Bill Miller on This Tough Market

by: Jason Kelly August 02, 2008 | about stocks: LM    

Jason Kelly

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Legg Mason's (LM) Bill Miller and many other seasoned pros are having trouble in this market. So am I. So, probably, are you. Mr. Miller reminded readers that it is at the end of a string of dismal months that future rates of return are highest, yet the smallest number of investors is interested.

Mr. Miller issued his second-quarter letter earlier in the week, from which I took the following excerpts:

[Warren Buffett] then made the perfectly sensible point that as we are all net savers, we should be happy if stock prices declined a lot more, so we could buy even better bargains. That is a point Charlie Ellis elaborated on in his fine book, Investment Policy, a few years back. As a matter of logic, it is irrefragable. As a matter of psychology, I think most of us value investors think we have plenty enough bargains already, and may not be able to handle that many more. Or more accurately, our clients may not be able to. We are value investors because we are persuaded of the logic of buying shares of businesses when others want to sell them, and we understand that lower prices today mean higher future rates of return, and high prices today mean lower future rates of return.

The best time to buy our funds or to open an account with us has always been when we've had dismal performance, and the worst time has always been after a long run of excess returns. Yet we (and everyone else) get the most inflows and the most interest AFTER we've done well, and the most redemptions and client terminations AFTER we've done poorly. It will always be so, because that is the way people behave.

This is the only market I have seen where you could just read the headlines in the papers, react to them, and make an excess return. I have used the mantra to our analysts that if it's in the papers, it's in the price -- which used to be correct. Indeed, it borders on cliché in the business that by the time something makes the cover of the major news or business publications, you can make money by doing the opposite. There is solid academic research to back this up. But in the past two years, you didn't need to know anything except to sell what the headlines were negative about (anything related to real estate, the consumer, or finance) and buy anything that was going up and that everybody liked (energy, materials, industrials).

It has been explained to me that it was obvious we should not have owned homebuilders, or retailers or banks, and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. "Don't you even read the papers?" was a common comment.

While I am quite aware of our mistakes, both of commission and omission, when I ask what is obvious NOW, there is little consensus. If there is something obvious to do that will earn excess returns, then we certainly want to do it.

Is it obvious financials should be bought now, having reached the most oversold levels since the 1987 Crash, and the lowest valuations since the last great buying opportunity in 1990 and 1991? Or is it obvious they should be avoided, since the credit problems are in the papers every day and write-offs and provisioning will likely continue into 2009?

Is it obvious energy stocks should be bought on this correction in oil prices from $147 to $123, a correction that has wiped 25 points off the prices of companies like XTO Energy (XTO) and Chesapeake Energy (CHK) in just a few weeks? Or is it obvious that oil had reached bubble levels at $147, and that buying the stocks here, down 30% from their highs, is akin to buying homebuilders down 30% from their highs in 2005? If you had bought Tesoro Petroleum (TSO) or Valero Petroleum (VLO) when their prices broke late last fall -- remember the Golden Age of Refining story that took Tesoro from under $4 to over $60? -- you would be looking at losses in this year greater than if you had bought Citibank (C) or Merrill Lynch (MER).

I do think some things are obvious: it is obvious the credit crisis will end, and it is obvious the housing crisis will end, and that credit markets will function satisfactorily and house prices will stop going down and then start moving higher. It is obvious that the American consumer will spend sufficiently to keep the economy moving forward long term. It is obvious that the U.S. economy, already the most productive in the world, will get even more productive and will adapt and grow. It is obvious stock prices will be higher in the future than they are now.

-- complete letter

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This article has 66 comments:

  •  
    Aug 02 01:50 AM
    Discipline trumps conviction. Don't fight the market. I would rather keep my cash for a more opportune moment than suffer the psychological water torture of holding on or adding to losing positions. Yes, stocks do eventually come back, but "eventually" is anyone's guess (tell that to Japanese investors who've been underwater for so many years). Preserve capital. Value investors are infatuated with buying stocks they think are bargains. However bargains may become even cheaper. Stop trying to pick bottoms. You can still make money arriving at the party late, however if you arrrive early it may be long hard wait. Miss the first 20% of the upside to be sure. If it is the beginning of the bull run, then missing the first year of gains is no big deal, bull markets usually last fo 3-4 years. Dont be caught in the trap of buying today's leaders which may become tommorrow's laggards. When I met Mr. Buffett, he told me it is much harder to make the returns he did, 40 years ago because information sources are so much more efficient. Where now can you really find stocks trading with large margins of safety?
    Value investors hate to concede defeat. As the old adage goes.."Cut your losses and let you profits run". Losers average losers.
    Reply | Link to Comment
  •  
    Aug 02 02:38 AM
    Financials are not cheap, and just because they are down in some case over 50% from their peaks, the market is right in bashing these stocks. Their fundamentals are still very poor and deteriorating. We are probably just half way (at best) through the credit write-downs, and once the books are cleansed they will still have the arduous task of rebuilding their businesses within an economy crippled from a severe credit contraction. Think about it these banks are levered to the tune of 10:1 to 15:1, and are probably under capitalised to the tune of several hundred billion. Now extrapolate that to the credit that is / will be sucked out of the economy - and boy it's going to take a while to reflate those valuations - and your hopes.

