10 January 1999 | The New York Times
by EDWARD WYATT
BALTIMORE, Md. — Perhaps it is the references to the fiction of Jorge Luis Borges, the late Argentine author whose metaphysical imagery he uses to illustrate a point about price-to-earnings ratios. Or maybe it is the nods to the philosophy of William James, whose theories are called upon to justify why America Online is a value stock. Certainly some hint is in the “thought experiments” that he calls upon his staff to perform.
Spend even a few minutes talking with William H. Miller III and it becomes clear that he is not a typical mutual fund manager.
The performance of his fund speaks to that. In each of the last eight years, the $6 billion Legg Mason Value Trust has outperformed the Standard & Poor’s 500-stock index. Since the beginning of the 90s, shareholders of the fund have seen their investment grow by 453 percent, or 20.9 percent a year, on average — well ahead of the 17.8 percent annual return of the S&P.
None of the thousands of other mutual fund managers currently plying the trade has equaled that feat; barely 1 in 10, in fact, have beaten the benchmark over the last three years. Anyone else aspiring to the mantle of fund manager of the decade should note that not even Peter Lynch, the legendary former overseer of the Fidelity Magellan fund, ever strung together such a consistent record.
Yet almost nothing that Miller does would seem to fit within the traditional parameters of the religion he claims to practice: “value investing,” the method of buying assets for a small portion of their true worth whose best-known evangelist is Warren E. Buffett.
By contrast, Miller, 48, oversees a portfolio whose two largest holdings are Dell Computer and America Online, stocks whose market values have been hyperinflated by the craze for anything to do with the Internet. Such stocks are all but shunned by strict value types.
That those two stocks account for more than three-quarters of the gains in the Legg Mason Value Trust over the last two and a half years only adds to the skepticism of people who doubt that Miller is anything more than a crowd-follower. Without those investments, Miller might be just another value fund manager, struggling to keep up with a runaway bull market.
At the least, the holdings raise questions for current and prospective investors in his fund — including whether he can realize profits without causing huge tax burdens for fund shareholders.
Soft-spoken and unflappable, Miller expresses confidence in both his methods and the results, steadfastly defending his style as holding to traditional value methods.
“Most people don’t want to figure out what a company is worth,” Miller said. “They want to know where the stock is going. We’re always trying a Rubik’s Cube approach, looking at something from all different directions. We want to know, ‘What’s the best description of what’s going on?‘”
It is an approach he honed in the mid-1970s at Johns Hopkins University as a graduate student — not in business, but in philosophy.
Michael Hooker, a former philosophy professor at Johns Hopkins who is now chancellor of the University of North Carolina at Chapel Hill, recalls his first impressions of Miller. “Every morning I was the first faculty member to get to work,” Hooker said. “And when I would arrive, Bill would be sitting in the faculty library reading The Wall Street Journal. It was odd.”
Over months of talking to Miller about a dummy portfolio he was managing and hearing Mr. Miller’s excited explanations of the theories of Buffett and Benjamin Graham, the father of value investing, Hooker began to discern in the student “an ability to connect the dots where other people don’t even see the dots.”
Hooker encouraged his protege to quit philosophy — before earning the doctorate he had been studying for — and to try his hand at finance.
The principles that have had the greatest influence on Miller are those of William James, the father of the school of philosophy known as pragmatism. James believed that the way one knows that an idea is true is if it is useful, and that knowledge can be rightly understood only in its context. To Miller, that means that the value of companies like America Online and Dell Computer must be considered in light of how technology is changing the ways in which companies do business and people communicate.
For example, technological advances that let companies better control their inventories have taken some of the big swings out of the economy — and, as a result, out of the fortunes of historically cyclical companies, like makers of heavy equipment.
Traditional value investors might be tempted to buy those relatively cheap, cyclical stocks, in anticipation of the next big upturn in the economy. Miller, however, thinks any such swings will be longer in coming and of smaller significance than history teaches.
By contrast, Dell serves companies capitalizing on this new economy — and its own inventory controls are the envy of its industry.
“It is a lot like the change from an agrarian economy to an industrial economy,” Miller said. “It didn’t happen all at once; it happened very subtly, year after year, but the accumulated change was very large.”
That way of thinking also informed the discussion of America Online on a recent blustery December morning at the offices of Legg Mason, hard by Baltimore’s Inner Harbor. The evening before, American Online had been selected as the newest addition to the S&P 500. Its stock was certain to open higher, as investors anticipated the surge of buy orders that would come from index funds that track the S&P.
On that morning, Miller was meeting with his team of analysts and portfolio managers, who contribute to the Value Trust but who also manage four other funds, Legg Mason Special Investment Trust, Total Return Trust, American Leading Companies and Focus Trust. The topic was whether America Online’s rising value should lead the fund to sell some of its shares.
The fund had bought the stock in late 1996, when a flood of new subscribers to America Online overwhelmed the capacity of the service’s computers. Investors, fearing that subscribers would flee from the service, sent the shares down 50 percent from their high.
But Lisa Rapuano, an analyst on Miller’s team, believed that Wall Street misunderstood the significance of America Online’s problems. The higher demand meant customers loved the service, she figured — that it was changing the way that millions of people gathered and shared information. She convinced Miller to buy a million shares for the Value Trust.
