Fund Lessons From Bill Miller

NEW YORK ( TheStreet.com) -- Last week, I shared a profile of leading growth stock investor, Peter Lynch. Lynch, a former golf caddy, eventually went on to manage one of the best-performing mutual funds of all time. By following a number of personal rules, including know what you own and investing in things that are boring, Lynch helped the Fidelity Magellan Fund ( FMAGX) grow from $20 million to $14 billion before he retired.

This week we'll consider a growth investor who has made a significant mark in the investment world during the past several decades. He has his own approach to stock picking and has influenced many of today's most successful and promising fund managers -- including the top guns at Fidelity: Bill Miller.

Soon after Peter Lynch broke millions of investors' hearts by retiring from the mutual fund management game, a man named Bill Miller took over sole management of a struggling fund called Legg Mason Value Trust ( LMVTX). That was back in November 1990. He then proceeded to outpace the S&P 500 for 14 straight calendar years -- thrashing Peter Lynch's previous record of seven years.

Many investors know Miller as a value investor -- so what's he doing in a series about great growth investors? Well, for one thing, he bought shares of skyrocketing technology stocks such as AOL ( TWX) (up 3000% from 1997 to 1999) and Dell ( DELL) (up more than 1000% during the same period) during the late '90s. And unlike many of the so-called growth investors who piled into those stocks 10 years ago, Miller sold them before the tech bubble burst. What's more, he did so because he understood their business models and prospects better than most of his peers.

Miller laid the intellectual groundwork for his famous technology investments in the early '90s. Like other value funds, LMVTX had spent the '80s buying stocks that looked cheap based on traditional measures such as price/earnings ratios.

But Miller noticed that value stocks as a group tended to suffer through long droughts. He investigated and found that most low P/E stocks were shares of cyclical companies with modest long-term returns on capital. Their returns grew during the early stages of an economic recovery, but fell when the economy slowed -- and the firm's stocks fell with them.

In contrast, some firms had business models that could consistently generate superior returns. Buy those stocks cheaply enough, and you might enjoy strong investment results over an entire economic cycle.

The trick was to spot those superior business models before other investors did. Miller's first big find was Dell, which Value Trust began buying in March 1996. Other value players also liked the stock for its single-digit P/E -- the result of concerns that competition would dampen returns for PC makers. But those value investors abandoned Dell once its P/E rose into double-digits. Miller held his shares as the price and P/E skyrocketed -- and the value of the fund's holdings climbed to more than $1 billion.

Miller held on because he believed the company's business model could generate returns high enough to justify the share price. The company's direct sales kept overhead down (no stores; low inventory) and profit up. Customers loved Dell's prices and made-to-order PCs, so revenue was soaring. And the faster Dell grew, the more cash it generated -- new customers paid immediately, but Dell didn't have to pay its bills for months.

Miller reduced Value Trust's technology stake before the Nasdaq's big tumble in the spring of 2000. He figured technology stocks were priced to reflect economic growth of 6% or 7% -- which wasn't sustainable. The risk in the stocks had climbed dramatically, so he sold them.

In the early part of the decade, Miller came up with other ways to sustain his fund's shining record. He has owned, or still owns, shares of growth stocks that he considers undervalued ( Google ( GOOG) has been a big winner) as well as dirt-cheap shares of neglected or out-of-favor companies such as Tyco International ( TYC) and Eastman Kodak ( EK). That eclectic mix is testimony to his view that the distinction between growth and value investing is largely artificial. Smart investors, he rightly points out, take a company's growth prospects as well as its share price into account.

During the most recent global economic downturn, Miller's choice to hold onto financials proved that even the best investors make mistakes. During the inflation of the financial bubble, Value Trust saw a great deal of growth. However, when that bubble popped, it dragged down Value Trust and Miller along with it.

However, today, with signs that the economy is beginning to heal, the same companies that dealt the damaging blow to Miller, including Goldman Sachs ( GS), J.P. Morgan Chase ( JPM) and Wells Fargo ( WFC), are also the same ones that are helping to assist the fund's recent resurrection.

These profiles of great stock pickers suggest that labels such as "growth investor" or "value investor" can be useful, but it's important to look beyond them when you're examining the methods and performance of any fund manager. We do just that when we're evaluating the funds in our model portfolios. It's just possible that some of the managers at those funds will be remembered as great investors in their own right.

-- Written by Don Dion in Williamstown, Mass.
At the time of publication, Dion had no positions in stocks mentioned.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.