    The cheap, tend to get much cheaper in the final run. You just wait and see.
    Reply | Link to Comment
  •  
    Aug 02 05:43 AM
    Warren Buffet also said this current downturn would be much longer than most people think it will be.

    The U.S. is in a secular bear market until 2016. Has been a bear market since 2000.
    You have to make good trades to make $ in this kind of market. Buy and hold may or may not beat inflation.
    Reply | Link to Comment
  •  
    Aug 02 06:45 AM
    i agree with zenalgo. My assumption is that this is a flat market until 2016/2020.
    Look at the last 60 years: 1950 to 65, bull market; 1965/80, flat/bear market; 1980/2000 secular bull; we're in the next flat cycle. And that's only beginning from 1950. If you go further back, you get the same picture since 1870 or so (since we record stock prices).
    So, this thing is going nowhere for another 7 to 10 years. Doesn't mean you can't make money, it just means you can't make money by buying the market and waiting, in other words "there's no beta", you got to go out there and earn your upkeep (or that of your clients). Plenty of bear market rallies to come, enjoy the parties but stay close to the door!
    Reply | Link to Comment
  •  
    Aug 02 06:47 AM
    Sorry Mr. Miller. The only obvious sign out there is that cash is king right now, and I'm hanging on to mine.
    Reply | Link to Comment
  •  
    Aug 02 07:04 AM
    I guess Bill never read this WSJ article last week

    No sooner had financial stocks gotten up off the mat than poor existing-home sales body-slammed them.
    The abrupt halt Thursday to the relief rally that started last week underscored how little confidence investors have in the sector. Many feel they can't get a handle on bank balance sheets.
    Details that emerged earlier this week from Bank of America's purchase of Countrywide Financial help explain why that is the case. The deal's numbers show that big losses could still lurk in banks' closets.
    If so, their loan portfolios are worth far less than the stated values, and reserves taken against possible losses are inadequate. And if bank capital is overstated, firms could again be forced into dilutive capital raising.
    Turn to Countrywide -- and the huge amount by which Bank of America wrote down its assets. In second-quarter results out earlier this week, Bank of America said Countrywide's equity available to common stockholders, or its net worth, on a market-value basis at June 30 was just $100 million.
    To put that in perspective, Countrywide had $172 billion in assets at the end of June. Plus, Bank of America paid $4.1 billion for the firm, once the country's biggest mortgage lender.
    How could Countrywide's net worth be just $100 million? When a financial firm is acquired, the purchaser applies market values to all its assets and liabilities. Banks normally hold a big portion of their loans at historical cost with a reserve set aside for potential losses.
    At Countrywide, this marking to market of its loan portfolio resulted in a $9 billion hit, which was on top of about $5 billion in reserves. This, along with some offsetting items, took common equity to $100 million from $8.4 billion.
    The new market value was equivalent to about a 15% average mark on the firm's nearly $100 billion loan portfolio, David Hendler, an analyst at CreditSights, said in a research note. The mark was driven by low market values for home-equity, option-adjustable-rate mortgages and subprime assets.
    Granted, such a mark is a point-in-time estimate based on all the assets being sold. In reality, banks offset credit losses over time with earnings. And most big banks wouldn't face anywhere near as severe a market-value hit.
    Still, the reduction in the value of Countrywide's loans raises the question of what would happen to other banks if they similarly marked loan portfolios to prices they could fetch if sold in the market today. Typically, banks create reserves equal to 1.5% to 3% of those portfolios, but the prices applied to Countrywide's loans show those set-asides could be too low.
    Applying a mark of 5% -- more aggressive, but still well below Countrywide's -- at Citigroup, J.P. Morgan, Wells Fargo, Wachovia, Washington Mutual and Bank of America results in 10% to 30% reductions in the banks' stated book values. Push the mark to 7.5% and book values are 20% to 50% below stated levels.
    "That is why you see so many banks trading at such a discount to book value," says Craig Emrick, a bank analyst at Moody's Investors Service.
    That explains why many investors didn't think share prices were irrationally low in the beginning of July. It also shows why markets could again plumb those lows if bank losses exceed current expectation
    Reply | Link to Comment
  •  
    Aug 02 08:56 AM
    Bill Miller doesn't get it.LOWER prices are NOT good if you picked the WRONG STOCK like Miller has done with MANY.
    Reply | Link to Comment
  •  
    Aug 02 09:00 AM
    Over the past 20 years America has gorped its way to an in extremis position. Hank Paulson and Ben Bernanke are frantically trying to bail out the swamped boat. The government is in debt up to its eyeballs, corporations are being bailed out by foreign sovereign funds, and consumers have hocked their houses (which are now plunging to their actual market values).