Now, two years later, America Online’s shares were trading at about $138, about 15 times the $9 or so that Value Trust had paid. Based on Ms. Rapuano’s models, which calculate the immediate value of the future cash flows of America Online’s business, the stock was close to its full value.
But in the longer term, Ms. Rapuano said, America Online’s potential remained great. “The company has a $60 billion market value,” she said. “In our long-term model, this is potentially a gigantic company — $200 billion to $300 billion over the next 10 years. Over the next 12 to 24 months, we shouldn’t have quite so much in AOL, but that doesn’t mean we don’t want to have a large position over the 5-to-10 year horizon.” The fund sold a few hundred thousand of its eight million shares that day.
In the roughly two years after Miller bought America Online and Dell Computer for the Value Trust, those stocks grew to account for 14 percent and 9 percent of the fund’s assets, respectively. But even though the fund took in more than $3 billion in new cash from investors over that period — by itself enough to triple the fund’s size — the fund has made no additions to those holdings. On balance, the fund has sold more than $100 million of those stocks since its first purchase.
Still, it is unusual for a fund called the Value Trust to be holding on to stock that trades for 600 times the company’s earnings, as America Online does. The issue is not lost on Miller.
“There are a lot of value funds out there with good long-term records and not-so-good one- and five-year records,” he said. But he said the Value Trust’s superior performance this decade goes beyond Dell and America Online.
In the early 1990s, Miller invested a big portion of the fund in bank and financial stocks, which were depressed because of high interest rates and worries over loans to developing countries. Since then, financial stocks have been among the market leaders, and the fund still counts many of them among its holdings.
In the mid-1990s, the Value Trust snapped up shares of health care companies when they were beaten down by concerns over President Clinton’s health care plan.
“I’ll easily trade no rate of return in the near term for higher confidence that a stock will outperform in the long term,” he said.
There are plenty of examples of that philosophy in the Value Trust’s portfolio. Consider Circus Circus, the casino stock that Miller bought in the first quarter of 1996 — at the same time he bought Dell Computer.
While Dell’s shares have since increased 35-fold, Circus Circus has fallen from the mid-30s to $12. Miller has responded by gradually quadrupling his holdings of Circus Circus, to more than five million shares — more than 5 percent of the company. And recently he has been adding shares of Mirage Resorts and MGM Grand as well.
“The stocks are flat, but the cash flows of gaming companies have been growing,” he explained. With new construction slowing down in Las Vegas, Nev., Miller expects those companies’ cash flows to soar.
Low-priced assets, high cash flow, a business turnaround — all traditional value-investing approaches, Miller points out.
How to detect the signs of change that will lead to big turnarounds in a company’s market value is the subject of an exercise occasionally used by Miller for his team of analysts and portfolio managers. He calls the drills “thought experiments.”
In a recent example, Miller — drawing on the work of Douglas North, the 1993 Nobel laureate in economics — asked the group to think of two continents with the same climate, land mass, indigenous populations and natural resource base that were settled at about the same time. Then, he asked them to figure out why one had created enormous wealth and the other had not.
Like many experiments in a science lab, the “answer” lies as much in the process as in the results. The continents, he explained to his team, are North and South America, and the application of traditional economic theory might lead one to conclude that, because the two continents started with equal assets, they should have been able to create equal levels of wealth.
But when viewed in the context of the ideas and institutions that guided the settlement and development of North and South America, Miller said, those assets have very different values — and the outcomes, of course, have been far different, too.
What does any of that have to do with managing a mutual fund?
“It gives us a framework to think about things,” said Jay Leopold, who follows health care and finance companies for Miller’s team. “He doesn’t cram philosophy down our throats. But he gets us to think about how the context of something affects the anticipated outcome.”
Miller also draws on the work of the Santa Fe Institute, a research organization in New Mexico devoted to studying the science of complexity — things like swarm behavior, the collective actions of groups of bees, ants, birds or portfolio managers.
Just as managers have swarmed to stocks with even a glancing connection to the Internet, so have traditional value investors fled from the high price-earnings ratios that those stocks carry.
“People look at price-earnings ratios like the Aleph,” referring to the Borges short story by the same name. “The Aleph” is a mystical tale of a man who discovers in his cellar a point in space that contains all points in time, a center of infinite knowledge where, Borges writes, “without admixture or confusion, all of the places of the world, seen from every angle, coexist.”
To perceive the P/E ratio as an Aleph, a be-all indicator of a company’s value, Miller says, is a “pathetically simple view,” one which would have led him to sell his most successful investments months ago. No simple ratio can tell everything that any investor — value or otherwise — needs to know about a stock.
One of the monumental tasks ahead of Miller is dealing with new investors, who likely believe that the fund’s 40 percent annualized returns over the last four years should continue.
“The probabilities favor those returns being a lot lower in the future,” he said. “Our record looks great right now,” he added. “But I’ve had streaks that look really bad. We could have a streak that makes us look really mediocre.”
In fact, he eschews summing up his legacy. “As William James would say, we can’t really draw any final conclusions about anything.”