hate, like Kodak, or 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.
  
  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. "Don't you read the papers?" one exasperated client asked us after we bought a stock that was embroiled in scandal. As I also like to remind our analysts, if it's in the papers, it's in the price. The market does reflect the available information, as the professors tell us. But just as the funhouse mirrors don't always accurately reflect your weight, the markets don't always accurately reflect that information. Usually they are too pessimistic when it is bad, and too optimistic when it is good.
  
  So grounding our security analysis on valuation, and trying to abstract away from the sorts of emotionally driven decisions that may motivate others, are what leads to the stocks that we own, and it is the performance of those stocks that has led to our performance.

And last but not least his comments of portfolio management:

• The other factor in our results is portfolio construction. We construct portfolios the way theory says one should, which is different from the way many, if not most, construct their portfolios. We do it on risk-adjusted rate of return. We do not do it based on the sector or industry or company weightings in the index. We do not approach things saying we want to be overweight financials because we think the Fed will ease, we want to have tech exposure because it is the right time in the cycle to own tech, or whatever. That is, we don't do things the way most others appear to do them.
  
  We do not start out thinking we need to be exposed to each sector in the market, because that would mean we would automatically be invested in the worst part of the market. (Some sector has to be the worst, and if your policy is to be in each of them you are going to be in the worst.) If we are in the worst part of the market, it is because we made a mistake, or we have a different time horizon from others, but it will not be as a matter of policy. We want our clients and shareholders to own a portfolio actively chosen based on long-term value, not based on index construction.
  
  A key reason for the streak has been our factor diversification. By that I mean we own a mix of companies whose fundamental valuation factors differ. We have high PE and low PE, high price-to-book and low price-to-book. Most investors tend to be relatively undiversifed with respect to these valuation factors, with traditional value investors clustered in low valuations, and growth investors in high valuations. For most of the 1980s and early 1990s we did the same, and got the same results: when so-called value did well, typically from the bottom of a recession to the peak of the economic cycle, so did we. And when growth did well, again usually as the economy was slowing and growth was harder to come by, we did poorly, along with other value types.
  
  It was in the mid-1990s that we began to create portfolios that had greater factor diversification. In the mid-1990s, many cyclical stocks were down and acting badly, just the sort of thing we tend to like. I looked at steels, and cement companies, and papers and aluminum, all things being bought by classic low PE, low price-to-book, value investors.
  
  At the same time, though, technology stocks were also selling at very cheap prices. Dell Computer was selling at about 5x earnings. Even Cisco could be had for about 15x earnings. I could not see why one would own cyclical companies that struggled to earn their cost of capital when you could get real growth companies that earned high returns on capital for about the same price. So we bought a lot of tech in the mid-1990s.
  
  Buying tech was not something value investors did back then. That was because tech was not thought to be predictable in the way something like Coke was, for example, since technology changes rapidly. But we had learned from Brian Arthur at the Santa Fe Institute about path dependence and lock in, which meant that while technology changes rapidly, technology market shares often don't, so they were much more predictable than they looked. We bought them and got lucky when tech values turned into a tech mania in 1998 and 1999.
  
  The result was we did well when first-rate value investors such as Mason Hawkins and Bill Nygren did poorly. They had almost no tech, and if you didn't have it, you had almost no chance to outperform.
  
  We realized that real value investing means really asking what are the best values, and not assuming that because something looks expensive that it is, or assuming that because a stock is down in price and trades at low multiples that it is a bargain. Federal regulations mandate how concentrated a mutual fund can be; they require a certain amount of diversification even in funds called non-diversified. Diversification has rightly been called the only free lunch available on Wall Street. It follows from the fact that the future is uncertain that one should multiply independent bets. Indeed, the Kelly formula, discussed in Bill Poundstone's Fortune's Formula, would indicate that if you were certain about something earning an excess rate of return, you should put 100% of your money in it.
  
  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 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. 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. Sometimes growth is cheap, as it was in 1995, and is today in my opinion, and sometimes so-called value is cheap, as it was in 1999. The question is not growth or value, but where is the best value?
  
  We were fortunate to recognize that so-called growth was cheap in the mid- 1990s and so avoided the extended underperformance of many of our value brethren in the late 1990s. We were also fortunate to recognize it was expensive in 1999 and sold a lot of those names reasonably well. We were not so smart as to have realized we should have sold them all, so we did less well than many of our value friends during the bear market that ended in March of 2003.
  
  We continue to be factor diversified, which I think is a strength. We own low PE and we own high PE, but we own them for the same reason: we think they are mispriced. We differ from many value investors in being willing to analyze stocks that look expensive to see if they really are. Most, in fact, are, but some are not. To the extent we get that right, we will benefit shareholders and clients.
  
  It has been wrongly suggested that concentration, owning fewer rather than many stocks, is a strategy that adds value. Studies have shown that concentrated portfolios typically outperform others.(2) All true, but an example of what Michael Mauboussin would call attribute-based thinking. The real issue is the circumstances in which concentration pays, not whether it has in the past.
  
  We suffered from being too concentrated last year. Being more broadly diversified would have led to better results. We benefited, though, from our concentration during the streak period. But being too concentrated was one reason the streak ended.
  
  Concentration works when the market has what the academics call fat tails, or in more common parlance, big opportunities. If I am considering buying three $10 stocks, two of which I think are worth $15, and the third worth $50, then I will buy the one worth $50, since my expected return would be diminished by splitting the money among the three. But if I think all are worth $15, then I should buy all three, since my risk is then lowered by spreading it around. For much of the past 25 years, there were those $10 stocks worth $50 around. For the past few years, they have been largely absent, as inter-industry valuations have only been this homogeneous about 2% of the time.(3)
  
  
  
  
  

Housing, Upside Down Logic and Greatest Manager

Update on the housing: Home Sales Plummet in 38 States in 3Q.

• The once-booming real estate market's persistent weakness over the past year has reined in expectations for economic growth but hasn't been severe enough to offset a rising stock market, lower gas prices and improved consumer expectations.
  
  The National Association of Realtors reported Monday that sales of existing homes fell in 38 states during the summer. Sales retreated to a seasonally adjusted annual rate of 6.27 million units nationwide, down by 12.7 percent from the same period a year ago. Nevada, Arizona, Florida and California led the declines.
  
  Home prices also dropped: The realtors' survey showed that the midpoint price for an existing home sold during the summer dipped 1.2 percent year over year to $224,900. Some 45 metropolitan areas saw home prices decline.

WSJ has a survey: http://online.wsj.com/article/SB116370236302025327.html?mod=home_whats_news_us

And another worthwhile reading article: Is the Housing Bubble Collapsing? 10 Economic Indicators to Watch.

And did you read Bill Fleckenstein's The upside-down logic of Wall Street?

And finally, here's a nice article on Bill Miller on Fortune: The greatest money manager of our time

• As it stands now, Miller has compiled one of the most remarkable records in the history of investing: His fund has outperformed the stock market for 15 straight years. That's right, 15 years, starting in 1991 - during George Bush the elder's presidency - through the tech bull market, then the crash and now the recovery

Here's a tip.

Think!!!

• "What we are really trying to do is to think about thinking," Miller tells me. "Understanding how groups behave is central to understanding how complex adaptive systems - such as the stock market - work."

Cheers!