    The financial services industry thus far has acknowledged $300 billion in losses but the bottom has yet to be found. How does $1 trillion grab you? This mess will not begin (underlined) to fix itself until the real value of the American economy has been determined. In the process FNM and FRE should be placed into receivership, their management scoundrels fired and both GSEs dissected into manageable entities.

    As for buy and hold, those of us in our sixties will find it challenging to await 2030 or whenever. IMHO cash, TIPS and very short duration foreign bond funds (PIMCO has one) are the safest places to be for at least the next several years.
    Reply | Link to Comment
  •  
    Aug 02 09:36 AM
    I believe that reversion to the mean is still as good a tracking/planning tool as any. On that basis, the mean return of approximately 7% (without dividends) over 100 years is a benchmark that should hold over a full market cycle of 30-40 years (one secular bull market plus a following secular bear market). Using the markets since 1980 (see taojaxx, above) we should expect the market from then until sometime between 2012 and 2020 to produce an annual average return around 7% (without dividends). From the 1980 low on the S&P 500 of 103 we have a total index return of 1130% as of yesterday's close of 1267. That is approximately 9.4% average annual return (compounded). If I pick a year in the middle of the range discussed, 2016, the value of the S&P 500 corresponding to a 7% average compounded return is 1074. This would require a average annual return for the next eight years of -2%.

    Whether this calculation is exactly correct or not, it is prudent to recognize that there is a significant probability that we are in the middle of a secular bear market. In bear markets, successful investors do not invest in indexes, but rather emphasize sector and stock selection, as well as dividends.
    Reply | Link to Comment
  •  
    Aug 02 09:41 AM
    I, too, am upset with the fools in the banking industry, Congress, the Bush administration, and in the government agencies who have been incompetent in doing their jobs ( like the SEC, Feds, Commodity Futures Trading Commission, etc.)

    As a retired fellow ( who will sign up for Social Security at age 66, hopefully on March 1, 2009) I shudder to think what will happen to all those people who are being foreclosed on , those employees who are losing their jobs, those young people who can't find decent jobs, etc.

    Eight years of a Republican administration, a former Senator named Phil Gramm ( The Enron Loophole Genius ), and a Republican Congress have resulted in the mess we are in.

    For one solution to one problem, go to:

    www.stopoilspeculation.../

    to sign a petition to help lower oil prices.

    Also, STOP SCREWING AROUND IN HEDGE FUNDS AND SPECULATION.

    If some predictions come true regarding lower stock prices, bank failures, more bankruptcies, it is possible that we will see a recession of five years instead of two years.

    People like the former CEO's at CFC, WB, Merrill, Fanny, Freddie,etc. who became multimillionaires could care less about the small investors who trusted them who have now lost money investing in their companies.

    In November, toss out the politicians ( incumbants )who screwed up.

