January 15, 2004, 9:18 a.m.
Benchmark Beater
The Value Trust streak continues.

For the 13th year in a row, a mutual fund called Legg Mason Value Trust (LMVTX) has beaten the benchmark Standard & Poor's 500-stock index. No other fund has come close to this amazing feat. In fact, most funds, most of the time, fail to return more than the S&P, which is a good proxy for the market as a whole.

Value Trust has:

Returned 43 percent for 2003, including dividends, compared with 28 percent for the S&P.

Returned an annual average of 17.4 percent for the past 10 years, compared with 10.6 percent for the S&P.

Finished in the top quartile (that is, among the top 25 percent of all stock funds) for nine of the past 10 years.

Turned a $10,000 investment, made at the fund's inception on April 16, 1982, into roughly $300,000.

But the most incredible achievement of low-key fund manager Bill Miller is his winning streak against the S&P since 1991, the financial equivalent of Joe DiMaggio's 56-game hitting streak in 1941. In fact, Miller's mark may be even more impressive: He achieved it in markets that were led by hot tech stocks and markets that were dominated by stodgy value stocks, in good times and bad, and, in recent years, by comfortable margins.

Bill Miller seems to be playing in a different league from his competitorsí. Using a computer screen provided by Morningstar, the scorekeeper for mutual funds, I looked at the 10 U.S.-stock mutual funds with the highest annual average returns through the 10 years ending a week ago. Legg Mason Value Trust ranked seventh, but all the others were niche players: small-cap funds like Wasatch Ultra Growth (WAMCX), mid-caps like Calamos Growth (CVGRX) and specialty portfolios such as Vanguard Health Care (VGHCX). Value Trust was far and away the best of the broadly diversified large-cap funds.

Calamos, a superb fund whose praises I sang more than a year ago, returned an average of 21.2 percent for the past decade, but it failed to beat the S&P in six of the past twelve years. Wasatch Ultra trailed the benchmark in five of the eleven years since its inception, including a deficit of 34 percent in 1997.

Bill Miller's success is so far off the charts that you have to ask whether it is superhuman. Quite simply, portfolio managers are not supposed to be this good. Is it mortal genius, or is it celestial luck?

Under the Efficient Market Hypothesis (EMH), which is widely accepted by economists, today's stock price reflects the sum of contemporary investor knowledge. It is, therefore, the "right" price for the moment. Stock movements in the future simply cannot be known from the perspective of the present; they perform a "random walk." If EMH is correct, you can't beat the market consistently through superior intellect. Stock pickers who appear to be brilliant, or have a hot hand, are actually just lucky (just as someone at a roulette table who makes a winning bet on number 29 three times in a row is lucky).

EMH posits that managers of diversified portfolios have roughly the same chance of winning, so a smart investor should refrain from being enticed by the funds that are doing well right now and simply buy those with the lowest expenses — which tend to be index funds that use computer programs to mimic the markets.

Still, under EMH, it is possible for a few managers to beat the market by wide margins.

Imagine, for simplicityís sake, that the odds of a manager achieving returns greater than the S&P index are even (actually, they are a bit worse than that, but let's keep it easy) in any calendar year. In year one, therefore, a manager has one chance in two of beating the index. The chances of a manager beating the S&P in both year one and year two are 1 in 4. The chances of beating the index in years one through thirteen are 1 in 8,192 (2 to the 13th power).

The Investment Company Institute reports that there are now 4,682 funds, so it's not out of the question for Miller's apparent genius to be merely a stroke of very good luck. In other words, if you ask 4,682 people to flip a quarter over and over, there's a decent chance that someone will get heads 10 or 12 or even 13 times in a row.

Still, my own judgment is that Miller is smart, not lucky. The best evidence is that he started running another Legg Mason fund, Opportunity Trust (LMOPX), at the beginning of 2000, and this one has done even better than Value Trust — and with different stocks. Opportunity Trust clobbered the S&P in all four years, broke even in 2000 and 2001 (while the S&P was losing a total of more than 20 percent), and in 2004 returned 67 percent. Opportunity Trust is more aggressive than Value Trust, and it owns companies that are smaller. It is not a minor variation on the older fund but a new invention that also has a perfect record against the benchmark. For example, among the top 20 assets of both funds at last report (September 30), only three names are the same: Amazon.com (AMZN), Tyco International (TYC), and AES Corp. (AES).

It's safe to say that Miller is not throwing darts. He is good — very, very good, and he proves the validity of what Warren Buffett, chairman of Berkshire Hathaway Inc., said about academic advocates of EMH 15 years ago: "Observing that the market was frequently efficient, they went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day."

