If you were learning to play golf, you'd probably be pretty grateful to get a few pointers from Tiger Woods. And if you were taking up tennis and John McEnroe offered to help you with your backhand, you'd probably listen.So it is with investing and Bill Miller, the manager of ( LMVTX) Legg Mason Value Trust, a past master of Wall Street. Until last year, he had beaten Wall Street, as measured by the Standard & Poor's 500 index, for a record 15 consecutive years. Much of the financial press have been focusing lately on the fact that the record ended in 2006 (more about this later). But Miller's latest letter to shareholders instead discusses something much more interesting -- he explains how he did it. Miller says that if you want to find value in the market, you shouldn't just look for stocks that appear cheap compared with their net assets or next year's projected earnings. He says the real value investor needs to look at a company's stock price compared with all of its future cash profits -- including those many years in the future. "As I often remind our analysts," he writes, "100% of the information you have about a company represents the past, and 100% of the value depends on the future." That's why, for example, he was able to make big profits for his investors in technology stocks back in the late 1990s, when most "value" funds avoided them because they looked too expensive. And it's why he was willing to pony up for stocks such as Amazon ( AMZN) and Google ( GOOG) in the recent years.
Amazon is still one of his biggest holdings, even though the Internet retailer is once again unloved by Wall Street. Miller says investors are wrong if they believe the company will suffer from low margins forever. When Miller screens stocks for those likely to beat the market, he pays close attention to two things: companies with a high cash-flow yield, which means high cash profits compared to the stock price, and companies that are spending a lot of money buying back their shares. (Aside: A London-based portfolio manager with a terrific 30-year record once shared with me the rules of investing he had accumulated over that time. Among them: "Strong cash flow is almost always the basis for sustained outperformance.") Miller says he finds a sustained edge by fighting Wall Street's mob mentality, which he calls "the source of the only enduring anomalies in an otherwise very efficient market." Wall Street, he says, tends to overreact to short-term events. The market may also be too slow to change its mind about a company with a troubled past. Miller says that that's how he once got a good deal on shares in Xerox ( XRX) and that it's why he thinks he has a bargain now in Sprint ( S). He is happy to buy a good stock caught up in a scandal, when most people are too afraid to.
"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," he writes. Most portfolio managers pay a lot of attention to sector weightings, making sure they own stocks in each sector in order to make them diversified. Not Miller.He just looks, from the bottom up, for stocks that offer the best balance of potential reward to risk. He doesn't want to be in every sector, because, as he points out, that would guarantee that he was in the worst ones as well as the best. As for diversification, he says most "growth" or "value" funds don't really have it. Yes, they may own lots of different stocks. But their investments all tend to have the same characteristics. Your typical "value" fund, for example, will usually have all its money in stocks with low price-to-earnings ratios. And you'll often find that those tend to rise, or fall, together. Instead, Miller diversifies by looking for shares that are going to move independently of each other -- regardless of which sectors they are in. Miller also believes the technology industry is more predictable than most people believe it is, which creates opportunities for a value investor. He cites a study by a scientific think tank, the Santa Fe Institute, that argues that although technology changes rapidly, market shares often do not.
He says concentration only works when you see chances to make some really big profitable bets on individual stocks. In the past year, when value was spread more evenly, being too concentrated ended up hurting his fund. Miller enters 2007 very bullish: As RealMoney.com's James Altucher pointed out earlier this month in his story "Bill Miller's Internet Stock Revenge," Miller has revealed he is starting to use leverage to buy stocks for the first time since 2002. As of Dec. 31, 2006, his top 10 holdings were power company AES ( AES), Tyco ( TYC), Sprint Nextel, UnitedHealth ( UNH), Amazon, Google, Wall Street bank JPMorgan ( JPM), Qwest Communications ( Q), Sears ( SHLD) and mortgage lender Countrywide Finance ( CFC). One final note: Miller-watchers always focus on his Value Trust fund. But since the end of 1999, he has also run the smaller, lesser-known ( LMOPX) Legg Mason Opportunity Trust . And it's doing better -- a lot better. Value Trust only rose 5.85% last year, compared with 14.8% for the S&P 500. But Opportunity Trust grew 13.41%. In fact, over its seven-year life, Opportunity Trust has produced four times the profits of Value Trust -- an overall return of 96% compared with 22%. The reason? This fund gives Miller much greater freedom, and he can take more risks and put more money into small-cap stocks and foreign markets. The current differences: Two of this fund's top three holdings are steel companies -- U.S. Steel ( X) and overseas giant Mittal ( MT). Naturally, the fund is more volatile. But it's also making the returns. Incidentally, I'm kicking myself, because I have had a small stake in the Value Trust for years, but I have nothing in the Opportunity Trust.