    I will...it's how I intend to get my revenge.
    Reply | Link to Comment
  •  
    Aug 02 09:55 AM
    Am i an optimist or pessimist? I am a realist .There is no gaurante that america will go back or continue to be the once great country it was .We have massive problems which you either know about or don't ,so repeating won't make a difference . Its my impression is that this is not a Bear market or a Bull market . I think its a pyschotic market . Somehow the asylum inmates have taken over wall street .There are a lot of good companies making great profits ,mostly from over seas business , mostly asia or china . Yet the market has money moving fron good companies such as RIG ,which trades a very acceptable multiples and huge profits and an industry which wiill have massive profits for as far as the eye can see and putting money into stocks such as financial ,airlines and autos ,who are losing billions for as far as the eye can see and no sure model of how they are going to earn money in the future or even when in the future. all because they have cheap stock prices . I remind everyone of the dotcom bubble when tech stocks have come down to incredible prices which pretty much exist today . so ,until we can get the nut cases out of the market , its going to move side ways or most likly down .
    Reply | Link to Comment
  •  
    Aug 02 09:55 AM
    Ask anyone at Wells Fargo or B of A and you'll most likely hear about the fact that they are all worried about the upcoming write-offs on their HELOC exposure. Not to mention PRIME ARMs resetting over the next few years. We'll see many more walking from their homes, not just the subprime crew, and the losses will again be more than most expect, resulting in even lower than low prices for some of these banks.. I for one am waiting. Subprime is old news, but the HELOC/Prime write-downs will result in some huge opportunities.
    Reply | Link to Comment
  •  
    Aug 02 09:58 AM
    jjason, how about this: In November, toss out ALL the politicians, kill all the taxes, wait for a month to see how much money we all have, and then start over with NEW policies. Forget supporting slackers who refuse to work, forget national health care, just go back to the beginning when we each supported ourselves based on our ability to trade our skills with others. Let those who will be slackers fade away. Americans worked to build this country, let us work to keep it.
    Reply | Link to Comment
  •  
    Aug 02 10:28 AM
    The 20th Century was the American Century. We won two wars while the rest of the world was devastated, and went from an agricultural country to the greatest industrialized power in the world. No surprise about the huge returns to the US stock market in that epoch. Now, ask yourself, what are the odds that the 21st century will be equally favorable to the USA, and its stock market? The performance of stocks in 21st century will in all likelihood be MUCH lower than they are telling us.
    Reply | Link to Comment
  •  
    Aug 02 10:49 AM
    Boo hoo. What a whiner. Here's something obvious:

    "Investors need to avoid managers who "believe the market is wrong and they are right," says Mark Salzinger, editor of the No-Load Fund Investor newsletter. In a radio interview, Salzinger defined that type of manager as one who is unwilling to bend, losing objectivity about what is happening in the market, and falling in love with investments in their portfolio. Accordingly, Salzinger said he would sell Bill Miller's Legg Mason Value Trust"
    Reply | Link to Comment
  •  
    Aug 02 10:54 AM
    You will see starts and stop for the next 12 months. The financial sector will recover over time. One must look to UYG the 2x ETF to invest in this recovery. One should also study the Fidelity Select Finacials Mutual Fund. It can double over the next 36 months.
    Reply | Link to Comment
  •  
    Aug 02 11:03 AM
    Every 25-years(a generation) seems to be accompanied by financial crises. Right on target, in 2007 we had the mortgage debacle.

    I have posted about the 25-year cycle.
    The excesses of a generations can not be corrected in a few months.
    Reply | Link to Comment
  •  
    Aug 02 11:17 AM
    Say what you want about economics, politicians, media, stock pickers, etc. but in the end we will all see stock prices climbing much higher before Xmas - Sit on cash and lose big!!
    Reply | Link to Comment
  •  
    Aug 02 11:34 AM
    I love how any kind of downturn in the markets brings out the Chicken Littles. That is how you know that this is a historic buying opportunity.

    Reply | Link to Comment
  •  
    Aug 02 12:03 PM
    Ahhh, well if it were only a downturn in the markets....

    Have you been out much lately???? How often are you at the grocery store or the mall? When was the last time you mingled with the middle class?
    Are you as removed from the Average Joe as our current politicians?
    Because if you step outside, and start conversing with the waiter at your favorite restaurant or the guy that cuts your grass or the woman who cleans your house or your child's nanny or teachers or the guy the student ringing up your drycleaning bill...they will tell you that "their" world is falling apart.
    That is the only chart I need to follow when I invest.. Talk to the people in the street, watch the patterns emerging, notice the small things... like the increase in coupon usage at the grocery... these things will tell you more than any fancy chart and a you will know it 4 months faster than any other investor.
    That's why I am long on Gold and Silver. I see worry and fear headed to panic as we reach the cold dark months of winter.
    It will be the behavior of these Average Joes and their hard earned nickel that will determine this market...not the "well heeled" investors as they speculated could cure us on CNN last night.
    Reply | Link to Comment
  •  
    Aug 02 12:09 PM
    its a brand new world.financial & otherwise.historicgrap... & charts may no longer apply.think for yourself.all have an agenda.dont believe anybdy about anything.there is no more ethics or honesty or accountability.be my guest-be an optimist,dont whine & perhaps lose a loy of money.
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  •  
    Aug 02 12:21 PM
    I AM A DAY TRADE AND I CONTINUE TO MAKE MONEY IN A GOOD AND BAD MARKET. I SELECT THE BEST COMPANIES BUY THEM LOW AND SELL THEM HIGH IN SOME CASES I WOULD GO IN AND OUT OF A GIVEN STOCK 10 TIMES IN ONE DAY SOMTIMES I LOOSE BUT MY GAIN EXCEED MY LOSSES.
    LONG TERM INVESTMENT IN STOCK IS OVER THAT WAS NOT NOW
    THE MARKET HAS CHANGED.
    EXAMPLE THE RESULT OF LONG TERM INVESTMENT MSFT, BA, GE,
    T, ALL GOOD STOCKS YOU WOULD NEED TO HOLD THESE STOCKS FOR PERHAPS 10 YEARS AND IF YOU ARE LUCKY MAKE 5%
    I COULD ACHIVE ON DAY TRADING A RETURN OF 40% TO 80%
    THE MARKET NO LONGER MAKE SENSE AS XOM EARNINGS GO UP OR COP EARNINGS GO UP THE STOCK GOES DOWN.
    SOME BANKRUPT COMPANIES SUCH AS AIR LINES WHEN OIL GOES DOWN THEIR STOCK GOES UP.
    JOSEH FOSTER USA UK.