Yes, some people can beat the market, but not many, and they aren't easy to identify. Besides that lesson for small investors, Miller's success provides these:

To win spectacularly, you have to take risks. Morningstar's proprietary rating system ranks Value Trust's risk level as "high," and its beta is 1.19, indicating a volatility that's one-fifth higher than the market as a whole.

Miller's strategy is to find stocks that are being shunned by the market but that (in his estimation) shouldn't be. Often those are companies with troubles that Miller figures to be temporary. Such assessments can, of course, be a lot riskier than simply relying on tried-and-true growth stocks or plodding value companies that pay a consistent dividend.

But it's a rule in finance that higher risks produce higher rewards. Miller, for example, has been a buyer of Tyco, a conglomerate torn apart by scandal, its chief executive on trial, its balance sheet overloaded with debt. Miller believed that Tyco had excellent assets and that it was being vastly undervalued by the market; he made it his third-largest holding, worth 6 percent of the entire portfolio. And, in fact, Tyco shares have doubled in price since March. Lately, with much the same idea in mind, Miller has been buying Eastman Kodak (EK), once the world's photography champ and lately left in the dust by the digital revolution.

Buy and hold. For Miller's strategy to work, he needs time. He owns few stocks — just 32 in Value Trust, and the top ten of those constitute more than half the fund's assets — and, when he decides on a purchase, he's a believer. He's in for the long haul. For the past decade, the fund's turnover rate has been 20 percent annually; in other words, he holds the average stock for five years, compared with about one year for the typical fund manager.

Miller never lost faith, for example, in Amazon. He continued to buy it when it was ridiculed by analysts and, as Morningstar's Christopher Traulsen puts it, "reviled by investors." This year, Amazon has performed beautifully — both as a business and as a stock. It's up 179 percent. Only now, with Amazon representing nearly one-tenth of his total portfolio, is Miller lightening up on his holdings. Another big gainer this year has been the wireless firm Nextel Communications (NXTL), a similarly reviled stock that Miller bought and held. Despite rising 143 percent this year, Nextel still trades at a modest price-to-earnings ratio of 13.

Be eclectic. While Miller uses the term "value" in his fund's name, he's not a conventional value investor. He owns stocks like Amazon and Home Depot (HD) that can only be called "growth" companies; that is, they are rapidly increasing their sales and earnings.

What Miller seeks are companies that are underestimated. Investors assume Amazon's sales will grow, but Miller guesses they will grow a lot more than the consensus.

Miller also has catholic tastes when it comes to sectors. Lately he sees financial stocks as unappreciated. Among his top 15 holdings are six financials: Washington Mutual (WM), MGIC Investment (MTG), J.P. Morgan Chase (JPM), Citigroup (C), Bank One (ONE) and Fannie Mae (FNM).

Are there drawbacks to Legg Mason Value Trust? Well, it's not cheap. The fund charges an annual expense ratio of 1.76 percent, considerably higher than average. By comparison, the leading fund that tracks the S&P, Vanguard 500 Index (VFINX), charges 0.18 percent. Fidelity Contrafund (FCNTX), which a few years ago I called the best all-around core mutual fund, charges 0.99 percent.

One of the best large-cap funds, Dodge & Cox Stock (DODGX), charges only 0.54 percent, despite returning an annual average of 14.9 percent over the past 10 years and whipping the S&P and 98 percent of all funds. (But Dodge & Cox failed to beat the benchmark in five of the last nine years and Contrafund in four of the last nine.) Calamos charges 1.4 percent in annual expenses but, unlike Value Trust and the others, also adds a front-end load, or commission charge, of 4.75 percent.

In fact, Miller's accomplishment is even more impressive when you consider his high expenses, which are deducted before returns are calculated. In other words, he's beaten the S&P 13 years in a row with one hand tied behind his back. His ten-year average annual return, before expenses, is more than 19 percent, compared with less than 11 percent for the benchmark.

But can Miller keep it up? Let's put it this way: I have been writing with enthusiasm (though not this much) about Legg Mason Value Trust for about five years now, never expecting the streak to continue. Evidence: I never bought the fund myself. Certainly past performance is no guarantee of future results, but does it really make sense to ignore someone who can pick stocks the way Bill Miller can?

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com . Of the stocks and mutual funds mentioned in this article, he owns Amazon, Washington Mutual, Home Depot, and Fidelity Contrafund — but not, alas, Value Trust. This article originally appeared in the Washington Post.

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