Fundmastery Blog

Will Top-Performing Value Managers — Bill Miller, Warren Buffett, Marty Whitman — Rebound?

Kurt Brouwer August 14th, 2008

Several fine value-oriented investors –Bill Miller, Warren Buffett, Marty Whitman & Dave Dreman — have struggled over the past year or more. This piece from Bloomberg [emphasis added] makes the point of how rough of a patch they are going through:

Value Stock Losers Miller, Buffett Poised As Winners (Bloomberg, August 11, 2208, Michael Patterson and Eric Martin)

Bill Miller, Martin Whitman and David Dreman, mired in the worst slumps of their careers, are poised once again to trounce the stock market.

…Growth investing, which focuses on companies with the fastest projected profit increases, beat value strategies for the first time this decade in 2007 and by 15.5 percentage points so far this year, the widest margin since 1980, according to data compiled by Paris-based Societe Generale SA.

The five prior times since 1952 that growth beat value two years in a row, the latter group recovered and won by 17 percentage points annually on average for seven years, the data from Societe Generale show. Cheap stocks are becoming more attractive because of tumbling commodity shares, which had led the five-year bull market that ended in October, according to Societe Generale’s James Montier, voted top global strategist in Thomson Extel’s survey since 2005.

Value stocks became a liability as even Warren Buffett’s Berkshire Hathaway Inc., the investment vehicle for the richest person in Forbes magazine’s 2008 global tally, fell as much as 25 percent from a December record. Miller’s Legg Mason Value Trust, which beat the Standard & Poor’s 500 Index for 15 years through 2005, lost 27 percent including dividends this year, Bloomberg data show.

…”This is one of the worst periods I’ve seen for value,” said Dreman, 72, who oversees about $15 billion as chairman of Dreman Value Management LLC in Jersey City, New Jersey. “The more it underperforms, the more it normally snaps back. The probabilities are very strong we’ll have a major upswing.”

By way of background, growth funds primarily invest in companies that are experiencing rapid growth in revenues and earnings. In addition, growth funds are usually fully invested, that is they hold small amounts of cash. Value mutual funds primarily select companies that have strong balance sheets and stable yet growing revenues. However, some companies are selected by value funds because of their potential for a significant turnaround in revenues and earnings. Value funds are more likely to hold significant cash positions when the fund’s management thinks stocks are fully valued.

Even though value-oriented mutual funds have struggled recently, I think this has actually been less of a traumatic period for them than the 1990s technology and growth stock boom. That slump, which lasted for five years — 1995-1999 — led to an almost existential crisis among value managers because they began to question their philosophy of value. Back then, value investors and value mutual funds were often viewed as archaic relics of an earlier — and somewhat quaint — school of investing.

In fact, it got so bad that one prominent value manager — Julian Robertson — closed his value-oriented hedge funds and gave investors their money back. Here is what he wrote in a letter to his investors on March 30, 2008:

Since August of 1998, the Tiger funds have stumbled badly and Tiger investors have voted strongly with their pocketbooks, understandably so. During that period, Tiger investors withdrew some $7.7 billion of funds. The result of the demise of value investing and investor withdrawals has been financial erosion, stressful to us all. And there is no real indication that a quick end is in sight.

...I have decided to return all capital to our investors, effectively bringing down the curtain on the Tiger funds. We have already largely liquefied the portfolio and plan to return assets as outlined in the attached plan…

Even though Mr. Robertson wrote that there was no end in sight, in fact, his letter was sent out about the time that growth and technology stocks began to stumble. The closure of the Tiger funds was an almost perfect reverse indicator.

The Bloomberg article continues:

The flagship funds run by Miller, Third Avenue Management LLC’s Whitman and Dreman are headed for their worst annual performances, data from Chicago-based Morningstar Inc. show, after subprime losses roiled financial markets and sent the S&P 500 into a bear-market decline of more than 20 percent from its October record. Omaha, Nebraska-based Berkshire had its steepest first-half drop in New York trading since 1990.