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  •  
    Aug 02 12:37 PM
    Kelly, where do you live? Because what I see is totally different. No one I see or talk to is in that frame of mind. Stop listening to the News on TV and everything may get better. I hate to hear about people losing their jobs and they should be worried. But most and I mean most people are in good shape. We have so many complainers and slackers that I stay away from. You should too!
    Reply | Link to Comment
  •  
    Aug 02 01:22 PM
    Great article and good conversation after. I have to agree with Kelly, where before somewhat conspicuous consumption was fashionable among my friends and coworkers, the latest trends have been conservation and savings. Talk has turned to strategies for taking public transportation or taking local hiking trips rather than vacations to Europe which we would have done without worry a few years ago.

    My father is a disabled veteran, who currently lives on his $1500/mo disability check and is waiting to collect Social Security in 8 months. He isn't a complainer and certainly isn't a slacker, but all he talks about now is the cost to get to the VA hospital and the 25% increase he has seen in his grocery bill.
    Reply | Link to Comment
  •  
    Aug 02 02:02 PM
    Kelly L is right and x-terminator lives on another planet . All you geniuses who think that by investing in this market you will be rich by x-mas are in for a rude awaking . I'll bet when things go bad for you guys , you'll blame any and everyone for your loses but yourself .Like jjason complaining about his 401k or retired account going down and then complaining about the cost of gas and how the oil companies are gouging americans , meanwhile his retirement fund is most likely invested in these energy companies who are making money to fund his retirement . And he complains and blames evryone but himself . Don't blame the politicians , blame the people who put them there . I hope he gets what he wants , a completely democratic gov , which he will support , and then blame them when things go bad . The problem with america is people don't take time to learn about what the truth is , they simply watch TV and believe the bias and prejudice they spew . So , as america sinks to 3rd world status , don't blame anyone but your self .
    Reply | Link to Comment
  •  
    Aug 02 02:53 PM
    I suppose my two cents worth of comment is worth just that but the Fed trying to support the financials is just a useless exercise. At this moment in time the Fed thinks the economy and the financials will somehow come roaring back into profitable existance and yet the reality is that we have EXCESS FINANCIAL CAPACITY and the demand for fanancial transactions are DOWN DOWN DOWN so the Fed support of these dying institutions at this moment in time is a big money loser to the country. Engineering major contractions is the right thing to do. Everbody that has FDIC protections should survive...the rest is questionable.
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  •  
    Aug 02 03:34 PM
    this is all just vegas noe,only slower & nobody brings you a drink.co,s are beginning to eliminate matching funds to 401k plans.whine or dont whine,it makes no difference.the middleclass is done.the last to wake up are the beer(belgium) swillers when they no longer can fill the stadiums.dumb & dumber.
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  •  
    Aug 02 03:42 PM
    This is a great article - wise men acknowledge their own befuddlement. Fools trumpet their own wisdom and advise you to follow their advice to Hallelujah Land.

    I would rather read anything by Jason Kelly than the crap dispensed by his commenters, drawn like horseflies to honey.

    Reply | Link to Comment
  •  
    Aug 02 03:42 PM
    This is a great article - wise men acknowledge their own befuddlement. Fools trumpet their own wisdom and advise you to follow their advice to Hallelujah Land.

    I would rather read anything by Jason Kelly than the crap dispensed by his commenters, drawn like horseflies to honey.

    Reply | Link to Comment
  •  
    Aug 02 03:44 PM
    Alas, wise men rarely repeat themselves.
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