The investors’ stock picks retreated as U.S. companies trading at the lowest prices relative to cash flow trailed the most expensive shares compared to cash flow by 15.5 percentage points in 2008, according to data compiled by Montier and Kenneth French, a finance professor at Dartmouth’s Tuck School of Business in Hanover, New Hampshire.

…That’s the widest margin that “value” lost to “growth” on an annual basis since a 28-point gap in 1980 and follows a 4.5-point underperformance last year, Montier said in a July 30 report.

...Miller, Whitman and Dreman adhere to the investment philosophy pioneered by Benjamin Graham, the late money manager and author of “Security Analysis.” Buffett, who attended Graham’s Columbia University classes in New York in the 1950s, used the strategy to transform Berkshire from a failing maker of men’s suit linings into a $179 billion company by purchasing assets he deemed cheap…

The value managers listed above all are serious, disciplined investors with excellent tracks records. They have had dismal performance for a year or two after many years of excellent results. Bloomberg continues:

Miller’s $9.7 billion Legg Mason Value Trust was dragged down by McLean, Virginia-based Freddie Mac, the U.S. mortgage- finance company hobbled by record foreclosures, and Arlington, Virginia-based AES Corp., a power producer with operations in more than two dozen countries. Investors fled, causing the fund’s assets to fall more than 50 percent in the past year. The Massachusetts state pension fund fired Legg Mason last week, citing “inconsistent” returns.

“The best time to buy our funds or to open an account with us has always been when we’ve had dismal performance,” Miller, 58, wrote in a letter to shareholders two weeks ago. The Baltimore-based investor said he’s a “long-term optimist” even though “valuation appeared not to matter” in recent years.

…Whitman’s Third Avenue Value Fund returned 958 percent from its inception in November 1990 through July, according to New York-based Third Avenue’s Web site. The S&P 500 gained almost 500 percent, including reinvested dividends, during the same period, Bloomberg data show.

The $9 billion fund lost 19 percent in 2008…

Dreman lost 19 percent for clients in his $7.1 billion DWS Dreman High Return Equity Fund this year as Minnetonka, Minnesota-based UnitedHealth Group Inc., the largest U.S. medical insurer, slumped. The fund had outperformed the S&P 500 for seven straight years through 2006…

In answer to the question in the title of this post — will great value managers rebound? — the answer is yes, I believe they will. Now, it is important to evaluate whether or not the manager still has the motivation, the energy and the passion to do the things that made him great in the first place. Assuming that is the case, then I am very confident these managers will rebound.

Miller’s point above — that the time to buy his fund is when performance has been poor — may be self-serving, yet it is also probably true. I recently saw a quotation from the late, great Sir John Templeton, founder of the Templeton family of mutual funds (now Franklin Templeton). Templeton said this,

…buy at the point of maximum pessimism…

This point of Templeton’s echoes a comment my good friend, the late Claude N. Rosenberg, Jr., made in an interview in Kurt Brouwer’s Guide To Mutual Funds (Wiley 1990). Claude founded two very successful investment firms, was the author of several fine books and was a great humanitarian and philanthropist (see here for more on Claude). Here was Claude’s point from that lengthy interview in my now out-of-print tome:

…I can’t overstress the importance of avoiding the latest hot investment and focusing on areas that are out of favor. Attention to these two points could probably make you a 50 percent better investor, all by itself.

…With mutual funds, you should periodically take money from the best-performing fund and put it in a well-run fund that’s been out of favor.

As Claude pointed out later in the interview, this is a sound strategy, but difficult to carry out. First, you have to put money in a mutual fund that is currently exhibiting very doggy behavior. Another problem with being contrarian is that the out-of-favor portfolio managers can stay out for quite a long time. So, you have to be patient. But, you also have to have a bit of courage too.

Update: Here are more mutual fund posts:

The Best Fund Manager — Robert Rodriguez

Gross Likes Dollar vs. Euro For First Time

Morningstar: Top 10 Mutual Funds For Net Cash Outflows

Morningstar: Top 10 Mutual Funds For Net Cash Inflows

Selected American Shares — Success Under Stress

Sequoia Fund To Open Up Again